Dec 10 2015

Handle with care

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Anyone who has been on a foreign holiday will know the difficulty of predicting currency moves: “Should I buy some euros now, or wait until just before we go? Are we going to miss out on a big move while we’re out there?”

While the dilemma here really comes down to saving a few pennies on the cost of a poolside gin and tonic, for investors, getting currency decisions right can make a big difference.

At the moment, currencies across the world are being tugged on by both macroeconomic and technical factors. With sterling and the US dollar on the rise, and the euro and yen pushed down by extremely loose monetary policy, major developed market currencies are in a period of marked divergence. As a result, many investors may be wondering about whether to hedge out currency moves. But how do you know if hedging is appropriate? And how can you make sure investments are hedged efficiently?

Traditionally, investors tend to hedge their fixed income investments and not their equity ones. This makes sense: risk tolerance is inherently lower for fixed income investors, who are mainly concerned with securing steady predictable cash flows, than for equity investors, who are prepared to take extra risk for the chance of higher returns. Today, though, the potential for large currency movements may mean equity investors are more likely to be considering hedging than usual.

The potential for currency movements to impair the return on foreign securities is notoriously difficult to model, but there are a few rules of thumb that can help with the decision of whether or not to hedge.

First, enduring relationships between the behaviours of currencies and markets can serve as a rough guide. For example, as global risk appetite rises, European equities gain. Sterling, which has been seen as a pro-risk currency in recent years, also gains. That means the return to the sterling investor from European equities is reduced. As a rule, then, if your local currency tends to rise against other currencies when the foreign market you invest in rises, the currency effect will dampen your gains. Importantly, though, it works both ways: if the foreign market – European equities in our example – sees sustained losses, the corresponding fall in sterling should over time shield you from a portion of the losses.

While some may make the decision to hedge based on this directional call, hedging is more often used to remove volatility that currency movements can impose on returns in foreign currencies. The expectation is that hedging will smooth returns and lead to lower volatility over the lifetime of the investment. Again, this depends on whether and how your local currency moves vs. the foreign-denominated asset classes you invest in.

If the relationship is positive, as in our sterling/European equities example, a rising base currency will dampen the swings in foreign asset prices, reducing the return when the overseas investment rises and dampening losses when it falls. In this scenario, hedging the currency impact would actually lead to more volatility in returns. The choice to hedge, therefore, is determined by the foreign asset classes the investor intends to buy and the relationship between those asset classes and the base currency of the fund.

Looking at historical movements of key developed market currencies (the US dollar, the euro, sterling, the Japanese yen and the Australian dollar) and developed market equities (using the MSCI World index) reveals long-term relationships that are gratifyingly close to what we might expect. In the period from 2001 to today, the currencies we think of as safe havens (such as the US dollar and the Japanese Yen) – because they tend to appreciate when risk assets fall – are shown to have a negative correlation with global equities. The more cyclical pro-risk currencies, such as the euro and particularly the Australian dollar, are positively correlated with developed market equities.

Crucially, these are long-term relationships, and there are short-term exceptions: for example, over the last 12 months, the dollar has had a very strong rally despite the positive performance of risk assets.

This is an important reminder that whatever investors decide to do about hedging, it should not be a short-term decision. Effective currency hedging is not about trying to time and tap into short-term currency moves, but benefiting from the long-term relationships between currencies and asset prices to pursue smoother returns.

Nandini Ramakrishnan is a global market strategist of JP Morgan Asset Management