Economics

To Hedge Or Not To Hedge – Currency Risk In Your Portfolio

Should I hedge currency risk in my portfolio?

This is a good question a subscriber asked. It is also a question I have given a lot of thought and done a lot of research on as I invest my own money wherever in the world I find the most undervalued good quality companies.

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What is a currency hedging?

If you have a portfolio with foreign currency denominated companies in it (Japanese for example) your portfolio will be hedged if you have an equal and opposite investment in the currency (a loan in Japanese Yen).

Do not worry if this is hard to understand the following example makes it easy to understand.

How does hedging work?

To hedge a currency you have to borrow the foreign currency and invest the borrowed money in that market.

Let’s look at an example.

Say the currency where you live is Euro and you want to invest in Japan but you do not want to sell your Euros and buy Japanese Yen because you are worried that the Yen will fall in value against the Euro and so give you a loss on the capital you invested.

To not have any Yen risk you have to borrow Yen and buy the shares in Japan with the borrowed Yen.

When you sell the Japanese shares you will use the money to repay the Yen you borrowed and only the profit or loss will have to be converted to Euro.

Remember you will ALWAYS have currency risk on your profit or loss as you only hedged (borrowed Yen) for the capital you invested.

But when you borrow money you have to pay interest.

You thus borrow Yen and have to pay interest on this loan. Some brokers allow you to do this quite easily but they charge quite a lot for these loans. And you have to pledge your portfolio to your broker as security for the loan. Remember the broker needs something as security should you not repay the loan.

Yen interest rates are very low but even if your broker charges only 2% per year - if you hold the investment for 3 years – the loan will cost you a total of 6%.

That is expensive!

What does the research say?

I looked for independent research on currency hedging and found two interesting research papers.

In the third quarter of 2015 GMO (www.gmo.com free registration required) published an interesting quarterly report called: Just How Bad Is Emerging, and How Good Is the U.S.? and Give Me Only Good News!

In the report they looked at the hedged and unhedged returns of emerging markets over the 20 year period from 1995 to 2015.

In the report they wrote:

Is it just a currency thing?

Falling currencies have indeed been a significant driver of losses in emerging equities over the past few years. In the 12 months ending September 30, for example, the local return to emerging stocks was -7.1% while the loss from the currency movements cost 13.1%. This might tempt one to think about currency hedging their holdings in emerging markets, but this turns out to be a bad idea historically. 

In fact, it seems to be a spectacularly bad idea, as we can see in Exhibit 3.

Currency Risk

Source: www.gmo.com Just How Bad Is Emerging, and How Good Is the U.S.? and Give Me Only Good News!

This is a truly striking chart. Since 1995, the rather anemic returns of +3.0% real in U.S. dollars for emerging equities turn into a truly depressing +0.9% real. So much for the idea of currency hedging! 

So for emerging markets hedging is a bad idea

So if you invested in emerging markets hedging currency risk was a bad idea over the 20 year period from 1995 to 2015.

In the newsletter I do not recommend emerging market companies which mean this research report is not that relevant but I am sure you also found its conclusion very interesting.

Another research paper

In 2007 The Brandes Institute, part of the respected value fund manager Brandes Investment Partners published a research paper called: Currency Hedging Programs: The Long-Term Perspective.

In the paper they looked at 34 years of data to find out if currency hedging is worth it.

The result of the paper can be summarised in the following chart which shows the benefit or loss to your portfolio if you hedged currency risk:

currency hedging 2

Source: Brandes Institute - Currency Hedging Programs: The Long-Term Perspective

What does the chart tell you?

What can you learn from the chart?

  1. The most recent currency movement is a bad predictor of future movements. This is especially true in times of wild currency movements. You can see this if you look at the small horizontal white line (Most Recent Quarter Result) in the chart. In nearly every time period it is at an extreme level compared to the median value in each bar. This means if you only look at the most recent currency movement (last quarter in the chart) to decide to hedge or not you may be making a big mistake as the next movement may be in the other direction.
  2. Currency movements are big over one year periods and remain large over five and even 10 years. This means you must be prepared for long periods of hedging losses or gains, or if you do not hedge, some big currency movement profits or losses.
  3. Your base currency matters as some currencies are more volatile than others.
  4. Hedging can make a difference if you plan to invest for less than five years. After that hedging gains and losses get smaller but they do not disappear. For example a US based investor that hedged currency risk over the 34 year period would have had an average annualised loss of 1.8%. That is a huge drag on performance but it could just as well have been a profit. The thing is you just don’t know.

In summary

What can we learn from the above two examples?

  • Hedging emerging market currency risk was a bad idea over the 20 year test period. Will this be any better in the future? – You and I do not know and if some expert says he does he is lying – humans can’t forecast as numerous research studies have proved.
  • Hedging currency risk of developed countries can give you a slight positive or negative return over 10 years, a lot larger gains or losses over 5 years and even more so over one year. If you want to avoid all currency profits or losses you must follow a strict hedging strategy and stick to it.
  • What both studies mentioned is that there is a huge behavioural risk that comes with currency movements. The risk is that you may want to predict future currency movements based on the most recent past, think 1 to 3 years, especially if you have just had large losses due to currency movements. The risk is that the loss may cause you to hedge your currency risk just as the currency turns around, resulting in your hedges causing you large currency losses.

Recommendation

I have been investing for 30 years and have never hedged currencies.

This is because:

  • It’s expensive
  • The part of your or my portfolio invested in different currencies being relatively small and
  • It makes investing even more difficult because you have to not only buy and sell a company but also manage the currency hedge
  • Over long periods of time currency movements net out to close to zero

I thus do not recommend that you hedge currency movements.

Keep it simple

Like you I want to keep investing as simple and systematic as possible. Hedging currency risk is not something I want to do if over time it is most likely to only increase or decrease your investment returns by a small percentage.

If you want to hedge – do this

You may have a different opinion to hedging currency risk and that could of course also be correct.

If you do you must make a conscious decision and then stick to it – this means hedge all the time. If not you will most likely start hedging after a large currency loss, just as the currency turns around.

Your not hedging analyst wishing you profitable investing

Tim du Toit

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Article by Quant Investing

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