Investors often tend to underestimate the currency effect linked to investments in foreign currencies.
Bond yields are heavily influenced by foreign currency movements. With equities, currency fluctuations generally even out over time.
Investing abroad means taking foreign currency risks. This has been made painfully clear to many investors over the course of the past year.
It was undoubtedly a good year for equities by historical standards. In 2017 the S&P 500 Index generated a yield of 21 percent. However, this return only applied to US dollar investors: it was just 6.3 percent for European investors due to the weakness of the US dollar versus the euro.
The US dollar lost almost 13 percent against the euro, with a correspondingly negative impact on returns. Should foreign currency risks be hedged as a rule? And if so, does that principle apply to all asset classes?
The currency component not only affects the yield on an investment, but also its risk profile. Let’s start by looking at the yield.
Currency impact on yield
Hedging the currency risk in 2017 would have been the right decision from a euro investor’s perspective. But currency hedging would have significantly reduced overall returns from 2014 to 2016.
In the long run, the difference between hedged and unhedged returns is minimal for equities. In many cases a weak currency can be a positive factor. On one hand, export-oriented companies can sell their goods abroad at lower prices. On the other, the euro investment will become more attractive for investors outside the euro zone due to the weak currency, which fuels demand. Conversely, investors should not expect to be rewarded for taking currency risks over the long term.
Over the short term, there is no single correct answer, as currency movements are simply too volatile. Critically, investors should only assume currency risks if they have convictions regarding the currency trend. Otherwise, they should concentrate on the investment’s fundamental rationale and avoid any currency exposure.
The same applies to bonds. In the medium to long term, however, the picture is different. The yield difference between hedged and unhedged bonds does not normally even out over the medium to long term. Yield is dominated by the significantly greater volatility of the currency component.
This may be good or bad, but either introduces an element of uncertainty. It is therefore a good idea to hedge currency risk completely for bonds, especially during periods of historically low interest rates, when the low coupon may barely provide a risk buffer.
Currency impact on the risk
The scenario is slightly different when it comes to currencies’ contribution to risk. Given currencies’ high volatility, the marginal risk contribution is essentially positive (except for Japan, since the Japanese yen tends to move in the opposite direction to the equity market).
The strong currency impact on overall risk is disproportionately higher for bonds, as the risk contribution made by the currency component to the underlying asset class depends on its inherent volatility. While the risk contribution is manageable for equities, the foreign currency component is responsible for 70 percent of investment-grade bonds’ volatility.
The risk profile is largely shaped by foreign currency exposure. From a risk management perspective, it is generally a good idea to hedge the currency risk for bonds.
The impact of currencies on yield – and especially on the risk profile – is often underestimated. Investors tend to assume that currencies are ultimately a zero-sum game and do not take sufficient account of this issue when making investment decisions.
While currency fluctuations do actually even out over time for equities, this is only over a long-term horizon and overlooks what can be massive swings within a year. After all, the volatility of currencies is in the double-digit range; maximum losses can be above 20 percent. This means that the investor takes risks without being compensated for them.
Failing to make a decision regarding the currency component of a foreign investment is tantamount to a currency bet. That is fine – provided there is a clear opinion on currency movements. If not, the investor should hedge the currency. This applies especially to asset classes with low volatility, such as bonds: a strong currency devaluation can easily wipe out the coupon payments for a whole year.
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