Despite the growth in assets under management in currency-hedged ETFs, most actively managed equity fund managers still don’t hedge currency risk, and that probably is at the detriment of their clients, agreed panelists at the Morningstar ETF conference in Chicago on Wednesday.
The panel, moderated by Patricia Oey of Morningstar, consisted of Arne Noack, director of exchange-traded product development for Deutsche Asset & Wealth, Luciano Siracusano, chief investment strategist for Wisdom Tree, and Francisco Torralba, senior economist for Morningstar. Both Noack and Siracusano thought at least a 50/50 currency hedged portfolio was a prudent start, especially with the global currency and equity volatility that’s been in play over the past few years.
“If currencies and equity markets are correlated, they have certain benefits in the long run. Not to hedge can have a positive risk return due to non-correlation,” said Noack. “We found currency is correlated in such a way that it is additive. Ultimately, if you invest internationally without hedging currency risk…you are increasing volatility in a portfolio by virtue of foreign equities and foreign exchange. Taking one out can … reduce this risk and volatility.”
In viewing the global currency landscape, closer to home all panelists thought it was a long shot that the Fed would raise rates in December, which would be a key driver in global currency moves.
Torralba noted that the global economy is slowing down and “soon markets are going to catch up to the fact that we are far along in the business cycle in the U.S. So the Fed won’t raise because the economy [would get] shakier.” Noack agreed, saying there was a 50/50 chance the Fed would raise rates, adding, “the globalized economy is not in fantastic shape. What has become apparent is the Fed is conscious of its global responsibility; it’s not only setting U.S. rates and impacts U.S. policy, but due to interdependencies globally, whatever they do impacts somewhere else.”
Siracusano thought there was only a one in three chance of a December rate increase, due to the global economic outlook. “The Fed doesn’t want to complicate the global scene…it’s the banker of last resort and [its decisions have a] potential for a chain reaction in global markets.”
However, the panelists concurred that the U.S. dollar would continue appreciating, Siracusano adding “this is the third big bull rally for the U.S. dollar. In the 1980s under Reagan, the dollar rallied 50% over five and a half years. Under Clinton it rallied 35% over six and a half years. Now it’s a 30% rally in four years…the key question is what the market currently anticipates.”
What happens to foreign-domiciled companies with sales overseas? Siracusano said it made them more sensitive to U.S. dollar fluctuations. “Multinationals have taken a hit last year both in earnings and sales growth…companies with more sales in the U.S. are doing better in the last year. Internationally you can make the argument that impact on the currency is a second bet…you bet on stocks then bet on currencies. Unless you have a 100% conviction on the way those markets are going, you don’t want to be 100% unhedged,” which is why most active managers are unhedged.
“There’s no reason the dollar should depreciate going forward, but if you feel unsure,” he suggested beginning with 50% of the portfolio hedged and 50% unhedged.
Siracusano cited a study that looked at European equity returns for past 20 years, where the average annual return was 9%. A closer look revealed that the average annual return was really 2% when the Euro appreciated, while the average annual return was 14% when the Euro depreciated. With a stronger U.S. dollar projected, this could impact equity returns.
He also said that during the past 10 years, the Japanese equity market has been negatively correlated to the yen, so as its currency weakens, it’s been good for the stock market because it helps exporters. Siracusano noted there’s a similar trend in Europe, pointing out that the Euro is a “funding currency” like debt. Today when the euro loses value, equities rise.
Oey interjected that another study found that shorter-term results of hedging currencies were slightly different, but longer term there was practically no difference in hedged vs. non-hedged returns.
Noack cautioned on looking at absolutes, stating the return and risk has to match investor objectives. “If the investor objective is to get as much absolute return as possible, the volatility of returns doesn’t matter,” he said. “If you have a U.S. dollar as liability currency, then taking FX exposure is not likely to be beneficial, especially not where the currency is being a local drag on markets.”
Siracusano added that the cost to hedge is cheap in developed countries where interest rates are near zero. He also noted a growing trend in managers hedging currency risk, especially with increased globalized investing and emerging market risks. He said that 33% of new inflows are going into currency hedged equity products.