The Case for Not Currency Hedging Foreign Equity Investments: A U.S. Investor’s Perspective by Catherine LeGraw. GMO.
Investors often ask about GMO’s approach to currency hedging, even more so recently as the U.S. dollar has strengthened. We hedge currency for fixed income investments as they represent a nominal stream of cash flows in the local currency, but we do not typically hedge currency for equity investments. In the age of globalization, most companies have multi-currency costs and revenues; shorting the local currency on top of the equity investment does not hedge an exposure, but rather adds new risks to the investment. Therefore, as a rule we do not hedge currency for equity investments, but there are exceptions. For example, if we owned a portfolio of domestically-oriented stocks with most costs and revenues in a local currency, we may decide to hedge the currency exposure.
Many investors cite volatility reduction as a rationale for currency hedging. In this paper, we intend to show that:
1. While currency hedging may reduce volatility over short investment horizons for USD investors, it does not reduce volatility over long horizons;
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2. Volatility reduction has decreased over time as companies have become more global;
3. Even if currency hedging reduces the short-term volatility of the international equity holdings, it does not reduce the volatility of the global equity portfolio because hedged equities are more correlated with U.S. equities than unhedged equities;
4. Hedging introduces leverage, which can lead to higher tail risk.
Although we do not employ simple currency hedging strategies for international equity investments, we engage in active currency management, incorporating currency positions supported by highconviction views.
The Case For Not Currency Hedging Foreign Equity Investments – Introduction
Many investors ask whether we hedge the currency risk associated with positions in non-U.S. equites. To adequately address this question, it is necessary to describe our investment philosophy, which drives our approach to currency management.
We believe that to be successful we must have a long horizon, understand that over that period fundamentals and valuations matter, and recognize that risk is not described by a single number.
Guided by these tenets, we will take active currency positions when we have a high-conviction view, but considering international equity investments, our default position is to own them unhedged.
Currency hedging is not hedging
In the age of global business models, most large cap companies are not exposed purely to the currency that their stock is denominated in. For example, roughly half of U.K. stock market capitalization is comprised of companies whose business has minimal exposure to the United Kingdom; these companies simply decided to list in London.2 Shorting the British pound against a basket of U.K. stocks does not “hedge” currency exposure; it layers on a directional short currency position.
From the perspective of considering currencies, companies can be divided into four categories (see Exhibit 1). Most companies’ cash flows are multi-currency; in some cases, the cash flows have no relation to the currency that the company’s stock is denominated in. For natural resource companies (energy, mining), the dominant exposure is commodity exposure. As commodities have a globally set price, the associated revenues are not linked to any particular currency. Multi-national companies have revenues and costs in many currencies, thus their cash flows do not have direct exposure to any one currency. Exporters earn the vast majority of their revenues abroad. Exporters may actually benefit from a fall in the home currency as their products become more competitive abroad; by the same logic, exporters can be hurt by the appreciation of the home currency as their goods become relatively more expensive. For that reason, an investor could rationally hedge the currency exposure of exporters by taking a long position in the home currency. Certain domestically-oriented companies, which do the vast majority of their business locally, do have exposure to the home currency. For these domestically-oriented companies, it may make sense to hedge currency exposure, but these companies make up only 15-25% of global market capitalization.
Globalization has increased significantly over the past 20 years. In 1992 60% of sales for developed international companies (as defined by MSCI EAFE) were domestic; today less than 35% of these companies’ sales are domestic (see Exhibit 2). For that reason, understanding the currency exposures of international stock holdings has become less straightforward over time.
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