FX vol threatens portfolio returns

By:
Farah Khalique
Published on:

Volatile currency markets in 2015 threaten to erode international investors' portfolio returns on traditional equities and bonds, highlighting the need for a strong hedging strategy, advise market participants.

Volatility in currency markets appears to be here to stay in 2015 – welcome news to FX traders who have long been starved of interesting currency moves that determine their P&L. 

Furthermore, smart investors can employ a more dynamic, dual strategy to not only hedge their existing portfolio but also generate more speculative profit on the back of currency swings.

One of the main drivers of volatility – the gulf between the US's economic recovery success story and Europe's struggle to fully rebound from the financial crisis – shows no sign of abating. Bank analysts predict that FX volatility is likely to spiral higher this year, as central banks continue to meddle with markets.

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However,  such volatility is not always welcome news for international investors with multi-asset portfolios, particularly in equities and bonds. The continued strengthening of the US dollar versus a gamut of currencies can wipe out returns for US investors with foreign investments.

For example, Toyota Motor Corporation returned 63.1% in 2013 for Japanese investors buying the stock on the Tokyo exchange, but the dollar-denominated US listing of Toyota returned only 33.4%, according to data compiled by Deutsche Asset & Wealth Management. This is because the US dollar steadily strengthened against the yen in 2013, so, for a US-based investor, almost half (47%) of the stock’s return was lost to changes in the exchange rate.

The US dollar is widely expected to continue appreciating for years to come, as its economy rebounds. Analysts at Barclays examined the impact on an international portfolio, hedged and unhedged, of a trend rise in the dollar.

The research, published last week, found that an increase in FX market volatility can erode portfolio returns, but FX hedging can generate "superior risk-adjusted portfolio returns during market stress and in 'normal' periods".

"We construct a standard 60%/40% (equities/bonds) international portfolio and find that higher Sharpe ratios – ie, risk-adjusted returns – are achieved, both ex-ante and ex-post, through FX hedging of the bond portfolio," the report states.

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Hedging options

The main hedging instruments to manage currency risk are currency futures, forwards and options contracts. Currency forwards are relatively straightforward to employ – the buyer can buy or sell a foreign currency at today's prices – and are priced cheaply in today's low-interest-rate environment, says Chris Turner, head of FX strategy at ING.

However, the premium for buying options – which offers a pay-out to the buyer if a certain pre-determined scenario is fulfilled – has risen due to heightened volatility in currency markets.

"Options prices have generally moved higher – it's a bit like the cost of insurance," says Turner. "The cost of paying out is perceived to be higher when there is more volatility."

A cheaper, hedging strategy for currency-conscious investors that is growing in popularity is currency-hedged exchange-traded funds (ETFs). ETFs are cheaper than traditional mutual funds because they passively track an index, say the FTSE 100, as opposed to buying the securities in that index. A currency-hedged ETF gives investors the chance to profit from a rising stock index without the headache of currency volatility eroding returns.

The two largest currency-hedged ETFs in the world – US-listed WisdomTree Japan Hedged Equity Fund (DJX) and the Europe Hedged Equity Fund (HEDJ) – have approximately $11.7 billion and $6.3 billion assets under management, respectively, as of the end of January.

Chips on the table

However, the downside of mitigating currency risk is that investors can lose out on potential profits, if currencies move in their favour.

Barclays' results demonstrate a clear benefit to hedging international bond portfolios in global portfolios, but it notes that an alternative approach is to implement a "dynamic hedging strategy", such as currency overlay, where FX is treated as an asset class in its own right and actively managed relative to a benchmark.

Axel Merk, president and CIO of Merk Investments, believes active management is the best strategy, and cautions against simply trying to remove currency risk altogether.

"An international investor is either taken for a ride by leaving currency risk in there or is leaving chips on the table by taking currency risk out," he says. "Our view is that you should be actively trying to manage currency risk. If you want to take it out that's fine, but don't always think it's going to work in your favour."