FX: Stronger euro prompts investors to reconsider hedging

The region’s currency has felt the benefit, rising to the highest level against the dollar since November in recent trade, leading some asset managers to ask whether it might be a good time to start hedging.

The tale of the euro in recent years has been one of steadily declining value, followed since the beginning of 2015 by a bumping along the bottom against the dollar, against which it hit a 14-year low in December.

However, since then, signs of economic revival have prompted a rally, and the euro was trading as high as €1.09 against the dollar late last week, before a weak inflation print took the wind out of its sails.

For asset managers in the eurozone who are invested around the world in a range of currencies, signs of an upturn in the euro present something of a conundrum.

For the past three years, buying non-euro denominated stocks and bonds has been an excellent carry trade, with investors able to obtain cheap funding through low European interest rates to buy securities in higher yielding countries, and at the same time to obtain a pick-up on the their currency exposure.

That double-whammy of additional beta has meant that any thought of hedging the euro has been largely ignored. Now, however, that might be about to change, with the currency risk of global investment coming back onto the agenda.

“If you look at euro dollar, we think that we are now in the last phase of dollar support, and that most of the coming US interest rate rises are priced in,” says Georgette Boele, a currency strategist at ABN Amro.

“Sentiment is going to change on the euro around the third or fourth quarter, and we see it rising to €1.10 against the dollar by the end of the year, and to €1.20 by the end of next year, when the ECB [European Central Bank] will probably hike.”

For a euro-based investor, some 84.7% of the MSCI world equity portfolio is exposed to foreign currency risk, with the exposure dominated by the US dollar, the Japanese yen and pound sterling.

Investors in overseas fixed income markets might face even greater risks. According to research by ECU Group, as much as 85% of the performance of an international bond portfolio can be attributed to currency volatility, compared with just 25% for a similarly internationally diversified equity portfolio.

“There is a golden rule of the currency risk of owning foreign bonds,” says Marc Ostwald, an FX strategist at ADM Investor Services. “And that rule is that there is no amount of carry you can achieve that isn’t easily wiped out by a sharp currency movement.”

Still, given the euro’s weakness in the recent period, few investors would have profited if they had hedged. Last year, an unhedged (euro-denominated) portfolio invested in the MSCI World Index outperformed the hedged portfolio, driven both by the interest rate and currency components of the portfolios.

“In the 12 months of 2016, the interest-rate differential was 1.1% and the currency difference was 1.6% – meaning a euro investor would have earned 10.7% from an unhedged portfolio and 7.8% from a hedged portfolio,” says Martin Kolrep, senior portfolio manager at Invesco Quantitative Strategies, in a note. “So a euro investor would have paid a high price for currency hedging.”

In fact, says Kolrep, the pattern of losing money from hedging overseas currencies and interest rates against the euro goes back to 2007. However, in the six years before 2007, an unhedged euro-based investor would have trailed a hedged investor by around 30%. Given the uneven performance over longer-periods of time, the best approach should be to hedge by degrees, he says. 

“Looking at the numbers suggests that it is sensible to partially hedge,” says Kolrep.

An investor following a risk parity strategy in US equities, treasuries, investment-grade corporate bonds, high yield and commodities would be exposed to an equal amount of volatility in each asset class, with bonds tending to dominate. For unhedged euro-based investors, portfolio volatility averaged 8.8% from 2001 to 2016, while complete hedging reduced volatility to 4.5%.

However, the best result – 3.9% volatility – would have been obtained by minimum variance hedging, which means allocating investment to assets with the lowest levels of currency volatility risk. By implementing a variance-minimizing currency allocation of the portfolio, the FX exposure on a back-tested basis between 2001 and 2016 varies between 4.1% and 40.4%, and averages 18%.

“Minimum variance reduced the average annual volatility of the portfolio to 3.9%,” says Kolrep.

A similar but weaker volatility dampening effect can be seen when the same minimum variance principles are applied to the MSCI equity portfolio, with no hedging producing volatility of 13.4%, full hedging leading to 14% volatility and minimum variance associated with 12.9% volatility.

“Based on past-performance analysis, neither full hedging of currency risks nor a complete lack of hedging deliver the reduction in risk sought by investors,” says Kolrep. “Depending on foreign currency weightings and the investor’s base currency, risk-based currency management can be used to reduce the overall risk profile.”