Download Disentangling returns from hedged international equities

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June 2009
Disentangling returns from hedged international equities
The purpose of this note is to describe the various sources of return that accrue to a USD-based
investor in international equities, including any hedging returns. We also comment on the importance
of being able to distinguish between these returns in reporting systems.
An investor in international assets (i.e. assets valued in a currency other than the investor’s base
currency) is exposed to two return streams, and a third if they hedge the currency exposure:
i)
the first return stream is that generated from movements in equity valuations of the underlying
portfolio, expressed in the local currency – so a USD-based investor in Toyota, for example,
would earn a 5.0% local equity return, expressed in local currency, if Toyota’s Tokyo-listed
share price increases from ¥4,000 to ¥4,200;
ii)
the second is that generated from movements in the exchange rate between the local
currency and USD – so the USD-based investor in Toyota, which has a ‘long’ exposure to
Japanese Yen (JPY) through this investment, would earn a further 3.1% currency return in
USD terms if JPY appreciates versus USD from a JPYUSD exchange rate of 100 to 97 (i.e.
3% fewer JPY are required to buy one USD than previously);
Please note that these two return streams can be combined – so the USD value of one Toyota share
has increased from $40.00 (¥4,000 ÷ 100) to $43.30 (¥4,200 ÷ 97), which represents an 8.2% USD
equity return (not 8.1% as the two streams are linked geometrically, not added together).
iii)
the third return stream is that generated from hedging, should the investor hedge. If the
investor hedges passively, with a 100% hedge ratio (i.e. hedging 100% of overseas
exposures), the hedge should produce an equal but opposite hedging return stream to the
currency return in (ii) above.
Record’s active hedging process, by contrast, is intended over longer periods to generate an
opposing positive return stream if the currency return is negative (i.e. hedge depreciating
foreign currencies), but limits negative returns to risk management costs if the currency return
is positive. Please note that this relationship is not necessarily seen every month, due in part
to the historic ‘ladder’ of positions established once the program is up-and-running, but does
emerge over time.
We can illustrate these elements for May 2009:
i)
the change in the MSCI EAFE Net Local Currency Index gives a local equity return of 5.3%
between April 30 and May 29, 2009;
ii)
the local currencies in the MSCI EAFE Net Local Currency Index experienced a weighted
average currency return of 6.2% – i.e. appreciation versus USD – in May 2009; and
iii)
combining the local equity and currency returns confirms the USD equity return, before
hedging, of 11.8%, matching the change in the MSCI EAFE Net USD Index.
RECORD CURRENCY MANAGEMENT LIMITED
MORGAN HOUSE, MADEIRA WALK, WINDSOR, BERKSHIRE, SL4 1EP, UK
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The chart below illustrates each of these elements:
114
14%
112
12%
110
10%
108
8%
106
6%
104
4%
102
2%
100
0%
MSCI EAFE Net Local Currency (LHS)
98
-2%
MSCI EAFE Net USD (LHS)
96
-4%
Weighted average currency move (RHS)
-6%
94
30-Apr
05-May
07-May
11-May
13-May
15-May
19-May
21-May
26-May
28-May
This chart illustrates the potential scale of currency movements compared to local equity movements
– over this one-month period, both made an approximately equal contribution of around 6% to the
USD-denominated equity return of approximately 12%.
The significance of both the local equity return and the currency return in determining the USD equity
return, and the lack of any systematic relationship between the two, means that reporting systems
capable of separately identifying these two elements, plus any hedging return, are absolutely key. It
is often the case that some enhancement to existing systems is required to distinguish properly
between these items, and we would be happy to discuss this further.
A more sophisticated approach
The analysis set out above, whilst intuitive, is somewhat flawed in that neither the local equity return
nor the currency return, as expressed, are in fact available to a USD-based investor. The local equity
return is not available because a USD-based investor will always necessarily determine their returns
in USD terms, and the currency return is not available as spot currencies are not directly investable.
Fortunately a solution exists, by separating the currency return into two further elements – “forward
return” and “currency surprise”. “Forward return” refers to the appreciation or depreciation of one
currency versus the other as anticipated in the relationship between the currency spot rate and the
forward rate - the forward rate is determined by the ratio of the two currencies’ interest rates 1 .
“Currency surprise” refers to the difference between the spot rate at the end of the period, and the
forward rate that could have been obtained at the start of the period, for a transaction settling at the
end of the period. These two elements can be shown diagrammatically as follows:
1
ABfwd = ABspot x (1 + iA) / (1 + iB), where AB is lower interest rate currency / higher interest rate currency
100
99
"Forward
return"
JPYUSD
98
97
"Currency
surprise"
Currency
return
96
95
Spot
Forward "fall line" on 30 Apr
94
30-Apr
04-May
08-May
12-May
16-May
20-May
24-May
28-May
01-Jun
05-Jun
09-Jun
Note: forward "fall line" is illustrative only
The USD equity return set out above can then be re-expressed in elements that are accessible to a
USD-based investor:
USD equity return = local equity return + 2 currency return
= local equity return + forward return + currency surprise
= hedged equity return + currency surprise
Here, the hedged equity return is the return that a USD investor would have earned by entering into
a forward contract (in this example, to sell JPY) at the same time as buying a JPY-denominated
security, and thereby locking-in the USD value of their JPY asset over this time horizon – or hedging.
