<p>Investors are increasingly turning abroad in the search for yield, and currency hedging only rises in importance as portfolios internationalize. In this MSCI Exclusive Masterclass, our panel of experts discuss the mechanics, ratios and tactical considerations associated with currency hedging, and provide a high-level discussion on how to slot these decisions into your portfolio’s framework.</p>
<ul>
<li><p>Raina Oberoi - Vice President Equity Applied Research at MSCI</p></li>
<li><p>Robert Bush - ETF Strategist at Deutsche Asset Management</p></li>
<li><p>David Carter - Chief Investment Officer at Lenox Wealth Advisors</p></li>
</ul>
Video Image:
Duration:
0000 - 00:48
Display Date:
Wednesday, December 7, 2016
Transcript:
<center><strong>Currency Hedge Masterclass Audio for transcription</strong></center>
Gillian: Welcome to Asset TV. I’m Gillian Kemmerer. As investors increasingly try to broaden the search for yield, currency hedging has become of the utmost importance. Here to share their views are three experts from across the investment landscape, so welcome to the Currency Hedging Masterclass. Thank you so much for joining us, we’re thrilled to have you here today. So let’s get started. I want to help our viewers at home understand both your relationship to the topic and your relationship to one another. So, Raina, starting with you, can you tell us a little bit about your perspective here?
Raina Oberoi: Sure. So we at MSCI are, you know, a big research focused firm. But at the same time our main business objective is to build benchmarks. So we, with the help of our research, we have actually built currency hedged benchmarks, so which almost kind of becomes a foundation of the discussion. Because once you have benchmarks you can have ETFs issued off of the benchmarks. And then portfolio managers can actually use benchmarks in their investment process.
Gillian: Perfect, and that tees you up well, Rob.
Robert Bush: Yeah, it does, Gillian, yes. So you’ve almost got like a mini food chain here of the ecosystem of ETFs because … so I work at Deutsche Asset Management. And we actually create and track indexes, including many that MSCI provide, to create ETFs. So that’s our role as an asset manager. And at Deutsche Asset Management we have a whole suite of currency hedged ETFs, international equity predominantly, across various regions and also across single countries, and more recently across fixed income as well.
Gillian: Okay, perfect, and David, last but not least.
David Carter: I see I’m at the end of the food chain, which probably makes sense. But my name is David Carter and I help manage a portfolio of global multi asset class investments, including currency hedging. So we have a fair sizeable allocation to non-US equities and we’ve been fairly active in hedging out that currency risk for roughly the last three years, so it’s worked well.
Gillian: Perfect. Well, I’m thrilled to bring in each of your areas of expertise as we continue the discussion. So, Raina you were kind enough to bring over some data from MSCI that we’re able to pull up that shows us the changing face of the investment landscape, so let’s have a quick look. So, Raina, can you just give us a brief overview of what we’re looking at here and the trends that you’re seeing?
Raina Oberoi: Sure. So the whole idea behind currency hedging and the fact that we’ve been sitting here discussing it was not something quite logical 30 years ago for example. So why are we sitting here and discussing this issue is because something has fundamentally changed in the investment landscape. You can see in this chart that what it’s showing is that now investors across the globe are allocating more and more of their assets to foreign equities. So initially there was this strong tendency for domestic buyers, for home buyers, and investors slowly but steadily across the universe are actually moving away from that. So as a result what’s happening is the FX exposure in their portfolios is becoming greater and greater, as a result we are sitting here addressing that question.
Gillian: Interesting. Now, David, you mentioned that you started currency hedging about three years ago. Tell us a little bit about how you’ve seen the landscape change from [inaudible].
David Carter: Yeah, great question. Yeah, I very much agree with your comments. When I think about how we manage portfolios, generally speaking roughly half of the equity allocation is in non-US equities. So out of the gate we know we’re taking some currency exposure. And for us the decision is really, do we want to hedge or not hedge that exposure? And you know we sort of had the view a few years ago that it might make sense to hedge a portion of that non-US equity exposure, really more for tactical reasons more than anything. We weren’t so much trying to minimize risk but our view was quite simply the dollar may appreciate, so we thought hedging some of that non-US exposure made sense. Fortunately it has, it hasn’t always been the case, but it’s worked well for us so far.
Gillian: Great, and Rob, from a product point of view, have you found that investors were increasingly demanding these types of products from you?
Robert Bush: Yeah, I think so. I mean this chart speaks to that, Gillian. To my opinion it’s an enormously exciting chart because this, what you see when people reach overseas is fundamentally improve portfolios, I believe. And actually we’ve just done a piece of research on this. And where we come out is that something close to global market cap is a pretty good starting point for a strategic asset allocation on the equity side. So that’s roughly 50% US, 40% developed international, 10% emerging or so. That, it turns out is not a bad strategic allocation from a risk reduction perspective, which is the main reason why I think you reach overseas. And it’s interesting, you look at this chart, you see the United States there, I think it’s just below 30% or so. So it actually to me speaks of the enormous opportunity still that’s out there for investors particularly in the US to improve their portfolios, by continuing to reach overseas. And then of course as the others have said when you do that, when you make that decision to go overseas then obviously currency hedging becomes, you know, a very pertinent question.
Gillian: So, Rob, there’s obviously a lot of optimism here as we see investors increasingly putting more attention to their international allocations. We saw some sparkling performances in emerging markets while much of the developed world was lagging. So, a very interesting landscape that we’re seeing, but of course that being said, as we increase our international allocation and of course you’ve all alluded to this, we’re also increasing the potential for currency risk. So it would be interesting to understand from each of you, what are some of the indicators you look at when assessing the overall currency risk in a portfolio. So, Raina, do you want to start with that?
