Investors with significant international holdings often hedge their currency exposure to protect their portfolios against movements in the exchange rate. This strategy is intended to provide an investor with returns that approximate the return of the local market by removing the impact of any appreciation or depreciation of the local currency vis-à-vis their home currency.
But for Canadian-based investors who hold equities in currencies commonly considered to be reserve currencies—such as the U.S. dollar and the British pound sterling—historical analysis has shown that an unhedged strategy can decrease the volatility of returns. This is because the investor’s exposure to the exchange rate (CAD/USD, in the U.S. case) is negatively correlated with foreign equities in reserve currencies, and any loss on the foreign asset is mitigated by currency exposure.
With the intent of minimizing regret, many investors choose a hedge ratio on a “basket” of foreign equity—in other words, hedging a portion of the portfolio to lower the effect of foreign exchange movements. However, this approach may mask the relationship between individual currency pairs, which may not be obvious in an aggregate basket.
A better solution could be to implement a strategic currency hedging policy that incorporates the following three key elements:
- evaluate the Canadian currency against select reserve currencies rather than a basket of foreign currencies;
- base the policy on forward-looking beliefs rather than historical data; and
- adopt a strategy based on purchasing power parity (PPP) to enhance returns. (PPP is based on the “law of one price” stating that exchange rates between currencies are in equilibrium when their purchasing power is the same.) Those investors who believe that the Canadian dollar is essentially a commodity currency and will therefore continue to show pro-cyclical behaviour (i.e., appreciating and depreciating in line with commodities) can reduce equity volatility by retaining foreign currency exposure, especially to the U.S. dollar. In addition, investors who believe in PPP can follow a simple dynamic rule to enhance returns.
Commodity Versus Reserve Currencies
Commodity currencies, such as the Canadian and Australian dollars, tend to show pro-cyclical behaviour. Reserve currencies, on the other hand, tend to show anti-cyclical behaviour—particularly when they benefit from a flight to quality during times of economic and financial stress. For Canadian and Australian investors, therefore, exposure to foreign currencies is anti-cyclical and reduces risk.
Based on the premise that commodity currencies are pro-cyclical and reserve currencies are anti-cyclical, an analysis covering the period 1999 to 2013 (with selective analysis back to 1970) found:
- negative correlations between equities and currency surprise exposures to the U.S. dollar, euro, yen, pound and Swiss franc (Currency surprise is the difference between changes in exchange rates to be expected on the basis of the pure interest rate differential and the actual changes in exchange rates.);
- an especially high negative correlation between equities and currency surprise exposure to the U.S. dollar;
- lesser, but still negative, correlations between equities and currency surprise exposures to the pound and yen; and
- a positive or zero correlation between equities and currency surprise exposure to the Australian dollar, given that the Australian dollar and the base Canadian dollar are both commodity currencies.
A History Lesson
A Russell Investments analysis covering the 24-month rolling correlation of the S&P/TSX Composite Index with U.S. dollar currency surprise for the 14-year period between 1999 and 2013 found that the unhedged equity portfolio had the lowest volatility. Furthermore, its volatility (12.5%) was below that of the S&P/TSX Composite Index for the same period (15.4%). This is true for the full 1999–2013 period, the pre-2008 crash period and the post-2008 period, illustrating that currency exposure dampens U.S. equity market volatility for Canadian-based investors.
Extending the analysis back to 1970, the correlation remained negative for most of that time, except during the early 1970s. The 1970s is a particularly interesting period: the Canadian dollar became a floating currency in 1970, the U.S. dollar went off the gold standard in 1971, and the oil crisis hit in 1973. The oil crisis led to inflation and recession, so the premise that pro-cyclical currencies are affected by commodity prices is questionable in this type of environment. Therefore, should a commodity-led inflationary period cause recession at some future date, the implication may be that Canadian-based investors should hedge at least part of their foreign currency exposures.
Investment managers have traditionally evaluated the currency hedging decision by examining historical relationships. But, as the chart on page 78 shows, currency relationships change.
Canadian-based investors who believe the Canadian dollar will continue to be pro-cyclical should use an unhedged default hedge ratio (where the default hedge ratio refers to the static, or passive, portfolio hedge). If this forward-looking belief changes or becomes uncertain, investors should consider changing their currency hedging policies.
A Dynamic Approach
Research has shown PPP to be the most dependable value factor in currency markets over the long term. Since many factors affect exchange rates in the short and medium terms, PPP is a poor choice as an active management tool, but its long-term nature may be helpful in selectively adjusting a strategic policy.
The Russell analysis covering the 1999–2013 period determined that, at some point, every currency was undervalued and overvalued, and then eventually returned to parity. However, the cycles can be lengthy: an optimal policy that seeks to minimize volatility does produce undesirable returns for long periods of time.
Can investors use the characteristics of exchange rate movements relative to PPP to improve the performance of a static hedge ratio? One simple rule will test this idea: hedge exposure to currencies that are 20% or more overvalued, remain fully exposed to currencies that are more than 20% undervalued, and return to the default hedge policy only when the currencies get back to within +/- 5% around parity. T
his rule is designed to implement a simple process to occasionally adjust a static strategic policy. A simulation from 1999 (the inception of the euro) to 2013 resulted in 15 trades over this 14-year period, in addition to the five trades (representing the basket of currencies within the portfolio) at the start of the period. That’s one trade per year, on average, after inception. Relative to a default 50% hedge policy, the simulation provided 1.4% annualized additional return with similar portfolio volatility.
The dynamic PPP strategy has the intuitive appeal of being equilibriumbased and forward-looking—it does not rely on historical patterns or anomalies, and it considers the prevailing level of expected future exchange rates. Also, the strategy does not force investors to trade: it trades only when currencies are significantly out of line with PPP, when the risks and opportunities are the greatest. If currencies are well behaved and remain near parity, no trades take place, which supports low currency volatility in the portfolio.
Intuition may suggest that currency exposure will increase a portfolio’s volatility because currencies are volatile. However, this is not the case for Canadian-based equity investors, as the diversification effect of foreign currency exposure on equity portfolios is strong and persistent enough to more than offset the volatility of currencies. These investors, therefore, should remain unhedged, except perhaps to the Australian dollar. Combining an unhedged static hedge ratio with a dynamic PPP adjustment provides an opportunity for investors to both reduce risk and enhance returns.
John Osborn (now retired) was a senior consultant, and Kendra Kaake is a senior investment strategist, Canada institutional, with Russell Investments. kkaake@russell.com
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