When investing abroad, currency matters

Will foreign currencies add diversification or more risk in a global equity portfolio?

Salman Ahmed, CFA 10 June, 2014 | 6:00PM
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Quite frankly, currencies are confusing. There are numerous cross currents to think about. For example the Canadian dollar may be strengthening against the U.S. dollar, but weakening against the Japanese yen. Now imagine that happening for all currencies in a global equity portfolio. Then there's the terminology -- derivatives, futures, forwards, swaps, spreads, overnight. It sounds like a cross between a sci-fi and bad romantic novel.

So I'll spare you the migraine and spend much of this article going over how hedging or not hedging foreign equities affects your portfolio rather than the intricacies of currency markets. (You can read Vishal's article on hedging in foreign bonds here.)

To hedge or not to hedge?

Investing in foreign securities exposes investors to changes in exchange rates, and there's a pile of research debating whether this foreign currency exposure should be eliminated by hedging or left in a portfolio. Like any great debate, there appears to be no clear victor. In a nutshell, those against hedging will tell you that currencies add a layer of diversification to a portfolio. When one currency zigs, another will zag. They'll also tell you that currency fluctuations will wash out over the long-run, eventually leading to a net return of zero.

Proponents of hedging, meanwhile, point to exchange rates that haven't always evened out over the years in cases like the Japanese yen. You could have tripled your investment if you converted Canadian dollars to yens 40 years ago and exchanged them back to dollars today. They also point to the fact that currencies add risk to the portfolio -- a risk for which investors aren't always compensated over long periods. For example, the risk-adjusted return (as measured by Sharpe Ratio) for the MSCI EAFE Index, which represents developed foreign markets excluding U.S. equities, is higher for hedged portfolio.

Name 3- Year Sharpe Ratio 5- Year Sharpe Ratio 10- Year Sharpe Ratio
S&P/TSX Capped Composite 0.44 0.90 0.53
S&P 500 (CAD) 2.01 1.83 0.35
S&P 500 (USD) 2.07 1.90 0.35
MSCI EAFE (CAD) 0.96 0.92 0.27
MSCI EAFE (Local Currency) 0.74 0.82 0.34
MSCI Emerging Markets (CAD) 0.15 0.61 0.48
MSCI Emerging Markets (Local Currency) 0.19 0.64 0.58

Note: Using benchmarks in their local currency eliminates the return contribution from currency fluctuation and is used as a proxy for fully hedged benchmark. In reality, a hedged portfolio returns will be deviate from the local currency return because of differences in forward and spot rates and transaction costs.

How do portfolio managers cope with foreign currencies?

Managers who hedge fall into two broad camps. In one corner you have funds that hedge a certain percentage no matter what's going on in the markets. For example, RBC Global Asset Management hedges away 90% of the U.S. dollar exposure on RBC O'Shaughnessy U.S. Value  . This approach has its benefits, the most apparent of which is discipline, which is especially important if investors aren't sure if a manager has the skill to manage currency.

In the other corner, there are funds that take a more opportunistic approach. When looking at these funds, it's important to understand the process the manager uses to manage currency exposure -- poor calls can be a drag on performance. Trimark Fund  , for example, hedges currencies to manage risk. It has hedged a chunk of its exposure to the yen because of Japan's effort to weaken its currency.

Of course there are numerous funds that don't do anything with their foreign currency exposure. Funds like Mawer Global Equity   and Capital International Global Equity   don't hedge any foreign currency exposure, but that doesn't mean they ignore it. Both look at the exposure in the portfolio and look for companies that can withstand large currency fluctuations.

How does currency impact Canadian portfolios?

Understanding the characteristics of funds is important, but investors need to make decisions on any security within the context of their total portfolio. So while a discussion on how hedged and unhedged equity funds perform on their own is useful, it's more important to examine how they may perform within Canadian investors' portfolios. The hedging decision varies depending on the asset class, so let's break it down into three broad categories: U.S. equity, international equity and emerging markets equity.

The U.S. dollar is considered a reserve currency. In times of crisis, investors around the world flock to the stability of these currencies. Even during the credit crisis in 2008-2009, while the U.S. economy was struggling, the U.S. dollar gained about 3% against the loonie. That means you may want to have exposure to the U.S. dollar and leave your U.S. equity exposure unhedged. In fact, the S&P/TSX Capped Composite Index's correlation to the S&P 500 in Canadian dollars over the last 10 years is far lower than its correlation to the U.S.-dollar version of the S&P 500 (see table below).

International equity funds include exposure to the euro and Swiss franc, which like the U.S. dollar are also reserve currencies. About 40% of the MSCI EAFE Index, the most commonly used benchmark for the asset class, is comprised of Eurozone and Swiss companies. But it also includes a potpourri of other currencies. This makes the hedging decision trickier. On the whole, an unhedged international equity exposure has had lower correlations to Canadian equities. But the difference between the hedge and unhedged international equity exposure isn't as meaningful as U.S. equities.

Over the past decade, emerging markets have gone from the he next hot thing to a necessity for investors. But let's take a step back for a second. Yes, on their own, emerging markets can diversify a portfolio's exposure to countries. But as part of a portfolio, they may not provide Canadian investors a large diversification benefit. That's because Canada is a large exporter of commodities; 38% of the S&P/TSX Composite is in the energy and material sectors (that number has been as high as 50% in the past). And the price for commodities has been driven by demand from developing markets. It often surprises investors when they find out that Canadian equities have been more correlated to emerging market equities than to U.S. or even international equities. If you do have emerging market exposure, hedging their currencies has challenges, the biggest one being its high cost. Many currencies trade infrequently, which increases the cost to trade them; this may negate any benefit of hedging them in the first place.

Index correlations to S&P/TSX Composite
3-Year 5-Year 10-Year
S&P 500 (CAD) 0.62 0.59 0.50
S&P 500 (USD) 0.75 0.77 0.78
MSCI EAFE (CAD) 0.71 0.56 0.64
MSCI EAFE (Local Currency) 0.66 0.67 0.78
MSCI Emrg Mkts (CAD) 0.79 0.69 0.77
MSCI Emrg Mkts (Local Currency) 0.77 0.73 0.81

So what should you do?

If you're considering a fund that invests in foreign equities, find out how its managers deal with currency risk. If they hedge reserve currencies, understand that they are trading off these currencies' defensive quality. If they hedge emerging market currencies, there may be considerable costs that the manager is undertaking. If the manager is trying to add value through currency calls, find out what skill or tools he has in making the right calls.

Like I mentioned, currencies are difficult to follow and too often investors ignore them because of their complexity. You don't have to know the inner workings of the currency market. But you do have to understand their impact on your portfolio.

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About Author

Salman Ahmed, CFA

Salman Ahmed, CFA  Salman Ahmed, CFA, is an associate director of active manager research with Morningstar Canada.

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