Raina Oberoi: Sure. And I could actually go on to the next graphic if that works.
Gillian: Perfect. Absolutely.
Raina Oberoi: And so the idea of currency risk is that it’s a growing portion of your portfolio risk today. So this chart is showing you the percentage of currency risk in your overall equity portfolio. And you can see both in developed markets and emerging markets, it’s been on the rise. And in emerging markets now it’s at the level of about 25% of your overall portfolio risk. So it’s not a small portion of risk and it’s a risk that cannot be ignored. So again, to evaluate this currency risk, there are a few things that you have to look at. You know, a lot of investors will talk about this currency volatility; some will talk about equity returns, currency returns. But as far as we are concerned I would say there were primarily four things that we look at to evaluate currency risk in a portfolio. One is what is your implicit and explicit currency exposure in your overall portfolio? What are the individual currency volatilities in that portfolio? How are the currency returns in your portfolio correlated to each other? And how are the equity returns correlated to the currency returns in your portfolio? So if you were to look at some commodity based currencies like the Canadian dollar or the Australian dollar, they have a positive correlation with equity markets. So when there is a bear market you can have amplified drawdown. But then you look at safe haven currencies like the Japanese yen or the Swiss franc, they are negatively correlated to the equity markets. So they could prove to kind of diversify or lower a risk, if you may, if you have the understanding of how these different pieces in your portfolio work together.
Gillian: All great points. So obviously it’s a lot about the interactions, not just the elements in the portfolio themselves.
Raina Oberoi: Absolutely, yeah.
David Carter: I think that’s an excellent point. And for us that was very much the second decision because again I was delighted to hear you say that you feel a global equity allocation makes sense, that’s exactly how we run the portfolios, so roughly 50% US equity, 50% non-US equity. So we know we take this currency exposure and we made the decision to hedge part of it out. But then the second question was, am I doubling up on risk somewhere? Am I doubling up on a bet somewhere? So I think there is somewhat of a second step in there, I agree with you.
Gillian: Absolutely. Rob, how do you think about this overall when you’re evaluating risk?
Robert Bush: Yeah, I mean, Gillian, so the first point I would make is an obvious one, I think it’s an important one, but I think it’s one sometimes that people forget, which is that if you invest internationally you’re long two assets essentially. And this I think is sometimes overlooked. But if you invest overseas, whether it’s equities or fixed income, you are also long in the currency. And it’s a crucial thing to remember because if you take that simple step, it helps you to think about the decision in, I would argue quite clear terms, because now you can make not just your, let’s say your equity decisions. But you’ve also got to make your currency decisions. So you can think about that in a number of ways. And I think a useful way to think about that is to split it into kind of tactical and strategic considerations. So if you’re thinking about this more tactically and you invest overseas, you may want to remain unhedged in a situation where you have a positive view about that currency for example, okay. So if you’ve got conviction in a particular forecast or a particular currency, that it’s going to strengthen, it makes sense not to be hedged. And the opposite is obviously true, if you’re bearish on a particular currency, then maybe you want to hedge that out. So I think the tactical level return is probably the overriding consideration. At the strategic level, which is a kind of … to my mind at least a longer term way of thinking about this, then I think it’s many of the points that Raina has made. You can start to think more in terms of the long run return, the volatility, the correlation and also hedging costs.
Gillian: All interesting points, and it will be great to actually talk through your Brexit case study a little bit later, which I feel like was really an interesting case in point that we had just this year, that could explain the dynamics between how much you hedge and why. So let’s talk a little bit about monetary policy. There’s been a lot of focus lately on The Fed obviously when yet another December rate hike watch probability is looking quite high for The Fed to raise rates. How does monetary policy fuel currency volatility? Raina, I’ll let you address that first.
Raina Oberoi: So monetary policy is a big driver of currency volatility, and you know, some of the reasons why currency risk is such a big part of your portfolio today is because there is economic fluctuation, there is macro uncertainty. There’s so much central bank intervention. And that’s just given currency volatility a lot more a center stage, if you will, than what it was back in the day. And which is why I think it is something that cannot be ignored. It’s a question again whether you hedge or not hedge, it’s an active decision that you should make on how you want to address that risk in your portfolio.
Gillian: Great. How are you looking at global monetary policy right now when you’re assessing the risks in your currencies?
Robert Bush: So I think, Gillian the main way that it plays into our framework is probably as a feature of our forecasts for some individual currencies. So if you think about what we call policy divergence, which is really a key theme that’s going on at the moment in the world. So as you said, you’ve got The Fed, there’s a debate about the extent and the timing of when it will hike, but it’s a debate about hiking, it’s not a debate about further loosening of monetary policy. And I think it’s fair to say the opposite is true, certainly the Bank of England, Bank of Japan, European Central Bank, the debate there is not about hiking, the debate is about will there be more stimulus in fact. We saw recently a cut in rates from the Bank of England. And there’s, you know talk of interest rates in Japan and in Europe possibly going, you know, into further negative territory. And what we would argue is that that policy divergent creates a differential in yields effectively. And you see flows coming away from some of these negative yielding currencies into the dollar. And so that’s the, you know, the rationale if you like, for some of our forecasts. So we have a weaker sterling for example, weaker euro. And you know, that I would say is kind of playing to the tactical consideration that I mentioned earlier where when you’re thinking about this, you know, over the short run, it’s those sorts of return profiles that become very important.
