When is the right time to hedge international portfolios against currency fluctuations?
The rising value of the U.S. dollar since early 1995 has raised this important question for international investors.
Many dollar-based investors who focus on the long-term macroeconomic picture in their investment process have ignored the currency question. They see it as ancillary to the underlying investment decision-making process.
For many years, in a declining dollar environment, this proved a beneficial investment approach. However, recent experience shows ignoring currency fluctuations may prove quite detrimental. Just take a look at the Dow Jones Global Indexes. As of Oct. 24, in domestic terms the German index was up some 39% year to date, while in dollar terms the advance was only 18.69%. Similarly, the Swiss index was up 40% in domestic terms but only 27.75% in dollar terms.
And in the turmoil produced by the devaluation of many of the Asian currencies, the Japanese index was down 7.5% in domestic terms, while in dollar terms it fell 12.07%. Prior to the first currency devaluation of the Thai bhat July 2, however, the Japanese index was up 7.1% in domestic terms, but 7.93% in dollar terms. That was significant in light of the approximately 11% decline in the U.S. dollar against the yen from early May through June.
Along with a rising dollar environment, increased volatility is a significant factor when examining the issue of hedging risk. Thus, the question of how and when to protect a portfolio against currency fluctuations has taken on new importance. The extent of that import can best be examined by reviewing data provided by InterSec Research Corp. The growth in U.S. pension plans' international assets has been dramatic: to more than $450 billion in 1996 from $160 billion in 1991.
Along with the growth in pension assets, similar trends have developed in the mutual fund area. Data provided by Lipper Analytical Services Inc. show total assets in international equity funds have grown to $197.5 billion as of March 31, from $14.9 billion at year-end 1990.
The bulk of this spectacular growth in assets has occurred in a long-term declining dollar environment. Examining the longer term charts of dollar movement against the Japanese yen and German mark, the bulk of this growth has occurred below 120 yen per dollar and 1.70 marks per dollar.
The strength of the dollar since early 1995 has been fueled by both the bull market for U.S. equities, and the level of real interest rates in the United States. This issue of interest rate differentials has been one of the defining factors behind the movement in foreign exchange rates. Real interest rates in the United States, among the world's highest, look to remain within recent trading ranges as the market waits for the next action by the Federal Reserve.
In Europe, the spring elections in France sparked renewed concern over the terms of the Maastricht Accord. The high unemployment levels across Europe lead to the conclusion that while the political desire for the Maastricht Accord is still strong, the actual implementation of the accord, in all likelihood, will require some compromise. The recent rate increase by the German Bundesbank appears more aimed at initiating a convergence in European rates than any domestic monetary response to 11% unemployment levels in Germany. If concessions concerning fiscal policy to stimulate employment occur, then a weaker euro seems inevitable.
In Asia, the ongoing turmoil created by the summer devaluations has led to a reassessment of long-term growth rates throughout the region. In Japan, prolonged weakness has left policy-makers calling for tax cuts or other stimulative fiscal policies. The limitation on Japanese fiscal policy, restricted by the government's goal of reducing public debt, leaves little room for monetary policy maneuvering, given real interest rates in Japan. While the dollar's renewed strength against the yen has raised concern over growing trade imbalances, recent numbers have shown those imbalances are not as centered on Japan as expected. More of the imbalance seems to lie with China, clouding what type of response might be appropriate. It is not clear that the Clinton administration, after being on record that they were opposed to the continued use of the currency markets to influence trade, would be inclined to reopen that approach. In this environment, the strong performance by the U.S. dollar will continue to have adverse effects on an unhedged portfolio's performance.
No drop in demand
The demand for international assets continues, despite the Asian debacle, as investors seek diversification opportunities. Concessions that allow the Maastricht Accord to progress will benefit certain domestic European markets. In addition, investor appetite is being fueled as the U.S. equity markets reach record valuation measurement levels.
This summer, Fidelity Investments in its monthly mutual fund guide, made the case for international investments for the first time in a year:
"Foreign markets account for more than half the world's investment opportunities; historically foreign markets have tended to move in different cycles from the U.S. market, thus offering an opportunity for diversification. Many foreign markets are growing faster than the U.S., and that economic growth could translate into more attractive investment opportunities."
The turnout at a recent emerging markets conference confirmed to us that investors, after the Asian devaluations, are eagerly seeking new emerging markets as alternatives.
Fidelity's fund guide highlighted the attractiveness of investing in foreign markets: "Compared to the U.S., many foreign markets are attractively priced on the basis of traditional valuation measures such as price/earnings or price/book value." However, Fidelity does offer a caveat about the risks of overseas investment: "Foreign markets are more volatile than the U.S. market in that they introduce currency risk, political uncertainty and accounting differences into the investment equation."
