International Investment Portfolios Protecting Currency Gains

Transcription

1 International Investment Portfolios Protecting Currency Gains Executive Summary As of the Fall of 2011, the US Dollar has weakened against most major currencies for the last decade. As a result, US investors holding assets denominated in foreign currencies have benefited from additional currency returns, over and above those of the underlying assets. However, the Dollar s past behavior, and the theory of purchasing power parity, suggest that the Dollar cycle will turn in the future and the Dollar will strengthen against developed market currencies. When this occurs, investors will lose the currency gains accrued over the last decade. Investors can lock in these currency gains now by hedging. In this context, currency hedging achieves not only the strategic objective of volatility reduction, but also the tactical one of protecting currency returns built up over the last decade. This paper illustrates the Dollar weakness in a historical and fair value context and the extent to which it has enhanced foreign asset returns. It then outlines how a reversal would affect these returns, and how hedging can mitigate this. How USD weakness has affected foreign asset returns Unhedged foreign asset returns represent changes in the exchange rate between the foreign currency and the investor s domestic currency, as well as the local asset returns measured in the local currency. The extent to which US Dollar (USD) weakness has enhanced returns can be measured by subtracting the currency returns from the total unhedged returns to determine the hedged foreign asset returns, then comparing the unhedged returns with the hedged returns. Chart 1 below compares a foreign equity index for which we have used the MSCI EAFE 1 Price index to the USDhedged equivalent over the last decade. The chart begins at the end of 2001, when the current sustained period of USD weakness begins. Notwithstanding that the period since has been poor for equities (the unhedged index earned 1.8% per year), subtracting the currency returns (i.e. hedging to USD) would have left investors losing 1.9% annualised. Not hedging the index to Dollars gave investors nearly 4% per year in currency returns, pushing returns into positive territory. The reverse of this is that if the Dollar strengthens, it is reasonable to expect currency losses of a similar magnitude if no hedging is undertaken. 1 Europe, Australasia and the Far East RECORD CURRENCY MANAGEMENT LIMITED MORGAN HOUSE, MADEIRA WALK, WINDSOR, BERKSHIRE, SL4 1EP, UK 44 (0) Fax: 44 (0) Authorised and Regulated by the Financial Services Authority in the UK and Registered with the Securities and Exchange Commission in the US Registered in England No Registered Office as above VAT No

2 Page 2 of 7 Chart 1 Cumulative Return Index (31-Dec-01 = 100) Currency has been a major contributor to EAFE returns in past decade MSCI EAFE Returns Unhedged and Hedged, 31-Dec-01 to 30-Sep-11 MSCI EAFE Price index in USD MSCI EAFE Price index hedged to USD Source: Record Currency Management, MSCI In summary, the weak US Dollar since the end of 2001 means that currency returns have been a major contributor to EAFE asset returns. A US investor would have earned a total of 19% since 2001 exposed to the MSCI EAFE Price index with the currency exposure, but without the currency exposure, the investor would have lost 17%, as shown in Chart 2 below. Chart 2 40% Cumulative Equity and Currency Returns Dec 2001 to Sep 2011 Cumulative Return 30% 20% 10% 0% FX Return, +36.2% Total Return, +18.9% Total Return, -1.5% -10% -20% Equity Return, -17.3% MSCI EAFE Currency MSCI EAFE Equity MSCI EAFE S&P 500 Source: MSCI, Bloomberg, Record Currency Management. Price indexes used for MSCI EAFE and S&P500. Currency returns account for interest rate differential ( currency surprise ). To September 30 th, 2011 What does the above analysis look like from a longer-term perspective? As Chart 3 below shows, long periods of USD strength have historically alternated with periods of USD weakness. We have had, broadly defined, four such periods (and thus two complete currency cycles) over the last 30 years. This is to be expected in developed currencies where different cyclical drivers of short-term economic performance can lead to sustained periods of currency misalignments before real trade arbitrage forces long-term mean reversion.