Gillian: Sure. And, David, lastly, how do you find that you’re responding to some of your clients concerns? Obviously this Fed rate hike is now national news, it’s something that everyone’s paying attention to, not just economists and portfolio managers, how do you orient and how do you explain it to them?
David Carter: You know, I think, and you raised an excellent point that I think folks aren’t disputing if The Fed will raise rates, but it’s more when they will raise rates and by how much. So I think it’s generally expected or understood that The Fed will be raising rates at some point. And one of our views is that we’ll explain that, we anticipate that may happen. We don’t know if it’s next month or the next three months, but we anticipate will happen in the short term. We’ve positioned portfolios to benefit from that. And one of the ways we’re trying to position portfolios is to hedge out some of that non-US equity exposure by only long the dollar, with the simple idea, as you’ve all stated well, earlier, that generally tightening policy tends to increase currency values. So our view is that if The Fed raises rates, great, that should help at least a significant part of our allocation.
Gillian: So tying in everything that we’ve discussed so far, I’d love to bring in a viewer question to our discussion, it’s from Jeff Waters, he’s a Managing Partner at OFC Financial Planning. And he has a question about why hedging at all.
Jeff Waters: Hi! I’m Jeff Waters of OFC Financial Planning. And my question is this, since the expected return of a market basket of currencies is zero, and there’s a cost to hedge, why should an investor hedge?
Gillian: Anyone like to tackle this one first?
Robert Bush: I’m happy to have a go, Gillian, if you don’t mind.
Gillian: No, please, absolutely.
Robert Bush: So first of all I fully agree with Jeff’s assertion that over the long run the expected returns to a basket of currencies is zero. And we’ve done quite a bit of extensive empirical work on that, and we would fully agree with that. So again over the long run, so quite different from what I was saying earlier about tactical forecasting of currency. You’re talking about a period I think, when you talk about strategic, you’re saying, beyond my forecasting horizon. So I would agree with that. I would disagree with Jeff’s comment that there is a cost to hedge in fact, because the mechanics of hedging FX, certainly in developed markets mean that at the moment from the perspective of a US investor, there’s actually a positive cost of carry to hedging. So this is a very important point. And if you don’t mind I’ll just spend a second on this.
Gillian: Please, absolutely.
Robert Bush: So the way we do it at Deutsche Asset Management and the way I think many people in the industry do it is we sell our total currency exposure on a notional basis one month forward. And we do that in the one month forward FX market, that’s how we currency hedge. And if you roll that every month then you are hedged effectively. And what’s going on at the moment is that because US interest rates are higher than those of many developed markets, including what I would call the big four, the euro, the Swiss franc, the pound and the yen, there’s actually a positive cost to carry. So you’re actually selling currency forward at a premium and arguably collecting that differential, okay. It’s an implicit benefit, if you like, to currency hedging. And it’s in the investors favor from the US. So it’s actually quite a unique and interesting situation and story from a US investor’s perspective. Because of course that’s not true if you’re in any of those countries or economies that I’ve just mentioned. So I would argue there’s actually a positive cost of carry, so you get that pick up to hedging at the moment. Now, to just question, are you saying zero return, you know, we’ve just discussed the cost, why therefore hedge? It comes to the point Raina made earlier about really correlation and risk reduction. So you have to think about the impact that those currencies are having on your portfolio overall. And there we would argue that the correlation with currency and equity just isn’t low enough to offset.
Gillian: Okay. Raina, would you like to add anything?
Raina Oberoi: Sure. I mean I think of course from a long term perspective I agree that your kind of currency premium is zero, if you will. But again if you are considering from a medium standpoint, that may not be the case. You may be severely hurt if you are not hedged, if things don’t go your way. So again, the whole point to, you know, we can go back to our initial discussion is about currency risk. You are hedging and you are, you know, in some cases you are paying a cost to hedge that currency risk because it’s not only about the return, it’s about what can impact your portfolio, you’re trying to protect that downside in times when you need that protection, which is when currency hedging can help.
Gillian: Absolutely. And, David, anything else you’d like to add?
David Carter: Sure. And I think in some ways there’s really almost two sides to that coin, right, about currency hedging. It’s (a) am I reducing risk, am I hedging, or (b) am I looking at the return enhancement part of hedging? And our view very much is in some ways we’re more interested in that second part, in the tactical part. And in many ways we treat currencies and currency hedging as another asset class, like commodities, like high yield bonds. And if we have conviction, and you raised an excellent point earlier about having conviction to put these sort of positions on in a portfolio. I think if you have conviction I think it can be another asset class that can help return as well as mitigate risk.
Gillian: Okay. So as we begin to talk about hedging and let’s say 100 versus 50 etc, I think it would be helpful just to have a brief overview of what the actual mechanics are. So, Rob, can you kind of share with us sort of your process, some of the tools you use etc?
Robert Bush: Yeah, of course, yeah, Gillian. So here’s how we do it, and it’s, I think a fairly typical approach in the industry. What we do at Deutsche Asset Management is we evaluate what our total notional exposure is to a particular currency and a particular fund. So you imagine you’ve bought a basket of international equities, that’s going to have a particular notional exposure, a notional currency exposure associated with it. That’s known as soon as you buy those equities. We then sell that notional currency forward in the one month FX market. So we sell the exact amount of euros or yen or Swiss franc or whatever it may be that we are long, we sell an equal and offsetting amount. So that eliminates your currency exposure, because you’re back to zero, if you like. And you know what’s interesting is, you know, I said earlier, when you do that in the forward FX market, at the moment you’ve got this unique situation, you know, if US investors rates are higher, they’re lower in those developed markets, so you get that nice positive risk premium that accrues. Effectively you’re selling the one month FX at a premium. So that’s the typical mechanics. And it’s interesting because you know, when you hear about hedging you do typically think expensive or cost or how is that being done. You might think about like an insurance like product, you might think about options being used, those are all possibilities. But actually when you’re using the forward FX market, which are one of the deepest and most liquid markets in the world, with some of the tighter spreads, that’s a very efficient and nice way to hedge in fact.
