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Macro Insight A disciplined approach to currency management 17 March 2017 For Professional Client and Institutional Investor Use Only Summary When investing globally, a key portfolio management question is how to deal with foreign currency exposures: should we hedge overseas currencies? Or should we accept currency risk? And how should we manage this risk in our portfolio over time? We need to be thoughtful about how we tackle this. In our global multi-asset portfolios, we take a structured and disciplined approach to currency management We believe there is a compelling case for hedging currency exposures in “safety” asset classes, like global government bonds. Otherwise currency risk will dominate the volatility of global bonds different industries, and different economic cycles. Because of this, we believe it is right to allocate to overseas asset classes. But there is a challenge. When we invest in an overseas asset market, we also invest in foreign currency. This is an issue because currencies can be volatile, even over long investment horizons (see figure 1). Figure 1: Sterling against the US dollar GBPUSD 2.2 2.0 1.8 1.6 1.4 For riskier asset classes, such as global equities, the portfolio benefit of hedging currency exposure is ambiguous. And the costs to hedging are not “frictionless”. Our starting point is to leave currency risk unhedged Source: HSBC Global Asset Management, Global Investment Strategy But we also need to be active. When market exchange rates move significantly, we need to adapt how we deal with currency risk. We discuss this idea in the context of recent moves in sterling/dollar and how we have responded in UKbased global multi-asset portfolios What can we do about this? Well, we either accept currency volatility or we can (partly) hedge this risk. Some say currencies are a zero-sum game. Others argue that currency fluctuations can be quite random. This means that we can’t assume that we will always make money when investing in major currencies. Introduction One way to approach multi-asset investing is to focus solely on domestic asset classes. Taking this “home bias” does avoid currency risk, but it also restricts our investment universe and reduces our flexibility. In turn, this limits our ability to deliver good risk-adjusted returns to our clients. Taking a global approach to multi-asset investing is beneficial. This brings increased diversification benefits which leads to less volatility in overall returns and enables us to take exposure to different countries, 1.2 1.0 1997 2002 2007 2012 2017 Given that currencies produce additional volatility for our portfolios, hedging currency exposure (using FX forwards) could make sense. But we need to recognise that the cost of hedging is not “frictionless”. A typical assumption is that the price of a currency hedge should be the differential in interest rates between the two economies concerned. But since the possible strategies that the investor could adopt – (i) global bonds with currency exposures hedged, (ii) global bonds unhedged, (iii) global equities hedged, and (iv), global equities unhedged. financial crisis, this has tended not to be the case in some major FX rates. What’s more, the trading costs associated with currency hedging are not zero. Therefore, the key question is whether the cost of hedging is justifiable versus the saving we expect to make in volatility terms. On the basis of this data, since 1990, a US-based investor would have enjoyed strong returns across all these strategies! But the decision about whether to remove currency risk (by hedging) is still important. Our conclusion is that it is worth hedging overseas bond exposures, but it is less clear-cut for overseas equities. The easiest way to see this is by looking at the Sharpe ratios in the table under the chart. The Sharpe ratio shows the overall (excess) return above the risk-free rate which is adjusted for volatility. This research-led conclusion informs the HSBC Global Asset Management default policy which is to hedge overseas bond exposures but typically leave foreign equity asset classes unhedged. For global government bonds, the decision to hedge the overseas currency exposure dramatically improves the historic risk-adjusted return. The Sharpe ratio increases from 0.49 to 1. A structured approach to FX hedging We take a disciplined and structured approach to thinking about asset allocation. This starts with our valuation (risk premia) framework covering 250+ asset classes. This enables us to identify where relative opportunities might exist. The recent past has been a strong market environment for global bonds, so we shouldn’t expect such high Sharpe ratios from bonds in the future. But the large gap between the currency-hedged and unhedged strategies is meaningful. A key step in the process is to think about currencies like we would do any other asset class. This is because currency exposure creates a risk and – perhaps – the potential for return in our portfolio. At the same time, for global equities, there seems to have been a benefit associated with leaving currency exposures unhedged, but the difference in riskadjusted returns is much smaller than what we saw with global bonds. When a US dollar-based investor allocates to global equities on an unhedged basis, we can think about the overall investment return as being partly driven by the equity exposure and partly-driven by the currency exposure. The important relationship is how that currency element interacts with the underlying asset class position. The “optimal hedge ratio” A more refined way to make the same point is to think about a concept known as the “optimal hedge ratio”. What we mean by this is the percentage of foreign exposure which should be hedged back into the domestic currency in order to minimise portfolio risk at a particular point in time. An “optimal hedge ratio” of 1 means that we should fully hedge. An optimal hedge ratio of zero means that we don’t hedge at all. Figure 2: The impact of currency exposures 800 Global Bonds (U) Global Equity (U) Global Bonds (H) Global Equity (H) 600 Figure 3 shows that for “safety” asset classes, such as UK government bonds, the “optimal hedge ratio” has historically been stable at around 1; it is almost always worth fully hedging. 