3 Page 3 of 7 Indeed, what Chart 3 below demonstrates is that over time, currency can add risk for no anticipated return. During this period cumulative currency-only returns (so ignoring the impact of increasing or decreasing equity holdings) would have given an EAFE investor a 0.6% annual return with volatility of 8.8%. For the most part and depending on correlations between this currency stream and the underlying asset returns, at least some part of this additional volatility would have been transferred into increased volatility of the unhedged equity returns. Chart 3 Index (31-Dec-79 = 1,000) Currency contribution to MSCI EAFE - 31 Dec-79 to 30-Sep-11 1,600 1,400 Strong Dollar Weak Dollar Strong Dollar Weak Dollar 1,200 1, Others 10% MSCI EAFE Weights (30-Sep-11) EUR 28% AUD 8% CHF 9% JPY 23% GBP 22% Currency contribution 1 year 3 years 5 years 10 years Since inception (31-Jun-79) Ret % p.a. 2.1% 2.5% 2.5% 3.6% 0.6% Vol % p.a. 8.9% 10.0% 8.7% 7.9% 8.8% Source: MSCI, Record Currency Management. Price index used for MSCI EAFE. Currency returns account for interest rate differential ( currency surprise ). To September 30 th, 2011 USD weakness in a historical context Chart 4 below shows that the US Dollar has weakened effectively to an all-time low. Here we show the US Dollar exchange rate index against major trading partners (weighted by their proportion of total trade). Here the Euro (EUR) has currently a weight of 38%, Canadian Dollar (CAD) 28%, Japanese Yen (JPY) 16%, etc. This US Dollar index also broadly corresponds (with the exception of CAD) to the MSCI EAFE weights to which a US pension plan would typically have exposure, via either a passive investment or as a benchmark for an active investment process. The currency index is also adjusted for inflation, so that we are looking at the valuation of the US Dollar in inflation-adjusted ( real ) terms.

4 Page 4 of 7 Chart US Dollar Real Exchange Rate Source: Atlanta Federal Reserve USD Trade Weighted Index; Major Currencies; Adjusted for relative inflation; 30 Mar 1973=100 March US Dollar's high point Sep Plaza Accord Index March 1973 = Oct OPEC First Price Hike Aug Russian Default 1997/8 - Asian Crisis Sep Lehman Collapse OPEC Second Price Hike 70 Sep ERM Crisis July US Dollar's low point Chart 4 shows that as of July 2011, the Dollar was at an all-time-low in real terms. Furthermore, it has always recovered from these low levels in the past (1979, early 1990s), in line with the theory of purchasing power parity (PPP). Arguments for hedging now, therefore, arise not only from the benefit of reducing overall portfolio volatility, but also as a mechanism to compensate for losses in international portfolios going forward should foreign currencies depreciate and the Dollar rise over the short to medium term. Another way to assess Dollar weakness is to look at the current spot rates of developed currencies against the Dollar and compare them to fair value. Looking at the EAFE currencies and comparing them on an individual basis to the corresponding PPP rates, with the exception of the Swedish Krona the Dollar is significantly undervalued against all the currencies. Taking this undervaluation and looking back historically for the same mix of currencies produces the purple-shaded line in Chart 5 below. What is immediately clear again is that, on an EAFE-weighted average basis, the Dollar is currently very cheap, and that in the past such instances of dislocation from fair value have unwound as currencies mean-reverted. Consider, for example, the three peaks between 2004 and 2010, all of which were followed by a reversion to close to fair value (as determined by PPP). Moreover, the green line shows the EAFE historically-weighted currency returns (taken from Chart 3) implicit from exposure to the EAFE equity index. These are very closely correlated with dislocation from fair value, and have also mean-reverted along with this index. The implication, therefore, is that a correction in the US Dollar to fair value will be accompanied by a significant loss from exposure to the EAFE currencies.

