Currencies are notoriously difficult to forecast, but they have a substantial impact on portfolio risk and return. Over time, exchange rates can move either gradually or in sudden bursts because of macro factors – interest rate or growth differentials – geopolitical events, or government interventions.
For this reason, it is more productive to concentrate on the impact currency approaches have on portfolio returns rather than trying to forecast their absolute movements.
One well known, but often overlooked, impact of currencies is their effect on portfolio returns where they act as an accounting tool. Unless a portfolio is invested solely in domestic assets, the accounting of profits and losses will be done in reference currency. Therefore the portfolio performance might be heavily influenced by changes between the reference currency and the investment currency.
To illustrate this point, in 2016 if you were a US dollar-based investor invested solely in S&P 500 stocks, your calendar year return for 2016 would have been 10.9 per cent. If you were a sterling-based investor in the same assets, your return would have been three times as much. This is an extreme example, but it illustrates the concept and from an investor’s point of view.
It is interesting to see where your returns are coming from. In this case, more than two thirds of the returns were as a result of currency movements, whereas the commonly accepted thought is that the main driver of returns is asset allocation.
One solution to this conundrum might be to systematically hedge every investment back to the reference currency. While this is a good idea on paper, it can produce wide differences in returns.
Looking at global equities, portfolios hedged back to currencies with high interest rates tend to perform better than those hedged back to currencies with low interest rates. The annualised returns of Barclays Global Aggregate index hedged into different currencies produce very different outcomes, with sterling providing 5 per cent, but the euro 4 per cent. The Australian dollar leads the way with 7 per cent.
Leaving investments unhedged can lead to wide discrepancies in absolute returns, but also in risk-adjusted returns. Hedged returns tend to provide better risk-adjusted returns, as over the longer term currencies increase volatility, but not returns. Also, most global indices are heavily skewed towards US assets and as a result the difference between hedged returns and unhedged returns are limited. For other currencies, the return differences can differ widely depending on timing.
Fixed income assets are generally considered less volatile and therefore it makes sense intuitively to hedge any foreign currency risk. But is it the same for equities? The commonly accepted thought is that equities embed a degree of currency hedging because companies usually have their own hedging policies. While this may be true, it is difficult to understand the extent to which this hedging occurs.
Furthermore, not all indices are created equally when it comes to foreign currency exposure. In 2016, 32 per cent of S&P 500 revenues were non-domestic versus 72 per cent for the FTSE 100, and 42 per cent for the EuroStoxx 50.
Based on this, it seems the FTSE would be the best candidate for hedging.
However, the reality seems to be different. In 2008, as the dollar played a safe haven role, both the pound and the FTSE fell together while after the Brexit vote, that correlation was completely inverted.
It is interesting to note that due to these correlations, in a multi-asset portfolio, mixed hedged and unhedged assets improve the risk-reward ratio. A portfolio with a 50 per cent allocation to global fixed income and 50 per cent in global equities hedged to sterling would have provided annualised returns of 7 per cent with 6 per cent volatility. Unhedged this becomes 8.2 and 7.5 per cent and mixed-hedged results in 7.8 and 6 per cent.
The fully hedged portfolio has a better risk-reward ratio; however, hedged fixed income and unhedged equities can have an important impact on absolute return numbers.
As currencies serve as an accounting tool, this introduces a bias in portfolio structuring and allocation. By removing any currency impact on portfolio returns it means that a portfolio will have to be structured either as a fully domestic portfolio or a geographically diversified portfolio, hedged back into the reference currency. In both cases, impact on absolute returns can be significant.
Signia Wealth investment team