The benefit of this approach is that both the hedged equity return and currency surprise are
accessible to a USD-based investor. Furthermore, it is actually currency surprise, not currency return,
that is hedged – hence passive hedging eliminates currency surprise from the USD equity return to
leave, as the name suggests, the hedged equity return.
Over short periods of time, and in particular with low interest rate differences (such that the forward
“fall line” above is relatively flat), there is little difference between currency return and currency
surprise, but over longer periods of time the difference can be very significant, and hence important in
correctly attributing the impact of hedging.
2
“+” indicates geometric linking, or the addition of the natural logarithms of returns in percentages
All this material is provided for informational purposes only and is not intended to reflect a current or past recommendation,
investment advice of any kind, or a solicitation of an offer to buy or sell any securities, Record Currency Management Ltd
products or investment services. Published in the UK for Professional Clients and the views contained within are correct for
date of publication and may have changed since that time. Changes in rates of exchange between currencies will cause the
value of investments to decrease or increase. Past performance is not a guarantee of future results. The investment return and
principal value of an investment will fluctuate so that when realised, may be worth more or less than the original investment.
Before making a decision to invest, you should satisfy yourself that the product is suitable for you by your own assessment or
by seeking professional advice. Your individual facts and circumstances have not been taken into consideration in the
production of this document. Record Currency Management Limited is authorised and regulated by the Financial Services
Authority.
All data, unless otherwise stated in the footnote of the relevant page is as at June 2009 and may have changed since. This
information has been provided for the information of the recipient only and is not for onward distribution.
Issued in the UK by Record Currency Management Limited, which is authorised and regulated by the FSA. This material is not
intended for use by Retail Customers, as defined by the FSA.
This material is provided for informational purposes only and is not intended to reflect a current or past recommendation,
investment advice of any kind, or a solicitation of an offer to buy or sell any securities, Record Currency Management Ltd
products or investment services.
The views about the methodology, investment strategy and its benefits are those held by Record Currency Management
Limited. There is no guarantee that any of the strategies and techniques will lead to superior investment performance. All
beliefs based on statistical observation must be viewed in the context that past performance is no guide to the future. There is
no guarantee that the manager will be able to meet return objectives and tracking error targets. Changes in rates of exchange
between currencies will cause the value of investments to decrease or increase.
Before making a decision to invest, you should satisfy yourself that the product is suitable for you by your own assessment or
by seeking professional advice. Your individual facts and circumstances have not been taken into consideration in the
production of this document.
Record is authorised and regulated by the Financial Services Authority, a registered investment adviser with the Securities and
Exchange Commission in the US, is an Exempt International Adviser with the Ontario Securities Commission in Canada, is
registered as exempt with the Australian Securities & Investment Commission, is approved by the Irish Financial Services
Regulator to act as promoter and investment manager to Irish authorised collective investment schemes and is registered with
the Jersey Financial Services Commission.
Past performance is not a guarantee of future results. Portfolio returns are gross of fees and assume the reinvestment of all
returns. The investment return and principal value of an investment will fluctuate so that when realised, may be worth more or
less than the original investment.
Hedging foreign exchange risk is typically undertaken at periodic rebalance points so that exposures and hedges are
rebalanced to reflect the new information. Interim drift between hedged positions will take place because of market movements
or because of tactical asset allocation changes in the currency composition of the underlying assets. In addition, hedges are
generally rebalanced around certain tolerance levels. These factors will create divergence between the hedge returns and the
fx impact on the underlying assets. In addition dealing costs must be taken into account. Further divergence can be caused by
proxy hedges where the proxy currency and the underlying currency move relative to one another. Finally, it is generally the
case that not all currencies in the portfolio will be hedged or proxied. This is typically the case where there the cost of hedging
or the lack of a proxy currency becomes a factor.
All passive hedging risk warnings are relevant to the dynamic hedging mandates. The following warnings are also relevant.
Dynamic hedging mandates will vary the level of hedging in the portfolio at any time between the minimum and maximum
hedge ratio range that is agreed. The investment strategy seeks to remove a proportion of the hedges on currencies which are
observed to be strengthening against the base currency. This exposes the portfolio to losses in cases where the foreign
currencies weakens relative to the base currency of the client. While there is a risk framework in place to reactivate the hedges
when the foreign currency is observed to weaken, the portfolio will be exposed to losses between the periodic observation
points in proportion to the extent of unhedged assets and the magnitude of the relative currency movement. Significant short
term movements will cause greater losses.