CURRENCY HEDGING IN THE EMERGING MARKETS: ALL PAIN, NO GAIN

March 2016 Tim Atwill, Ph.D., CFA Head of Investment Strategy Parametric 1918 Eighth Avenue Suite 3100 Seattle, WA 98101 T 206 694 5575 F 206 694 5581 www.parametricportfolio.com CURRENCY HEDGING IN THE EMERGING MARKETS: ALL PAIN, NO GAIN Investors in foreign equities are exposed to potential risks from both the movement of security prices and currency exchange rates. Over the past three years, the U.S. dollar has strengthened significantly against most developed and emerging market currencies, resulting in material performance headwinds for U.S. dollar-based investors. This, in turn, has led to a growing interest in hedging the effects of currency movements on developed international equity holdings. As a consequence, many investors also wonder if they should apply a similar program to their emerging market assets. While this is a natural question, it ignores some of the major differences between implementing a hedging program for developed market currencies versus doing such for emerging market currencies. We discuss these implementation issues below, and point out the historical relationship between stock price movements and currency returns in the emerging markets. We find that for many emerging market countries, these implementation issues make it operationally impossible to hedge many of these currency exposures. For those that can be hedged, it is expensive in the current market environment. Furthermore, if one looks at the theoretical impact from hedging currency in emerging markets, it appears to be inconsistent over the long term, and is equivalent to making episodic market calls in the short term. IMPLEMENTATION ISSUES A number of institutions have recommended hedging developed international equity mandates against currency fluctuations, typically using the argument that currency adds unrewarded volatility to international equity returns, or by pointing out the potential future weakness in the value of the Euro. If an investor agrees with these arguments, the implementation of a currency hedge for developed equity portfolios is easily implemented, as a deep and liquid currency forward market exists in which to lay off such unwanted risks. Because of this abundant liquidity and current market conditions in developed economies, the cost to implement a currency hedge is relatively low. Currently, an investor interested in receiving hedged MSCI EAFE Index exposure would pay approximately 10bps in additional fees versus an unhedged exposure. When examining emerging markets currencies, challenges exist in both the availability and cost of currency hedging instruments. Trading volumes for emerging currencies are very small relative to those seen in developed currencies. This is a consequence of emerging market countries typically having lower levels of international trade and external investment than in developed economies, and as such, no natural market exists for currency forwards. In some cases, this lack of liquidity also reflects capital controls put in place by the governments of these countries which may go so far as prohibiting currency forward activity all together. For many small emerging market countries, and the majority of frontier market countries, their relative isolation from the global economy means a market for longterm currency forwards simply does not exist in any material size. In our experience, these barriers to efficient implementation mean that nearly a third of the countries in the MSCI EM Index cannot be effectively hedged. Pricing in such thin markets is also problematic, as it is very conditional on the size of portfolio which is being hedged. When asking brokers for how much they would charge to

