Don’t Ignore Currency Exposure When Investing Globally

Managing Exposures in 2021

In 2021, U.S. investors are likely to find improved return opportunities in overseas markets. This increased investment offshore creates currency exposure which is often an implicit bet rather than an intentional investment decision. In this text, we explore how currency exposures can be managed to lower risk or enhance return.

When U.S. investors make allocations to international assets, they are inevitably exposed to exchange rate fluctuations. For example, a US investor who buys an international developed-market ex US equity index implicitly has a long position in a basket of currencies consisting of roughly 30% euro, 23% Japanese yen, 13% pound sterling, 9% Canadian dollar, and other currencies.¹

That currency exposure can have a large impact on realized returns to the US investor. Between the start of 2017 and the end of March 2020 - a period of U.S. dollar strength - the currency-hedged MSCI ex USA index outperformed the un-hedged version by 11%. Since then, roles have reversed and the un-hedged index did better by 8.5%.²

Leaving foreign currency exposures un-hedged could be an implicit bet on continued U.S. dollar depreciation. However, for many investors the foreign currency exposure is not an investment decision they expect to earn returns from, but instead a mere by-product of the equity position. In that case, the unintended risk could be reduced or molded into rewarded risk.

Currency Hedging for Risk Management

Currency hedging using forward exchange contracts is a good way of reducing the unrewarded risk from currency. By selling an appropriate amount of foreign currencies forward, hedging creates positions that move in the opposite direction to the currency exposures in the underlying portfolio. In a static currency hedging program, a constant percentage of the foreign currency exposure is hedged, for example, 50% or 100%.

In our view, static currency hedging (on average) reduces risk without giving up expected return when looking at an appropriately long period. For that reason, some academics have called currency hedging a "free lunch."³ 

1 2 3 4
View single page >> |

¹ These are the currency weights in the MSCI ex USA index. Source: MSCI, as of 29 January 2021.

² Source: MSCI, Refinitiv Datastream, as of January 29, 2021.

³ ...

more
How did you like this article? Let us know so we can better customize your reading experience.
Comments have been disabled on this post.