Exchange-traded fund strategists at Deutsche Asset Management present a bold new idea: Fully hedging the currency risk of international equities should be considered the “new neutral” when making long-term asset allocation decisions.
Leaving exposure fully unhedged has often been considered to be the “default” position when investing internationally, according to Deutsche, largely because currency comes implicitly packaged with international equities.
“Most U.S. investors consider international equities through the lens of an unhedged benchmark. It’s been their default for years. It’s been their true north, so to speak,” said Dodd Kittsley, head of ETF strategy at Deutsche Asset Management.
A new white paper from Deutsche, “The New Neutral: The long-term case for currency hedging,” takes a deep look into currency and its long-term effect on international equities.
“From our research, we think the industry has it somewhat backwards,” Kittsley said. “We believe that the default, the true north, for long-term strategic investors should indeed be considered a hedged international benchmark and a hedged international investment. It’s a little bit bold in saying the industry’s got the benchmark wrong or should potentially consider a more appropriate benchmark for a long-term investor, but that’s why we’re so excited about this report.”
The paper’s contributors – Kittsley, along with ETF strategists Robert Bush and Abby Woodham – were all on hand to discuss their findings during a media briefing in New York this week.
“The number one takeaway that we have in this piece is that a very compelling case can be made that strategic currency hedging makes economic sense, makes intuitive sense and can add a lot of value for investors,” Kittsley said.
Through the team’s analysis of the returns and risks from both hedged and unhedged currencies, they found that currency exposure did not have a positive expected return.
“The expected return was about zero, on all the currencies,” Woodham explained. “So being unhedged with your international assets or particular international equities is not expected to improve your returns over time. On the return side it is not going to improve portfolio outcomes, which is a fairly standard view in the asset management world. Most asset managers assume that passively held currency exposure is not going to generate excess returns for your portfolio over time.” Then looking at risk – which Woodham said “is something that I think has been a little less explored in the literature from up until now” – the team found that currency increased volatility in a portfolio.
“What we found is currencies have volatility of their own that is additive to a portfolio,” Woodham said. “As a rule of thumb, [a currency’s] volatility is a third to half that of their respective equity market, which is a significant increase in volatility.”
Woodham said the paper also found that the longer the investor’s time horizon, the more likely the currency exposure would increase portfolio volatility.
“Over five-year rolling time periods, we found that about 91% of observations currency exposure increased volatility,” she said. “Over 15-year time periods it was 100% of the time, and that’s because that correlation between equity and the currency market trends to zero over time.”
The paper then asks whether having exposure to currencies is worth it.
“They’re not going to give you return and they’re going to increase your volatility in a persistent, material way,” Kittsley said. “What are you getting compensated for, for assuming that extra volatility? Because you’re not getting compensated from returns long term. Are you getting compensated from a diversification benefit or something else?”
The paper’s conclusion is that currency risk is typically uncompensated in international equity portfolios.
“Foreign currencies have not generated economically significant returns historically, and have added to volatility of international equities,” the whitepaper states. “Hedging international equities, at least partially, can therefore be expected to help improve portfolio outcomes.”
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