Strategic Exchange

Five currency myths debunked

June 21, 2023 by Peter Muldowney

Coin Stacks Sitting on A Financial Graph Background.

Institutional investors often grapple with the decision to hedge or not to hedge against currency fluctuations when investing in non-domestic investments. A common concern is the relative strength or weakness of different currencies, such as the Canadian dollar compared to the US dollar. These considerations have led to the rise of several currency myths that can influence investment decisions.

Myth 1 – Companies are equally affected by currency fluctuations.

While most companies in the global equity market have multi-currency costs and revenues, the impact is not experienced equally. The global equity market can be divided into four broad company classifications.

Multinational Natural resource Exporters Domestic focus
Coca-Cola Shell Nissan Itau
Unilever AngloGold Ashanti Swatch Unibanco
Multinational Coca-Cola Unilever
Natural resource Shell AngloGold Ashanti
Exporters Nissan Swatch
Domestic focus Itau Unibanco
 

Multinational companies represent the largest component and have revenues and costs in multiple currencies. The returns and volatility of individual companies will therefore respond to foreign exchange fluctuations relative to each company’s domestic currency.

For natural resource companies, such as those in the energy and mining sectors, changes in the price of the associated commodity are the biggest driver of returns and volatility.

Exporters earn most of their income outside of their home country, so a weak domestic currency can be beneficial as products will be more competitively priced, while a strong local currency can have the opposite effect.

Domestically focused companies conduct most business in their home market, so currency fluctuations have a low impact on returns and volatility.

Myth 2 – Investment managers take care of currency risk management.

Approaches to currency management vary based on individual investment managers’ style and process. The typical first consideration is stock-specific by breaking companies into broad classifications noted in Myth 1 to evaluate how each is managing the currency impact to the business, allowing the investment manager to identify the “true” currency exposure of individual companies.

Fundamental investment managers review currency overweight positions resulting from the stock and sector selection process to determine whether to hedge closer to the benchmark allocation. Such analysis does not always result in hedging.

In contrast, systematic (quantitative) managers will often perceive currency exposure different to the benchmark as an uncompensated risk and the currency differences from the stock selection process are hedged to be broadly neutral to the benchmark, after considering the costs associated with hedging.

Myth 3 – Global equities are more volatile than Canadian equities.

Over shorter-term periods (e.g. rolling three years), the returns of global equities have generally been less volatile than Canadian equities despite the currency exposure, although there are short-term periods when global equities can be more volatile. Figure 1 displays the relative volatility of returns over rolling three-year periods for Canadian equities (as represented by the S&P/TSX Index) compared to global equities (as represented by the MSCI World Index unhedged). When the volatility line is above the 0% horizontal line, Canadian equities were more volatile. Conversely, when the volatility line is below the horizontal line, global equities were more volatile. There has generally been more occasions when Canadian equities were more volatile.

Figure 1: Canadian vs. global equity relative volatility

Source: Bloomberg and MSCI

However, longer-term analysis (10-year rolling returns) highlights that global equities have almost consistently been less volatile than Canadian equities (Figure 2), benefitting from a more diversified universe of investment opportunities.

Figure 2: Canadian vs. global equity absolute return volatility

Source: Bloomberg and MSCI

Myth 4 – Hedging reduces global equity volatility.

As institutional investors often hold diversified portfolios that include global equities, currency exposure is an important consideration. Despite the common belief that hedging currency exposure is necessary to reduce volatility, research shows that this may not always be the best approach. Figure 3 illustrates how rolling three-year return volatility has generally been lower for unhedged returns, particularly since the mid-1990s. This is because currency movements can offset changes in equity returns, leading to lower overall return volatility. When the relative volatility line is above the 0% horizontal line, hedged global equity returns were less volatile. When below the 0% horizontal line, unhedged global equity returns were less volatile.

Unhedged currency exposure can offer potential benefits, such as the ability to profit from favourable currency movements. However, currency risk can also increase overall portfolio risk and should be carefully monitored and managed to ensure it remains within an acceptable level for each investor’s unique circumstances.

Figure 3: Hedged vs. unhedged global equities

Source: Bloomberg and MSCI

Myth 5 – Hedging 50% currency exposure is the optimal strategy.

Research papers often point to a 50% hedge ratio as being optimal. However, hedging decisions will vary by investor and depend on their specific currency exposure and risk perspective. For example, hedging strategies should be tailored to an investor’s specific portfolio. Figure 4 highlights that the level of hedging needed is dependent on each investor’s total currency exposure. Both Investor A and B have net 30% currency exposure, despite having very different hedging ratios.

Figure 4: Implications of 50% hedge ratio

  Currency exposure (a) Hedge ratio (b) Net currency exposure (a-b)
Investor A 60% 50% 30%
Investor B 30% 0% 30%
Investor A Investor B
Currency exposure (a) 60% 30%
Hedge ratio (b) 50% 0%
Net currency
exposure (a-b)
30% 30%
 

From a risk perspective, a 50% hedge ratio can be recommended to manage “regret risk,” the potential regret that an investor may feel if they adopt an unhedged or fully hedged approach that later turns out to be the wrong decision.

Figure 5 compares the rolling three-year performance of unhedged US equity returns less fully hedged returns (orange line) and unhedged returns less a 50% hedge ratio (green line). When the rolling three-year relative return is above the 0% horizontal line, an unhedged strategy outperforms. When the relative return is below the horizontal line, a hedged strategy outperforms.

Figure 5: Regret risk currency management

Source: Bloomberg and MSCI

The 50% “regret risk” hedging approach minimizes extreme outperformance or underperformance, which can be beneficial for some investors.

In a perfect world, investors would prefer a dynamic approach to currency management, allowing them to take advantage of a weakening Canadian dollar by remaining unhedged and using hedging strategies when the Canadian dollar strengthened.

One such consideration could be to set thresholds to trigger the timing and amount of currency to hedge based on the currency’s relative strength or weakness. Figure 6 below outlines illustrative thresholds used for a US equity index portfolio.

Figure 6: Dynamic thresholds

Exchange rate (USD per 1 CAD) % of US equities to be hedged
Greater than $0.90 0%
$0.85 to $0.90 20%
$0.75 to $0.85 40%
Less than $0.75 60%
Exchange rate (USD per 1 CAD) % of US equities to be hedged
Greater than $0.90 0%
$0.85 to $0.90 20%
$0.75 to $0.85 40%
Less than $0.75 60%
 

Based on rolling three-year relative return analysis, Figure 7 shows the difference in returns between a fixed 50% hedge approach compared to a dynamic thresholds approach. There is no consistent benefit from the dynamic thresholds approach and in fact, the largest outperformance was from the fixed hedge strategy from 2005 to 2013. The analysis does not consider the cost of hedging. Given that the dynamic approach requires more time and governance oversight and took decades to generate a material benefit, it’s likely that it would have been discontinued in favour of other strategies with greater potential benefit.

Figure 7: Fixed vs. dynamic hedging (relative returns)

Source: Bloomberg and MSCI

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CC&L Financial Group Ltd.
June 21st, 2023