5 Page 5 of 7 Chart 5 Over / under-valuation of EAFE currencies vs. USD 40% 30% 20% 10% 0% -10% Over / under-valuation vs. PPP and Currency contribution Jul-90 to Sep-11 Over / under-valuation of EAFE currencies vs. USD (LHS) Currency contribution to EAFE (RHS) 1,400 1,300 1,200 1,100 1, Currency contribution index (31-Dec-79 = 1,000), historic EAFE weights -20% Source: MSCI, Record Currency Management; over/undervaluation of EAFE currencies versus US Dollar is calculated by constructing an individual over/undervaluation relative to PPP for each currency and generating a weighted average based on the Sep-2011 EAFE weights; the currency returns index, rebased to Dec-1979=1,000 and taken from Chart 3, is constructed from the weighted average monthly returns (based on historic EAFE weights). Implications and hedging options for investors A stronger Dollar would act as a drag on foreign asset returns. US-based investors who expect eventual mean reversion should therefore consider ways to mitigate its effects through currency hedging, whether passive or dynamic. Passive hedging is the process of maintaining a portfolio of offsetting forward foreign exchange contracts each selling the foreign exposure currency and buying US Dollars as a fixed proportion of the underlying foreign currency exposures. Starting such a program would lock in historic gains and so negate losses from subsequent Dollar strength, but would prove costly if the Dollar continues to weaken. Dynamic hedging is any process whereby the proportion of the underlying foreign currency exposures that are hedged is varied, potentially between 0% and 100%. By having high hedge ratios when the Dollar is strong, and removing these when the Dollar is weak, dynamic hedging allows investors to participate in foreign currency gains while offsetting foreign currency losses. This can mitigate the timing risk of starting a hedging program, since the investor will continue to benefit should the Dollar continue to weaken, but will be protected as and when the Dollar turns.

6 Page 6 of 7 Chart 6 Cumulative Return Index (31-Dec-79 = 100) Strong Dollar Value added from hedging MSCI EAFE to USD 31-Dec-79 to 30-Sep-11 Weak Dollar Value added from 100% passive hedge Record value added from dynamic hedge Strong Dollar Weak Dollar Source: Record Currency Management. Monthly value added from 100% passive hedging and dynamic hedging relative to an unhedged benchmark includes contributions from JPY, EUR (France and Germany), GBP and CHF exposures to the EAFE (net) index in the appropriate index weights. Chart 6 above illustrates the differences between the two processes. While a passive hedge will profit during foreign currency weakness versus the Dollar (red shaded areas above), the opposite will happen in times of strength (green shaded areas). Dynamic hedging, on the other hand, will also profit during foreign currency weakness, but takes reduced or no hedging positions during the reverse scenario. Any negative returns instead occur from trading costs. While dynamic hedging will incur costs during periods of Dollar weakness, they will be to a much lesser extent than the currency losses from a 100% passive hedge. Conclusion The weak US Dollar since the end of 2001 has been a major contributor to MSCI EAFE returns, so much so that this is the difference between positive and negative returns to September 30 th, However, the Dollar is characteristically mean reverting, due to developed market economies being at different parts of their respective cycles. This mean reversion generally implies unrewarded risk in the long run. Given the Dollar s current weakness, any mean reversion would bring substantial losses to foreign exposures without any hedging program. Introducing a passive hedging program now would lock in gains, albeit at the risk that the Dollar could weaken further. Dynamic hedging would allow gains to be protected, whilst largely allowing the portfolio to benefit in case of further US Dollar weakening.

7 Page 7 of 7 Risk warnings All data, unless otherwise stated in the relevant footnote is as at September 30 th 2011 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. In accordance with SEC requirements, this material has been published for one on one distribution to sophisticated investors & consultants. All performance results do not reflect the deduction of advisory or management fees. Therefore actual client results will be reduced by the effect of any relevant fees. Standard fees have been published in Record s Annual Report and Accounts and a representative example of the effect of these average fees has been included within this material. Actual returns may differ when a client s fees are above or below the average fees used. 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. Passive and dynamic hedging risk warnings 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. Dynamic hedging 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.