Currency risk – how much hedging is necessary?
Globally diversified multi-asset investors inevitably have to address currency risks. Besides hedging costs and dedicated tactical views, just how much of a diversifying effect currencies have in multi-asset portfolios is also relevant. We examine this question taking into account various investment styles and risk profiles.
Author: Dr. Jérôme Koller, Senior Portfolio Manager Multi Asset Solutions
Combining different asset classes from a variety of regions in one portfolio involves positions in foreign currencies and therefore leads to currency risks. Exchange rate fluctuations can have a significant positive or negative impact on the total return of foreign investments. Our analysis of mixed portfolios with different investment styles provides orientation when deciding how much currency risk makes sense and how much hedging is necessary. Investors who are more risk-averse and tolerate little fluctuation in their portfolio can select the risk-based investment style "minimum volatility". Those who want the broadest possible diversification can opt for "maximum diversification". The focus here is less on absolute risk.
We will now examine these two investment styles for a variety of risk profiles with the Swiss franc as the reference currency. The risk profiles address different anticipated returns and volatilities, and therefore vary in their strategic allocation. In the "Relax" risk profile, fixed-income securities are predominant, while "Focus" concentrates almost exclusively on equities. We compare these with static investment styles with fixed hedging ratios. We refrain from using return forecasts and explicitly base our analyses on risk-based approaches.
"Full protection" may be more profitable...
Assuming investors always fully hedge their portfolio against foreign currency fluctuations, the following result emerges over time:
Fully hedged portfolios, regardless of the risk profile, perform better than portfolios without hedging (see table below). The surplus return is between 0.4 and 0.8 percentage points. "Full protection" has paid off, as the major foreign currencies have lost between 40 and 60 percent in value against the Swiss franc over the past 23 years.
...but the highest annual returns are achieved without hedging
In the "best year" category, portfolios without hedging take the lead. This goes for all risk profiles. The surplus return is between 1.2 and 2.5 percentage points. This shows that foreign currencies can generate added value with the right market timing. What's also interesting is that the maximum cumulative loss (maximum drawdown) of portfolios without hedging is similarly high relative to portfolios with hedging.
No hedging |
Relax |
Select |
Balance |
Ambition |
Focus |
Real return p.a. |
1.9% |
2.5% |
3.1% |
3.4% |
3.5% |
Real volatility p.a. |
5.1% |
6.4% |
9.0% |
12.0% |
14.2% |
Maximum drawdown |
-15.4% |
-19.2% |
-31.9% |
-42.6% |
-49.2% |
Best Year |
12.5% |
16.3% |
21.4% |
26.1% |
29.3% |
Worst Year |
-13.8% |
-14.4% |
-24.1% |
-32.5% |
-37.8% |
Full hedging |
Relax |
Select |
Balance |
Ambition |
Focus |
Real return p.a. |
2.7% |
3.1% |
3.6% |
3.9% |
3.9% |
Real volatility p.a. |
3.4% |
5.0% |
7.9% |
10.9% |
13.0% |
Maximum drawdown |
-15.6% |
-18.2% |
-30.8% |
-41.5% |
-48.0% |
Best Year |
10.0% |
14.4% |
20.2% |
24.8% |
27.5% |
Worst Year |
-13.2% |
-13.5% |
-21.9% |
-30.2% |
-35.5% |
Minimum volatility |
Relax |
Select |
Balance |
Ambition |
Focus |
Real return p.a. |
2.5% |
2.9% |
3.4% |
3.7% |
3.7% |
Real volatility p.a. |
3.3% |
5.0% |
7.8% |
10.9% |
13.0% |
Maximum drawdown |
-14.9% |
-18.3% |
-30.9% |
-41.6% |
-48.1% |
Best Year |
9.6% |
13.8% |
19.6% |
24.4% |
27.3% |
Worst Year |
-13.3% |
-13.4% |
-22.3% |
-30.6% |
-35.8% |
Maximum diversification |
Relax |
Select |
Balance |
Ambition |
Focus |
Real return p.a. |
2.4% |
2.7% |
3.3% |
3.6% |
3.7% |
Real volatility p.a. |
3.4% |
5.1% |
8.0% |
11.0% |
13.3% |
Maximum drawdown |
-15.1% |
-18.6% |
-31.3% |
-42.0% |
-48.6% |
Best Year |
9.4% |
13.6% |
19.9% |
24.7% |
27.6% |
| Worst Year | -13.4%
|
-13.6% |
-22.8% |
-31.1% |
-36.4%
|
(Source: Bloomberg, own calculations))
Minimum volatility
The table also shows that the "minimum volatility" investment style results in comparable values to "full hedging". In the risk-averse investment style of "minimum volatility", the foreign currency portion is almost always fully hedged due to the low fluctuation tolerance. However, this does not always make sense, as there are also phases in which the diversification potential of the currencies can lead to lower anticipated volatility.
This was the case, for example, for the period from the end of 2008 to the end of 2011. During this period, it would have been better for the "minimum volatility" investment style not to have hedged between 15 and 25 percent of a portfolio (assuming a 60-percent foreign currency share), depending on the risk profile. The development from the beginning of 2020 to the present day is also interesting. Over this period, the optimal unhedged foreign currency ratio has risen continuously and currently amounts to between 30 and 45 percent, depending on the risk profile. There has never been such a high ratio during the entire analysis period (since 1999).
This shows that the share of the hedged foreign currency ratio within portfolios should be treated flexibly and therefore also taken into account when constructing strategic allocations.
Maximum diversification
The "maximum diversification" investment style aims to achieve the broadest possible diversification in the portfolio. The absolute risk level is not the focus here and therefore the unhedged foreign currency ratio tends to be higher than with the "minimum volatility" investment style. Currencies can also make a significant contribution here. For the "maximum diversification" investment style, the dynamics of the correlation between investment markets and currencies are also reflected in the varying hedging ratios.
One notable finding is that in the "maximum diversification" investment style, the unhedged foreign currency ratio has been steadily increasing since the end of 2017. At present, the ratio is around 35 percent, regardless of the risk profile, and is therefore close to the "minimum volatility" investment style.
Summary
The foreign currency exposure does not necessarily have to be fully hedged for investors who aim to achieve the lowest possible risk ("minimum volatility") as well as the broadest possible diversified portfolio ("maximum diversification"). Rather, the diversification potential of foreign currencies should be used in order to further reduce the risk. At present, both risk-based approaches would permit around 35 percent of the foreign currency ratio to be unhedged, regardless of the risk level of the portfolio. Such a high ratio only occurs once in the period observed. Importantly, there is no universal answer to the question of how much of the foreign currency portion should be hedged, as this requires regular examination. Generally speaking, a lower correlation between asset markets and currencies, as is currently the case, allows a higher unsecured foreign currency ratio than a higher correlation.
Special thanks go to Dr Urban Ulrych for the valuable exchange.