Gillian: And what drives that one month FX rate?
Robert bush: So the primary driver of that is interest rate differentials, the one month interest rate differential is the primary driver. So you’ve got this situation at the moment where rates in the US are not high. But when you look at overseas, they are relatively high in fact. It’s kind of funny to think about the US as being a high interest rate regime right now, because as I say, in nominal terms they’re at historical lows in some sense. But think about what you’ve got in the Eurozone or in Japan or in Switzerland where these one month rates are in fact negative. So it’s the differential that matters.
Gillian: And again it’ll be interesting as we see divergent monetary policy come in to play here.
Robert Bush: Exactly, yeah. I mean in fact you could make the case that, you know, pertaining to our earlier conversation, given what we said about The Fed and these other central banks, if you think that your differential is in your favor now, you might think it’s going to stay that way or even widen.
Gillian: So this is the question that I find has been posed to us very often by our viewers. Let’s talk a little bit about 100% hedged versus 50 and how you choose. Raina, do you want to kick off the discussion on this?
Raina Oberoi: Sure. So we at MISCI have indexes that are unhedged. So they would be 0%, you would have a 50% constant static hedged where you’re of the view that I’m not entirely sure whether I want to hedge or not, I want to limit some amount of downside, so I’ll do a 50% hedged. That’s usually kind of a safe way to go. And then you have, well, I only want my equity exposure, I want to completely eliminate my currency exposure so I’m going to go 100% hedged. So that’s typically what people look at, some of them look at 25% hedge, 75% hedge, so you can choose your hedge ratio, that’s really fine, it’s going to be a more minor discussion. But the whole idea behind 0, 50%, 100% is that how much do you want your currency exposure to be? And in terms of given that we have indexes in all three, if you look at historical returns based on a few home currencies you’ll notice that actually in the long term the 100% hedge on a risk adjusted basis has actually performed better. So again the idea is that you cannot look at, you know, one component. As David mentioned earlier, it’s not a return alone or a risk alone basis, you need to look at it from a risk adjusted standpoint and see what benefit that brings to the table.
Gillian: Okay. And, David, how do you think about this 100 versus 50, versus 0?
David Carter: Yeah, sure. Well, several years we ran completely unhedged portfolios. So unhedged non-US equity exposure. And then we started to form this conviction or this view that there will be a significant interest rate differential going forward, quite suddenly as The Fed starts to tighten and other countries are easing. So our view was first, how do we reduce that currency risk? And then our second thought was really, well, we can make some money at this if we play it right. So we looked around and found that if there was an easy way to lay on or lay in this currency hedge. Our view or summary was that there were several good ways I think to put this view into portfolios. There’s some good ETFs out there, there’s some good mutual funds out there. We’ve been a long time holder of the Deutsche Bank product, which has worked very well for us. And not both from … well, (a) from a return perspective, but (b) probably equally … almost equally as importantly the fund did what we expected it to do. And what I mean there is that if EFA is up 2%, and the dollar’s up 2%, well I would expect the currency hedge product to be up roughly 4. And it’s exactly how it worked. So for us, our initial foray into currency hedging was really quite small, you know, call it roughly 20% of our non-US or equity exposure.
As we started to get a little more comfortable, in our view, in that we had a good vehicle to express that view, we continued to ramp up that hedged exposure, where today we’re roughly two-thirds of our non-US exposure is hedged out. We will start to take that down, and our signal point, like all of you we watch interest rate differentials fairly closely. So we tend to look at German bunds relative to US treasuries. And I think where our view is historically is when The Fed does start to finally tighten or when the Central Bank does start to tighten, that’s when you can lose a little bit of that currency appreciation. So if The Fed starts to tighten in February, I won’t be surprised if we take our significant hedge and cut it roughly in half, still remain a little bit hedged, but not as much as we are today. And the one thing that, you know, that hasn’t really been discussed, but always too in the back of our mind is I don’t think anybody likes to admit it, but it is reality is that when we think about our benchmarks, they’re unhedged. So if we choose to put a big hedged allocation on there, which is basically being long on the dollar, well, the dollar isn’t really expressly in any of our benchmarks. So again we just keep that in the back of our mind.
Raina Oberoi: Yeah. And one thing I wanted to add also is that sometimes when we work with clients who are looking into the hedging decisions, sometimes it can be very complex for them to figure out on a monthly basis, what should my hedge ratio be? So if you think about the MSCI World Index which is basically developed markets, it has a basket of currencies. If every client were to figure out what the hedge ratio would be for each pair every month that just becomes a very cumbersome and complicated process. So the idea here is that sometimes it’s almost an easier safer, simple decision to choose a static hedge ratio and stick with that. And then evaluate that every so often in time instead of doing it more on a monthly basis.
Gillian: So it would appear that having a long term viewpoint then would be important when choosing?
Raina Oberoi: Absolutely. I would say, you know, medium term of course and medium to long term, yes, for sure.