deliver a hedged MSCI Emerging Markets Index portfolio, we were simply told these implementation issues mean that no economical bids could be offered, and referenced the number of non-deliverable currency forwards such a mandate would involve, including major constituents Brazil, China and Korea. Non-deliverable currency forwards (NDFs) are tools used for those countries where currency cannot be held by a foreign investor. In these circumstances, no physical currency can be delivered at the expiry of a currency forward. This lack of physical delivery means that an arbitrage-free price is harder to enforce, and makes an NDF s price more sensitive to speculative trading activities. For those emerging market countries where a bid could be obtained, an additional cost of 50 to 100bps was typical, with some countries much higher. This reflects the costs inherent in hedging country returns in these less liquid markets. CURRENCY IMPACTS ON EMERGING MARKET RETURNS For the sake of discussion, let s examine the question of how impactful currency movements have been to emerging markets returns. While we present both hedged and unhedged returns below, we wish to re-iterate that the hedged returns presented are for the most part not achievable in practice, and do not include sizeable hedging costs. In Figure 1, we present the historical rolling 3-year excess returns of a hedged MSCI Emerging Markets Index exposure versus an unhedged exposure 1. Figure 1: Annualized 3-Year Excess Return, Hedged Versus Unhedged MSCI Emerging Markets Index, for Each Month-End From 12/31/2002 to 12/31/2015 10.00% 8.00% 6.00% Hedged Outperforms Unhedged 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% Hedged Underperforms Unhedged -10.00% Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Annualized 3-Year Excess Return of Hedged versus Unhedged MSCI EM 1 Throughout this piece, we will refer to the MSCI EM Index (USD) as the unhedged version of the index, and the MSCI EM Index (Local) as the hedged version. That is, the first reflects the changes in foreign currencies versus the US Dollar, while the second ignores these impacts. While MSCI also promulgates a Hedged version of their EM Index, this set of returns reflects a mechanical method to hedging currencies via 1-month currency forwards. This is a reasonable real-world proxy of a hedging program, but in emerging markets can lead to performance which is still materially impacted by currency movements. *Hedged Returns are represented by MSCI Emerging Markets Index (Local), Unhedged are represented by MSCI Emerging Markets (USD). Source: MSCI, Parametric; as of 12/31/2015. As Figure 1 shows, there can be dramatic differences between a hedged and unhedged index exposure to the emerging markets, varying between severe underperformance and dramatic outperformance. However, while recent time periods have seen a large positive payoff for hedging one s currency exposures, this decision is not uniformly positive (or negative) when viewed over the long term, and, it appears, has spent approximately equal amounts of time being detrimental or beneficial. In addition, the magnitude of gains and losses experienced historically are approximately the same. All of which is to say, we believe most investors, upon examining Figure 1, would agree that the benefit from hedging currency exposure in the emerging markets is very time period specific, which makes success or failure very sensitive to entry and exit points. It also makes it hard to judge the magnitude of the long-term benefit of currency hedging in the emerging market, or if such a benefit even exists. However, Figure 1 masks how an emerging market investor s experience from hedging currency exposure would have been highly impacted by their actual entry and exit points. To demonstrate this, 02

Figures 2 and 3 plot the 3-year annualized return of the hedged index versus the unhedged index returns, for each month-end from December 2002 to December 2015, for both MSCI EM and MSCI EAFE Index returns. A point above the line means the hedged index outperformed the unhedged index, while a point below the line means the hedged index underperformed. Figure 2: Annualized 3-Year Excess Return, Hedged Versus Unhedged MSCI EM Index, 3-year Period Return Rolling Monthly, for Each Month-End From 12/31/2002 to 12/31/2015 50% Hedged MSCI EM Index Return 40% 30% 20% 10% 0% -20% -10% 0% 10% 20% 30% 40% 50% -10% Unhedged MSCI EM Index Return -20% Source: Parametric, MSCI, as of 12/31/2015. Figure 3: Annualized 3-Year Excess Return, Hedged Versus Unhedged MSCI EAFE Index, Rolling 3-Year Periods, for Each Month-End From 12/31/2002 to 12/31/2015 Hedged MSCI EAFE Index Return 50% 40% 30% 20% 10% 0% -20% -10% 0% 10% 20% 30% 40% 50% -10% Unhedged MSCI EAFE Index Return -20% Source: Parametric, MSCI, as of 12/31/2015. 03