400 200 Figure 3: UK Bonds & Equity “optimal hedge ratio” 2015 Global Equity 0.09 0.25 Source: HSBC Global Asset Management Global Investment Strategy, total returns and Sharpe ratio from January 1990- February 2017 2000 2004 2008 2012 2010 2000 1995 2004 20082005 2012 Figure 2 helps us to see this relationship. The2000 chart Index shows the impactIndex of currency exposure for aIndex dollarbased investor focussing on global developed market (DM) bonds and global (DM) equities. There are four 0.0 0.2 0.4 0.6 0.8 1.0 Global Bonds 1.00 0.49 Bonds JapanUK Equity 1990 UK Equity 0.0 0.2 0.4 0.6 0.8 1.0 2010 Japan Bonds Eurozone Equity 0.0 0.2 0.4 0.6 0.8 1.0 Sharpe Ratio Hedged Unhedged 2005 0.0 0.2 0.4 0.6 0.8 1.0 1995 2000 Germany Bonds 0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0 0 1990 1995 2000 2005 2000 20102010 IndexIndex 1990 2000 2010 Index Source: HSBC Global Asset Management Global Investment Strategy, “optimal hedge ratio” from the perspective of a US dollar investor 2 To hedge or not to hedge? economic and political uncertainties persist, creating downside worries. Taken altogether, the way to think about this is that the volatility of government bond returns is dwarfed by the large fluctuations in currency markets. If we want bonds to act as a source of “safety” in our portfolio, we have to hedge the currency risk out. This idea holds up across different currencies and for different time periods.1 From our perspective, however, the important point is that sterling has cheapened materially relative to its levels pre-Brexit referendum. This means that the balance of risks has changed. We believe that it makes sense to acknowledge this shift in the market odds in our portfolios. As such, we have moved to partially hedge developed market equity exposures for sterling-based global multi-asset portfolios. But in riskier asset classes, such as UK equities, we find that the “optimal hedge ratio” has tended to be quite variable over time. And, unlike with government bonds, the Sharpe ratio since 1990 (i.e. figure 2) is not improved by hedging overseas exposure. Figure 4: Sterling against the US dollar, euro and Japanese yen 1.6 180 GBPEUR 1.5 GBPJPY (RHS) 170 160 1.4 Consequently, the portfolio benefits associated with currency hedging in equities are ambiguous. Research doesn’t provide a strong case to hedge and the cost of the hedge is not “frictionless”. In practice, the hedging decision may depend on which currency exposures are being taken and on the home country or currency of the investor. 150 1.3 140 130 1.2 120 1.1 Dec-15 Feb-16 Being active: a recent case study 110 Apr-16 Jun-16 Aug-16 Oct-16 Dec-16 Source: Thomson Reuters Datastream, as of February 2017 We take an active approach to asset allocation in our multi-asset portfolios. By this we mean that we adjust portfolio exposures over time to reflect the evolving market-implied rewards. It makes sense to think about currency similarly. In other words, if we have a view on currencies, we might move away from our “default policy” to reflect our investment conviction. Core principles Our multi-asset portfolios are invested globally across many different regions and asset classes. This enables us to gain a diversification benefit from different economic cycles and industries. But it presents a challenge: when we invest in overseas asset classes, we also invest in foreign currencies. We have a choice to either accept the FX risk, or hedge it (using forwards). The best way to see this is through a recent case study. How has our currency positioning adjusted in a UKbased global multi-asset portfolio in response to the recent sharp depreciation in sterling? The costs to hedging are not “frictionless”. Investors face a dilemma about whether the costs of hedging are justified against any saving in volatility. At the start of 2016, our currency valuation framework indicated that sterling was over-valued versus the dollar. Based on market prices, our tactical view on sterling versus other major currencies reinforced the “default policy” that global equities should be unhedged for sterling-based portfolios. When currency risk makes up the overwhelming proportion of asset class risk (e.g. for global government bonds), it makes sense to hedge. Where currency risk makes up a smaller proportion of overall asset class risk, the case for hedging is more ambiguous. We should typically take global equity exposure on an unhedged basis. But, in the immediate aftermath of the Brexit vote, sterling depreciated dramatically versus other major currencies. However, we also need to account for current market pricing. When exchange rates move decisively, active currency management can be used to enhance portfolio performance. Following this, our analysis implies that the risk to sterling/dollar has become more “two-way”. Valuation considerations imply that there is some scope for sterling FX appreciation, over time. Simultaneously, 1 190 GBPUSD The main reason for this is that the relationship between currencies and equities is much more complicated. For example, many companies have revenues and costs denominated in a wide range of currencies. Kim Kooner – Global Investment Strategy For example: see Campbell (2010) “Global currency hedging”; James, Marsh and Sarno (2012) “Handbook of Exchange Rates” 3 For Professional Clients and intermediaries within countries set out below; and for Institutional Investors and Financial Advisors in Canada and the US. This document should not be distributed to or relied upon by Retail clients/investors. The contents of this document may not be reproduced or further distributed to any person or entity, whether in whole or in part, for any purpose. All nonauthorised reproduction or use of this document will be the responsibility of the user and may lead to legal proceedings. 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