Robert Bush: And, Gillian, I mean my take on the 50, 100% question, and it’s a great one because we get asked it all the time. I would go back to my earlier comment about being long two assets and slot it into that framework, because I think that’s quite a helpful way of thinking about it. So if you go 50% hedged, you’ve got a situation where you’re still long 100% the equity, but you’re long just 50% now of the currency. And I think if you slot it into that framework that could help you to think about the parameters we discussed earlier, how you evaluate that decision. So I would argue that over the long run, return doesn’t change, whether you’re 50 or a 100, if you’re saying that long run return is zero, the hedging ratio is irrelevant in fact. Because if you, you know, over the long run it’s awash, therefore 100, 5, 10, 50, it just doesn’t matter, on the return front, it’s going to be awash. So where I think the decision becomes critical is on the risk reduction side. And here I would argue that 50% hedge does reduce risk, just as we argue that 100% does. But it does so of course naturally less than 100% hedged. Now, it turns out for, you know, for technical reasons, when you look at the risk of a portfolio, it’s not linear, okay, unlike return, it’s not linear. So when you reduce, you know when you reduce your currency exposure by 50%, ballpark you reduce your risk by about 75% of total possible risk reduction. So you know, put simply it’s like being offered half a steak or a whole steak, you know, I’ll take the whole steak.
Gillian: That’s a great way of thinking about it. And one thing I wanted to make note of, David, are you thinking country specific or regionally when you’re investing?
David Carter: A great question. I think for us, it’s sort of a bridge too far to start to get country specific. Again I think we can add conviction and form a reasonably educated fundamental view of the dollar against a broader basket of currencies, which is exactly what we’re doing. So our view is the dollar against the euro and the yen primarily. I think we would be unlikely to take a position on, you know, the dollar versus the Australian dollar or the Malaysian currency, I think that for us a little bit of a bridge too far. I think forecasting individual currencies is notoriously difficult. And I don’t think we necessarily, you know, want to play that game. So that’s where we draw the line.
Gillian: Well, this actually segways perfectly because I’d like to talk a little bit about what Deutsche Bank is thinking for some of these major currencies. I know David and many others are investing in, so maybe we could get started with just some thoughts on a currency forecast for the euro.
Robert Bush: Yeah, sure, Gillian. So our CIO team, part of our asset management division typically forecasts a year out. So we keep it very simple, we go out one calendar year. So our forecast for September 17 on the euro was 1.08. Now, what’s interesting, this forecast was made last month when the euro was up around probably more around the sort of 1.12 level. So we were somewhat bearish on the euro. And what you’ve seen over the last kind of month or so really, is a bit of a selloff in the euro and in fact in other currencies as well. So we’ve actually got quite close to that forecast already. So I would probably argue that directionally it was a good call and it’s actually got there a little faster than many people anticipated. So I’d be interested to see what our economists and strategists come up with when we meet next month as well when they revise that down a little bit, as I expect they might. But yeah, as I say, one year forecast, 1.08, and the rationale has really been the reasons we’ve discussed, policy divergence is the main one. The other one is quite interesting, it’s net portfolio flows is something we look at. So if you look at particularly fixed income flows in the Eurozone over the last year or two, they’ve actually gone negative. So investors in the Eurozone are looking around at these low rates and are actually voting with their feet. And they are looking for high yield in currencies, including the dollar. So that’s one thing we look at.
And then, I mean I think it’s fair when you think about forecasting, you want to be balanced, you want to look at the other side. The reason why you might say the euro, you might have reasons to be a little bit more bullish, well, one is the large current account surplus the Eurozone runs, which provides a continual bid for the euro month in, month out, that’s one thing. And then the other thing, and I think, David, you alluded to this earlier, is this slight flight to quality … flight to safety, sorry, bid that you see sometimes for the euro and for the yen. So if you get a period where there’s a little bit of turmoil in the market, sometimes you see people reverting to their home currency and that bids that up. So that would be the opposite side of the view there with the euro.
Gillian: And I’d be curious to know your thoughts on the yen as well, as it’s been very popular in the news, and when we talk about Brexit, that was also an interesting situation with the yen as well.
Robert Bush: Yeah, so yen, our forecast for one year is 100, nice even round number, it’s not far from that right now. That’s actually a slight strengthening forecast. But not by very much, I mean the yen has been a very range bound currency. And the dynamic looks quite interesting, there’s really two things to mention. One is, this idea that our Chief Currency Strategist has come up with, which is the very close correlation between real interest rates, and nominal FX rates. So if you look at that, that relationship, you find that in fact it’s really the real interest rate differential between Japan and the US that’s been driving that relationship in dollar yen. And when you look at that, that’s what leads you to believe it’s going to be quite close to where it is today, roughly range bound. And then the other dynamic is one that, as I alluded to earlier, we’ve seen this with the euro already, it’s this safe haven bid that you’ve seen with the yen. And it’s kind of intriguing because I’ve been in capital markets for almost 20 years. And you never used to think of the yen as a safe haven currency, at least I didn’t, you’d think typically of the dollar, you’d think of the Swiss franc, not the yen so much. So it’s really something that I think is, in my mind appeared in the last five years or so. I’m not entirely sure why that’s transpired, but it’s kind of interesting.
Gillian: Over the past three years do you find that you’ve put more focus on the yen than you have before?
David Carter: No, for us it tends to be a balance approach across. So we hedge against a basket of currencies and we have not changed the weight of that basket of the allocation. I think at one point, and again it was [inaudible] is that, you know, another driver of currency rates … currency values, of course not just interest rate differentials but more bluntly, if a central bank chooses to intervene and drive the value of the currency down or up. And I think if [inaudible] had thought of it, as we start talking about Japan, I think in some ways our view is that if you look at Europe and Japan, there’s been so much quantitative easing or this big buying of bonds to stimulate the economy. Well, that hasn’t quite worked, arguably. Arguably, it hasn’t quite worked as well as expected. And if we’re running out of bonds to buy, what’s the next trick to stimulate the economy. And our view is that you may see some intervention to drive down the euro and to drive down the yen, again for us is one more reason to continue to keep this hedge on to the dollar, but Europe relative to the yen, we haven’t changed that much at all, no.
