If there’s one thing a hedge fund should know something about, that would be hedging, right?
So investors may be interested to know that Boston-based hedge fund firm Grantham Mayo van Otterloo (GMO) takes strong exception to the conventional view that investors should hedge their foreign equity exposure.
In a new GMO white paper, Catherine LeGraw, a member of the firm’s asset allocation team, explains that hedging foreign equity paradoxically tends to increase portfolio risk rather than reduce it, as the conventional wisdom views the matter.
Indeed, LeGraw explains that GMO’s default position (barring a few specific exceptions) is to keep its international equity investments unhedged.
The paper’s subject is especially pertinent at a time when serial headlines have breathlessly heralded the triumph of currency-hedged ETFs over the past several months. Investors have poured billions of dollars into these funds, whose returns have been magnified by gains in these portfolios’ underlying foreign equities at a time when the U.S. dollar has been on a tear relative to other currencies.
In other words, if an investor’s European stocks have delivered handsome returns, as they indeed have recently, the fall of the euro in the past several months would have neutered those gains in an unhedged portfolio.
But hedged portfolios that shorted the local currency (in this case, the euro) have been a boon to investors.
“We worry that investors have observed the higher returns from hedged equities as the dollar has risen and concluded that currency hedging is the right thing to do,” LeGraw writes.
Indeed, it is standard practice to view currency hedging as a costly but necessary measure to reduce portfolio volatility. The standard line is that investors should focus on investing and not introduce currency speculation as an added risk while they pursue global diversification.
But the GMO white paper considers that kind of thinking outmoded. Indeed, the hedge fund goes so far as to say that “‘hedging’ is not hedging.”
A key reason is that globalization has radically transformed the currency exposure of most large-cap stocks.
“For example, roughly half of U.K. stock market capitalization is comprised of companies whose business has minimal exposure to the United Kingdom,” LeGraw writes.
Astoundingly, she adds in a colorful footnote, 49% of U.K.-listed companies derive less than 10% of revenues from the U.K. Thus, BHP Billiton (BHP), the world’s largest mining company, simply decided to list in London.
According to a four-tier classification of companies, only in a small proportion of cases would currency hedging make sense.
Natural resource companies like BHP derive their revenues from commodities, which have a global price. Hedging against the British pound or Australian dollar (the company is based in Melbourne) would make no sense.
The large cohort of multinational companies making up large-cap stocks — companies like Coca-Cola — have costs and revenues in multiple currencies — making a hedging strategy against the currency the stock is denominated in, the U.S. dollar, irrelevant.
As to global exporters like Toyota or Swatch, LeGraw points out that the company actually benefits when the home currency depreciates.
Only for domestically oriented companies whose cash flows are tied to local currency — think China Railway — might it make any sense to hedge currency.
But the GMO white paper notes that less than 35% of international companies’ sales are domestic today — down from 60% in 1992.