Recent volatility in foreign exchange markets has made a strong case for currency hedging in global portfolios. Selecting the right strategy is paramount, as Emma Cusworth discovers.
“I am surprised more UK investors don’t put more pressure on managers to offer sterling-hedged share classes in absolute return strategies.”Tom Joy
Currency risk has become an increasingly important challenge to institutional investors who have spent the last decade diversifying their portfolios geographically. With volatility on the rise as foreign exchange (FX) markets appear less able to absorb shocks, the case for hedging requires more careful consideration.
In the wake of the financial crisis, and even before then, UK institutional investors diversified globally in the knowledge that doing so would reduce volatility. However, given the base currency of their liabilities remained in sterling, investing abroad brought with it an unrewarded risk – currency risk.
Any investment in foreign assets carries an implicit bet on foreign exchange rates, which investors may or may not want exposure to.
“Currency can have a major impact on returns,” says Berenberg Asset Management’s head of relationship management, Matthew Stemp. Analysis of Bloomberg data by Berenberg, for example, showed that during the 12 months to 30 June 2015, while the Eurostoxx 50 was up 8.83%, the performance for a UK-based investor was -3.04% due to the depreciation of the euro versus sterling.
This year has seen a marked increase in currency volatility. Average volatility has picked up as global central bank policy takes a divergent path and the dampening impact of quantitative easing (QE) in the US and UK comes to an end.
“Currency volatility levels have been returning to historically normal levels, much of which is attributable to central bank policy,” says James Wood-Collins, CEO of Record Currency Management. “Currency markets are not immune from the volatility dampening effect of quantitative easing, which has kept background volatility low until this year. The withdrawal of QE in the US and UK, in contrast to policy in Europe and Japan, has led to an increase in volatility.”
MSCI data shows currency volatility is having a much greater impact on investors’ portfolios today versus 15 years ago. In January 2000 currency risk represented a negligible portion of the total risk in the MSCI World index. But, as the index and the companies it tracks have become more diversified, currency risk has shot up, contributing 10% out of a total risk of just over 12% at the end of July 2015, according to MSCI figures.