Raina Oberoi: Yeah. And there’s one thing that I wanted to add for us too given that we are building these benchmarks or building our currency hedge benchmarks say on EFA, building currency hedged benchmarks on MSCI World. So again these are, again, a basket of underlying currencies. And the reason why these benchmarks or indexes have become so popular is because it kind of takes away from you having to make a particular view on a currency pair as opposed to making a view on a basket of currencies or a region in general. And then letting the underlying benchmark or the product do what you want it to do.
Gillian: It’s a great point and actually I wanted to shift over and talk a little bit about emerging markets, I think given the performance this year it would be remiss not to. How will you re-imagine the Emerging Market Indices as let’s say the relationship between the BRICs and other emerging markets have changed etc?
Raina Oberoi: Sure. So you know, emerging markets again is a different animal than developed markets. It’s a heterogeneous pool as opposed to more of a homogeneous pool. So in emerging markets what we have seen is it’s not always a straightforward basket of currencies. Usually there’s a little more involvement in there, there’s a region specific maybe within emerging markets or a couple of currencies that people want to hedge out because again, you know, you will hear that the cost of hedging in emerging markets can be higher than what you would see in developed markets. So again there is that theory out there. The other theory is some people don’t believe in hedging emerging markets because they believe that the emerging markets premium is made up of the currency premium as well. So if you hedge that out then again you’re going to be leaving something on the table. But I think it’s just … the idea is it’s less simple than developed markets, it’s more of a complex approach and you have to take more of a view on which currencies you would want to hedge and which not.
Gillian: Sure. And, Rob, one interesting one this year was the Brazilian Real is [inaudible] in both the Real and the stock market in Brazil.
Robert Bush: Yeah, that’s right. I mean Brazil is an example of where you, this year would have wished you remained unhedged frankly. The Real has been on the tail this year, as has the Brazilian stock market. But with emerging markets more generally, Gillian, you know, I think there’s two critical considerations, one is cost as Raina said, and the other is correlation. So cost, you know, yes, it does typically tend to be more expensive to hedge in emerging market currencies. And it comes back to the discussion we had earlier about the interest rate differential. You typically see higher interest rates in some of these economies, often due to higher inflation. Therefore you’re paying more to hedge these currencies, that’s a basic point but it’s an important one. And it puts people off sometimes, you know, you can sort of think of that as one of the negative aspects of hedging emerging market currency.
But the other thing I would say is that when we look to this empirically, an analysis we did, we found two interesting conclusions. One is that actually the risk of emerging market currencies was lower than that of developed market currencies, when you look at them as a basket over the last 15 years or so. And the reason for that, I think is that you’ve got a number of emerging market currencies that don’t trade quite as freely or not on as much of a free flow as some developed market countries. So they pull down that volatility naturally because they are within a kind of a fixed peg or a band if you like. So that’s one thing. And the other thing is that they do naturally tend to have a higher correlation to their underlying equity markets. So if you come back to that portfolio framework I’ve mentioned before, you’ve got a situation where you have an asset in there that is not diversifying you as well, in fact it’s detracted because it’s got that positive correlation. That’s a strong positive to think about, you know, hedging out emerging market currencies.
Gillian: Yeah, very interesting point. And, David, how are you thinking about emerging markets broadly? Do you find that the investors that you work with, their appetite is increasing for allocations there?
David Carter: I think generally speaking allocations to the asset class hedge, or unhedge, I think there’s much more of a comfort level obviously with emerging markets. I think the view is it’s probably one of the few areas with true economic growth potential, and certainly relative with the US, relative to Europe, relative to Japan. So I think there’s a comfort level there. I think those markets have gotten a lot deeper I think, and the accounting metrics I think are a lot more sort of standardized. So there’s very much a comfort level there. I think in many ways our view however is that when The Fed does start to raise rates and the dollar starts to rally, that may hurt some of the emerging market equities and fixed income. Is it really still hedging or unhedging or EM equity exposure, we generally do not hedge that exposure. And I think again for us it’s just a little bit of a bridge too far where forecasting the euro or the yen in our view is a little arguably easier than trying to forecast an EM currency for us.
Gillian: So perhaps as alluded, based a bit more on fundamentals?
David Carter: I think so, yeah, I think so, yeah.
Gillian: Sure. So, Rob, I want to now go through a case study we had, one of the most interesting currency masterclasses of all time earlier this year which was Brexit. Talk us through what would have been the optimal positioning, how most investors were positioned moving into it?
Robert Bush: Yeah. And Brexit’s been a fascinating case study, Gillian. And there’s all sorts of kind of weird results that I don’t think you could have really anticipated. So I mean, look, back at the beginning of the year it was probably fair to say that it wasn’t something people were overly focused on. You know, as a firm, you know, we were trying to highlight it to people because we were making the case that this was, you know, a risk out there, a binary risk basically was the way we categorized it. And what we said was, “Look, if Brexit happens you’ve got the potential for a sharp depreciation in sterling. If Brexit doesn’t happen you’ve got the potential for a relief rally that we didn’t think would be as high to the upside.” So we thought we had like this asymmetric risk profile. So we did suggest to people to look at that currency hedged approach through Brexit. I think that events like Brexit actually are very good kind of geopolitical events to think about currency hedging from a tactical perspective. Because even if you weren’t planning on being in that position for a long time, it could have made sense to have at least been currency hedged through the Brexit vote. So what we saw leading into it, we saw kind of diminishing probability of it happening. I left that night on the Thursday night thinking this is not happening. I think, many took the same view. And then we all woke-up on the Friday to discover in fact it had happened.