Optically, it appears that the impact of hedging currency in emerging market portfolios is highly dependent on the overall return of the emerging markets over that time period, while no such equivalent pattern exists in MSCI EAFE returns. Figure 2 shows that hedging currency hurts the emerging markets investor in a strongly upwards moving market, while it helps investors in a flat to downward moving market. Said another way, hedging currency in the emerging markets essentially waters down your market exposure, in that all returns are reduced in magnitude, resulting in a return profile similar to a portfolio with a beta significantly less than one. As such, a rough proxy for hedging your emerging markets exposure is to simply hold less emerging markets exposure. Interestingly, Figure 3, which maps a similar relationship for developed markets, does not show a similar pattern that is, the direction of the underlying market does not appear to have a strong impact on whether hedging is beneficial or not. 2 There are many who argue that this is a natural dynamic in emerging market currency. These arguments typically state that a primary determinant of exchange rates in the emerging markets is the capital flow associated with the sale or purchase of financial securities by foreigners. If a market is moving strongly downward, more equity sales occur, and the repatriation of these proceeds then puts an additional downward pressure on the currency exchange rate. A strongly upward market has the opposite dynamic. Another camp would say that emerging market equities have been a risk-on trade, so that periods of financial stress have generally resulted in falling prices in emerging market equities and a broad strengthening in the U.S. dollar. Regardless of the reason, we would simply state that the historical record strongly suggests that the hedging decision is closely tied with making a tactical market timing call on the overall emerging market return (i.e. hedging returns is equivalent to reducing exposure, which is making a call that markets will be weak to negative in the near future). We argue that it is hard to consistently make such predictive market calls, and, so naturally, we believe it is just as difficult to consistently make calls on when to hedge or not hedge one s emerging market exposure. We wish to reiterate that the hedged returns presented in Figures 1, 2, and 3 do not reflect any cost for the hedging instruments or the ability to implement in all markets, but rather, they simply reflect the return streams with or without the impact of currency movements. Given the historically high cost and low liquidity of emerging market currency forwards, the above stated results are nearly impossible to achieve, or would at the very least incur a very high cost in the current market environment. 2 On a side note, Figure 3 does appear to show that for the vast majority of rolling three year periods, hedging currency risk in international portfolios did not improve returns. CONCLUSION While many investors are considering hedging the currency exposures in their developed international portfolios, we attempt to show above that the decision to hedge emerging market portfolios differs from this in three keys ways. First, market instruments to hedge currency risk in emerging markets are either very expensive, or simply not available, for the majority of emerging market countries. Second, the benefit from hedging appears to be relatively inconsistent making the benefits from such a hedging program questionable, especially given the high cost in the current market environment. And third, we note that the benefits from hedging in the emerging markets have historically had a strong connection with the returns of the broad market returns. This is a condition not present in the developed markets, and makes the decision to hedge an emerging markets portfolio essentially a market call on the direction of the emerging markets. Since we believe it is impossible to consistently make such predictions correctly, we find little evidence to motivate implementing a currency hedging program in the emerging markets. 04

About Parametric Parametric, headquartered in Seattle, WA, is a leading global asset management firm, providing investment strategies and customized exposure management to institutions and individual investors around the world. Parametric offers a variety of rules-based, risk-controlled investment strategies, including alpha-seeking equity, alternative and options strategies, as well as implementation services, including customized equity, traditional overlay and centralized portfolio management. Parametric is a majority-owned subsidiary of Eaton Vance Corp. and offers these capabilities through investment centers in Seattle, WA, Minneapolis, MN and Westport, CT (home to Parametric subsidiary Parametric Risk Advisors LLC., an SEC-registered investment adviser). Disclosure Parametric Portfolio Associates LLC. ( Parametric ), headquartered in Seattle, Washington, is registered as an investment adviser under the United States Securities and Exchange Commission Investment Advisers Act of 1940. This information is intended for use with investment professionals. It is solely to report on investment strategies and opportunities identified by Parametric. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. Investing entails risks and there can be no assurance that Parametric will achieve profits or avoid incurring losses. Parametric does not provide legal, tax and/or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy described herein. Charts, graphs and other visual presentations and text information were derived from internal, proprietary, and/or service vendor technology sources and/or may have been extracted from other firm data bases. As a result, the tabulation of certain reports may not precisely match other published data. Data may have originated from various sources including, but not limited to, Bloomberg, S&P, MSCI/Barra, FactSet, and/or other systems and programs. Parametric makes no representation or endorsement concerning the accuracy or propriety of information received from any other third party. Global market investing, (including developed, emerging and frontier markets) carries additional risks and/or costs including but not limited to: political, economic, financial market, currency exchange, liquidity, accounting, and trading capability risks. Future investments may be made under different economic conditions, in different securities and using different investment strategies. MSCI and MSCI Index names are service marks of MSCI Inc. ( MSCI ) or its affiliates. The strategy is not sponsored, guaranteed or endorsed by MSCI or its affiliates. MSCI makes not warranty or bears any liability as to the results to be obtained by any person or any entity from the use of any such MSCI Index or any data included therein. Please refer to the specific service provider s website for complete details on all indices. Parametric is located at 1918 8th Avenue, Suite 3100, Seattle, WA 98101. For more information regarding Parametric and its investment strategies, or to request a copy of Parametric s Form ADV, please contact us at 206.694.5575 or visit our website, www.parametricportfolio.com. 05