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.
In other words, this minority of domestically oriented revenues is more than offset by all the multinational, exporting and resource-oriented companies in today’s market.
“It is not possible to hedge an exposure that is not there,” LeGraw writes.
Given that hedging is thus not hedging — because of today’s globalized corporate environment — LeGraw goes on to argue that currency hedging actually serves to increase risk.
Noting frequently cited empirical research purportedly demonstrating that currency hedging reduces volatility over the short term (i.e., less than five years), LeGraw takes a closer look at hedging to show that the impact has significantly changed precisely as globalization has taken root.
Thus, in the period from 1970 to 1989, currency hedging did reduce portfolio volatility over the short term, though over 10 years the unhedged portfolio was only slightly more volatile than a hedged portfolio.
But in more recent times, an unhedged portfolio was only marginally more volatile than a hedged portfolio in the short term, while over a 10-year period the hedged portfolio was actually (slightly) more volatile than the unhedged one.
In a further investment insight, LeGraw notes that even when hedging genuinely reduces the volatility (i.e., narrowly, and over the short term) of an international equity portfolio, it does so at the expense of boosting the correlation with U.S. stocks.
Thus, hedging deals a double blow: it increases portfolio volatility in today’s globalized environment (after a holding period of just two years or more) while stripping the international portfolio of its valuable diversification benefits.
The dramatic abandonment of the Swiss National Bank’s euro peg back in January serves as a valuable illustration of this counterintuitive point. The Swiss franc shot up as a result of the move, while Swiss stocks got hammered (in the days immediately following the move).
A dollar investor’s unhedged portfolio was hardly affected by all this. The appreciation of the currency countered the fall in equities. But a currency hedged portfolio got hammered since the investments fell in value precisely while the investor was shorting the Swiss franc (as it was rapidly appreciating).
Adding to her brief against currency hedging, LeGraw notes that the practice adds inflation risk to the investing equation.
That is because equities represent real assets in goods and services, while currencies are not real assets and can be devalued by unexpected inflation.
“By adding an inflation-sensitive asset to a real asset, you effectively add inflation risk to your equity investment,” she writes. “Underwriting an additional risk without getting paid for it is not a good investment strategy.”
The GMO asset allocation strategist does note some exceptions to the hedge fund’s anti-currency hedging position.
It doesn’t apply to fixed-income investing, since the cash flows GMO is seeking for its investors are directly tied to a particular currency.
Also, as an active manager, GMO makes forecasts for every major currency just as it does for stocks and bonds and will buy and sell currencies when its managers have a specific high-conviction view.
And finally, GMO will hedge currency when warranted in the particular case of domestically oriented companies.
When the firm’s managers decided to buy Japanese equities oriented to the home market in 2013, a time when GMO was negative toward the yen, the firm hedged the investment by shorting the yen, LeGraw writes.
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