And then we had a kind of a very strange and interesting reaction. Sterling kind of did what we expected it to. Sterling over the course of this year, year to date, would stand around 13% or so, possibly a bit more or less, almost like an emerging market depreciation, of what is still obviously developed market currency. And then you had, I think the stock market taking it in a relatively more sanguine manner. So if you look at the MSCI UK Index year to date, up around 15½% total return. And that to me is the type of performance where, looking at that without knowledge of whether Brexit happened or not, somebody would look at that and say, “Well, clearly, Brexit didn’t happen.” And even then it’s still a good year. So it’s a very surprising result, I think, within the context of Brexit having happened. But really, I think the critical point is that if you were a US investor and you didn’t hedge, you’ve given back that 15½%, you’ve made roughly zero on being long the UK this year. Because whatever you made on the equity you almost exactly gave up in the currency. So if you’d hedged that, if you’d gone through Brexit hedged, you would have retained that local experience. You would have been up around 15½%, so it’s a stark example.
Gillian: It’s a great point of the value of hedging, how you don’t want to sit on the sidelines for a major event like that, you want to participate in the upside.
Robert Bush: Yeah, I think so.
Gillian: So let’s just round out our tactical discussion a bit. We actually have a viewer question. David, I want to direct this to you, it’s from Dryden Pence. He’s the Chief Investment Officer of Pence Wealth management, Product LPL Financial.
Dryden Pence: In determining the optimal hedge ratio, what are the tools that you use to help pin down the relationship between the volatility of the currency and the local currency equity return?
David Carter: I think that’s a great question. I think obviously whenever you’re trying to determine do I want to hedge or not and then how much do I want to hedge or not? And again for us it’s primarily tactical view; do we think we will make money on this trade? We’re obviously concerned about, you know, does it add risk to the portfolio or minimize risk to the portfolio after the fact? And again it tends to be more tactical in nature and it tends to be more fundamentally driven in nature. So for us the primary view is we just wear our interest rate differentials, what’s our view on monetary policy? What’s our view somewhat so on fiscal policy? Is there an opportunity for some sort of intervention in currency markets going forward? And those are the key drivers for us in setting that allocation.
Gillian: And I know that we’ve been primarily focused on static ratio. But do you want to give any thoughts on kind of how you would address this question?
Raina Oberoi: I mean there is obviously there’s a static point of view. But then you have other indicators you could use to determine whether you want to hedge in a different way in the medium term. And that’s more of a dynamic process. And in our research on currencies, we’ve looked at a few indicators that kind of work well to help you determine a level of hedging, but change that level of hedging. So you could use, for example, a carry signal, a value signal for currency, you could use a momentum signal for currency. These are all kind of return drivers in the medium term. You could use a volatility indicator and that would kind of help you minimize your risk. So there are a few indicators that you can use to again generate that alpha in the short term. And at the same time mitigate your risk. But again, going back to our original discussion, the longer term, yes, your currency premium is zero, but it’s really the risk reduction that helps you.
Gillian: Excellent. And, Rob, any final thoughts on that?
Robert Bush: Yeah. So the way we think about that, Gillian, is with this kind of model that I’ve alluded to, when you think about the currency hedging decision strategically you have to think about four things in my opinion. The currency return, the risk, the correlation and the hedging costs, so we’ve covered many of these. I think we’ve got some sort of consensus. I think that the long term currency return is zero. In terms of volatility, well, for developed markets, order of magnitude 10% or so, standard deviation for currencies over the long run, so about a half to perhaps two-thirds of what you see for the equity markets. The hedging costs, we talked about where at the moment it’s positive for EFA developed markets, you pay a bit more in emerging, that’s the third thing. And then the final thing is the correlation.
And this I think is absolutely critical, Gillian, because the long run correlation in our opinion, between developed market currencies and equities is around zero. And I think people look at zero as being low enough to diversify. We often hear the comment, “Why hedge because it’s zero correlation, so I’m okay leaving currency in.” And it turns out that if you have a zero return and around a 10% vol, zero correlation doesn’t do it for you. It’s still too high. To actually reduce risk under those assumptions you need a correlation of around negative .3, negative .4, something like that. And I think this is something that trips many people up, because as I say, you think zero correlation is doing it for you but it’s really not. You need a negative correlation. And we just don’t think that empirically you’ve seen that negative correlation. So I would advise, you know, in response to that question, to look at those four things and to, you know, to sort of play around with those scenarios yourself. And you know I would suspect people might come to the same conclusion that we did, which is that the correlation is just not there.
Gillian: Let’s talk a little bit about strategic considerations, so overall how do you slot these decisions into a practical framework, what do you advise? So maybe, David, I’ll start with you, how do you think about this two asset model where you’re essentially long two assets when you’re investing?
