Diversifying assets internationally
|Bonds & Currencies Indicator|
Where one is investing from is just as important as what one is investing in
The trend of investors diversifying their assets internationally has accelerated since the onset of the global financial crisis, prompted by a desire to spread exposure more widely, as well as a search for higher returns. Yet, with international exposure, of course, comes the question of what to do with the associated currency risk.
Dealing with foreign exchange risk should be part and parcel of any overseas investment decision. The traditional options are generally to be completely hedged or completely un-hedged. These two extremes, however, are not particularly thoughtful in terms of risk management. Instead, they imply strong views about the investor’s home currency, suggesting that it is seen as either very sound or very vulnerable.
An alternative approach is to exploit correlations between asset prices and exchange rates to improve a portfolio’s return characteristics. Importantly, these efficiency gains are not dependent on market views, and tend to be robust over time, the key driver being the relationship between the underlying asset class being invested in and the home currency of the investor. In other words, it not only matters what is being purchased, but also from where.
This is best illustrated by an example. For an Australian dollar-based investor buying local currency emerging market debt (EMD), both the home currency and the underlying asset class have similar drivers, and tend to be highly correlated when looked at from the alternative perspective of the US dollar. However, the Australian dollar is generally more sensitive to these common drivers than EMD. As a consequence, the risk characteristics of EMD held by Australian investors can be improved by selling US dollars back into Australian dollars in the form of a currency overlay. With the correct hedge ratio, volatility is minimised and the resultant portfolio becomes independent of the direction of the Australian dollar. Importantly, the outcome is fairly robust to different assumptions about the right hedge ratio.
The chart below illustrates this example: the volatility of returns of the EMD portfolio declines as the Australian dollar hedge ratio increases from zero, until an optimal hedge is achieved and then begins to rise again as hedging is increased further. The sweet spot denoting the optimal hedge ratio is large, giving plenty of margin for error, and is reasonably stable through time.
Source: Investec Asset Management, month-end data to Feb 2012 in AUD. EMD is a 50:50 mix of JP Morgan GBI EM and EMBI Global Diversified Indices from Dec 2002, JP Morgan GBI EM Global Index and EMBI Global Diversified Index from Dec 2001, and a 35:65 mix of JP Morgan ELMI+ Index and EMBI Global Diversified Index before Dec 2002 with an additional 25% in the ELMI+ funded out of 1 month dollar Libor, AUD hedged and unhedged returns are calculated using Bloomberg data for AUDUSD exchange rate and 1 month USD & AUD LIBOR
Gains can also be made by optimally hedging the currency exposure of other combinations of assets and home currencies. Indeed, to a greater or lesser extent – irrespective of asset class or investor base currency – we believe it has always been optimal from an efficiency perspective to hedge some of the currency exposure associated with global portfolios. By-and-large, asset classes with a higher fixed income component have shown greater gains in efficiency than equity-centric funds. This is due to the importance of currency returns to global fixed income performance and the greater overlap of macroeconomic drivers between fixed income assets and currencies, than between equities and currencies. The investor’s home currency is also significant, because the success of currency overlays that rely on correlations between exchange rate and asset class movements is proportional to the sensitivity of both to common underlying drivers, whether fundamental or financial. Fortunately for most investors, including those with US dollar, euro, sterling, yen and Australian dollar currency bases, exploitable relationships appear persistent.
A fully hedged or un-hedged approach to foreign exchange management has almost always proven sub-optimal from a risk-management perspective. This is because the connection between currency movements and other asset class returns is effectively short-circuited, instead of gainfully utilised. By taking advantage of the joint distribution of currencies and other assets, more efficient global portfolios can be constructed. Thus, irrespective of the underlying investor’s outlook or risk-appetite, an improvement to the risk / return characteristics of their international holdings can almost always be achieved with the use of an appropriate currency overlay strategy.
However, the extent of this improvement is not uniform, but depends on the home currency of the underlying investor (i.e the basis on which portfolio performance is ultimately judged) and the asset class being invested in. Understandably, the lower the volatility of the original assets relative to currencies and the more underlying macroeconomic drivers held in common between exchange rates and the end-assets, the greater the potential for portfolio efficiencies.
Currency overlays should continue to benefit portfolio construction, because their success relies on asset class correlations, rather than far more fickle individual asset co-movements. It is also the reason why the underlying trend – if there is one – of the home currency is not the fundamental determinant of global portfolios being made more efficient through the use of a currency overlay. A partially hedged strategy will outperform an un-hedged position in a period of appreciation of the investor’s home currency, while reducing volatility, but higher risk-adjusted returns are generally also obtainable with the use of an optimal hedge, even if the home currency depreciates consistently throughout the holding period. This is very significant, as it demonstrates that the use of these currency overlays is not outlookcontingent and makes their adoption a serious consideration for traditionally un-hedged global asset holdings.
Finally, the pragmatic implementation of these currency hedges – calibrated according to investors’ home currencies and particular global portfolio – is encouragingly robust. Empirically, the spectrum of improvement in the return / risk characteristics of global fund holdings versus an entirely un-hedged position is sufficiently extensive, that even if the optimal hedge ratios are not obtained, the case for currency hedging is unambiguously compelling, as in the Australian example above. Furthermore, if an increasingly correlated world is here to stay, then we believe the use of such hedges and a more nuanced assessment of the currency performance of global assets will become a necessity, rather than a luxury.
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