David Carter: Well, I think you do have to think, you have to make two decisions in many ways. So the decision for us, let’s just sort of think about Brexit for a minute. As it’s sort of an interesting example. So Brexit occurred, like you, we certainly didn’t forecast that. And our view on a fundamental basis was what does this mean for equities? And at [inaudible] our view was Brexit is more negative for European equities than it is for US equities. So we want to reduce European equity exposure, but move those proceeds into the US. So that was decision number one. What do we want to do with our equity exposure, our European equity exposure? And decision number two for us was really, well, do I take it from my unhedged basket or do I take it from my hedge basket? So the decision again was do I want to keep this dollar hedge on or not? And for us it was fairly straightforward. The view was that, well, Brexit probably won’t be good for the pound, for the euro, so I undoubtedly want to retain this hedge. So we took down our unhedged allocation. So essentially really what I did was I increased our proportion of our non-equities that were hedged. But again I think, for us, it was a very much a two step process.
Gillian: Great. In terms of how you would advise clients to look at this framework kind of within their larger portfolios, how do you suggest anyone that’s investing in your ETFs to think about this in the broader context, particularly the institutional clients?
Robert Bush: So I do recommend this two asset portfolio model we’ve discussed. I like it for a number of reasons. I like it because it forces you to think about the key things, the four key metrics that I just mentioned earlier, that you have to have a decision on if you’re going to be investing internationally. And many or all investors that go overseas for their international equities will have already made those types of decision about their equity. But as we said at the top of this conversation, they’re also on the currency. So you should also have those views and assumptions about the currency as well, whether you hedge or not, you do, I think, need to think about the term that you’re expecting and the risk and the correlation and the costs to hedge. So it’s a nice framework because it forces you to think about the important assumptions. The other reason it’s nice is because you can play with those assumptions and see where that takes you out. It’s very easy to set this up in a spreadsheet. And then you can play around with the numbers and you can actually tweak your assumptions. And you asked Raina a question earlier about signals for kind of active hedging. I would argue that could be thought of as being part of the return question. So if you’re somebody who likes to think of currencies not in an interest rate differential environment, which is something we’ve all discussed, but instead in more of a technical or quantitative way, that’s still going to have a return assumption linked to it. That’s still something you can plug into this framework. So it’s very kind of dynamic in that sense and very practical.
Gillian: Excellent. Now, I want to just make note that we’re actually coming toward the end of our discussion. So I want to give each of you an opportunity to share just some final thoughts overall for anyone that’s viewing, interested in becoming more adept at their currency hedging. What would be the things that they need to take away from this conversation, so, Raina, starting with you?
Raina Oberoi: Sure. I think going back to initial discussion, again here, we are all obviously very, very familiar with the hedging process. But, you know, I would like to remind you is you don’t always have to hedge, and you … hedging can be beneficial at some points. But you have to make an active decision about that. In the long term, hedging can help you reduce your risk and that’s something again will help your overall portfolio attributes, because again we are focusing on not only returns, we’re not focusing on risk alone. We’re focusing on risk adjusted returns. And making a hedging decision, whether it’s again medium term or long term, can help you navigate those environments better.
Gillian: Perfect. And, Rob, actually I’m going to give you an opportunity to give a final thought, but one thing I remembered, we’ve been talking mostly and focusing our conversation on equities, what about fixed income?
Robert Bush: Well, yeah, fixed income is really interesting, Gillian. We’ve actually just launched a couple of currency hedged international fixed income products. And we argue that what is true of equity hedging is even more true of fixed income hedging. So the assumptions, the return and the volatility of the FX don’t change. But what happens is that the volatility of the bond portfolio is lower. And therefore the additional risk that you have by retaining currency, it actually has the potential to swamp out that volatility from the bond. So we argue that when it comes to, you know, currency hedging fixed income, it’s even more critical that you have a look at that, in terms of a risk reduction perspective.
Gillian: Great. And then just final thoughts overall on currency hedging, anyone that’s looking to become more adept, what do they need to know?
Robert Bush: So I would say two things, first of all I would urge anyone to take a careful look at the costs involved. It’s perfectly reasonable to assume that the costs are there. But once you kind of get under the hood, you come to that point we made earlier about the interest rate differentials and you see that at least for developed markets, it’s a positive cost to carry, that’s a unique thing right now for US investors. So take a careful look at hedging cots, don’t rule it out because you believe it’s expensive, because as I say, right now it’s in your favor. The second thing is, you know, I would urge people to think about that framework that I set up, so, if you’re going to be internationally invested, whether you hedge or not, think about the return, think about the risk and think about the correlation of the FX as well.
Gillian: Excellent. Perfect, and, David, final thoughts.
David Carter: Sure. Yeah, I think it’s probably a basic tenet of investing, but I think when building out a multi asset class portfolio, one should always consider and be aware explicitly of what risks am I taking, so I think step number one. And owning non-US equities, is how much non-US equities do I want to own? And then number two, recognizing the currency risk that you’re taking there. Are you comfortable to take it or are you not comfortable taking it? And then just thinking through that process, and we found it very helpful just to think through that process, and how that then relates to the rest of the portfolio. So for a long dollar, well, the dollar and commodities tend to be inversely correlated. Well, if I’m long dollar and light commodities, it’s a double bet. Again it’s a good exercise to think about risks in the portfolio. And I think our experience has been that if one does choose to hedge, there are wonderful reasonably inexpensive reasonably liquid, efficient ways to hedge out that exposure, which has been great to see the evolution of those markets.
Gillian: It’s great, so if I can summarize and taking some language from you, a lot of this has to do with looking under the hood and really understanding the underlying factors in the portfolio. And understanding how they interact with one another. Well, thank you so much for taking the time to chat with us. I really appreciate sharing your point of view. Thank you so much for joining us for this masterclass on currency hedging. We appreciate your viewership and we hope you’ll interact with us on LinkedIn, Instagram and Twitter afterward. From our studios in New York, I’m Gillian Kemmerer, thank you for watching.
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