Know your risk tolerance
This combination of overseas potential and a strong dollar should encourage executives to examine currency fluctuation under the broad scope of the risk tolerance philosophy of the investment process.
The primary goal of that process is to ascertain the exact performance benchmark, and what level of risk, if any, is acceptable. Is the investor looking to measure performance against the exact portfolio or some index that replicates the portfolio? Many pension plans are mandated to various accepted industry benchmarks, such as the Morgan Stanley Capital International Europe Australasia Far East Index, either hedged or unhedged.
Once the benchmark is determined, then a discussion of the approach to hedging is next. Is the investor seeking to follow a passive or an active management approach?
First, the passive approach. If the objective is zero currency fluctuation tolerance, then a fully hedged portfolio using the foreign exchange forward markets is the traditional approach. Investors must be aware that in exchange for this safety, they forgo any potential domestic currency appreciation in individual markets.
This approach also carries increased costs including administrative control, as cash flows can be highly volatile. These transactional flows must be monitored closely, to be reinvested or liquidated, as currency exposure and or banking fees will result. Real world experience shows that even moderate changes in a composition of a portfolio produces the need for constant monitoring to ensure that full hedging is achieved. The higher short-term volatility in currency markets of late makes close monitoring imperative. In any event, given currency fluctuations, hedging may incur substantial cost.
As was mentioned earlier, some investors still view currency fluctuation as ancillary to the investment objective. In this case, the passive approach is an unhedged portfolio. Unhedged portfolios, until recently, benefited from the long-term decline in the U.S. dollar and added profitably to the portfolio. Additionally, there was little administrative burden as currency fluctuation was ignored. Some studies have shown that for many portfolios, the currency movement added greatly to the overall performance returns. Unfortunately, a strengthening U.S. dollar has the opposite affect. Unhedged investments made when the dollar was below 100 yen are clear examples. Unhedged portfolios, by definition, carry unlimited risk in both rising and falling dollar environments.
Ignorance is not bliss
The point to stress is: a great deal of risk is being taken, without any compensation, in ignoring currency fluctuations in a portfolio. Experience in currency markets should make investors sensitive to the dramatic price changes and volatility inherent in these markets. Any risk taken should be measured and compensated for accordingly.
Next, we examine the active approach. An active approach is based on risk management to increase the alpha of the portfolio, and risk control to lower the volatility. Using an active approach in a hedged portfolio provides some upside opportunity by taking limited currency risk. This risk can be clearly defined against the benchmark and thus exactly measured. This approach also lowers cash flow volatility.
An unhedged portfolio benefits from active management by reducing overall currency risk. This approach still allows the upside opportunity of currency fluctuations, while providing protection against downside risk. Again, the risk can be measured and evaluated against the benchmark. This measurement will define the compensation received for taking risk. Additionally, when implemented correctly, portfolio volatility can be reduced.
Active management requires currency expertise. The level of that expertise and the resultant costs will drive the decision-making process to determine if such expertise should be provided internally or outsourced. A close examination of the costs and potential benefits of any decision regarding currency expertise will assist in determining which approach best suits each investor.
Unpredictability is the rule
Currency markets are notoriously unpredictable. Euromoney magazine points out that during the past 13 years of professional currency forecasts for the value of the British pound against the U.S. dollar, the median forecasted direction was correct less than 50% of the time.
Thus, unlike pure speculation, the goal of successful currency hedging is not to forecast the direction of exchange rates, per se, but to design and execute strategies to adhere to the risk tolerances of a portfolio. Identifying those tolerances and then operating within the parameters of those tolerances is the key to successful currency risk management.
So, when is the best time to hedge? The answer is: After a close examination of the affect and risk of currency fluctuations on a portfolio, particularly the issues of cost and opportunity.
How currency fluctuations are handled might be the key to the overall success of a portfolio. Ignoring the currency markets might prove self-defeating. The U.S. dollar has reversed a 10-year downtrend. While this in itself does not argue for a higher dollar, it does rule out the predictable gradual slide investors might have become overly reliant on in the past.
Finally, the uncertainty generated over the Maastricht Accord leaves the European currencies in flux. The weakness of the Asian tigers , compounded by the continued economic weakness in Japan, leaves us looking for increased currency volatility, ultimately beneficial to the U.S. dollar. This argues for a more active approach to risk management of currency fluctuations, not less.
Gary Klopfenstein is president and Dermot L. McAtamney, director of institutional marketing, for GK Investment Management Inc., Bloomington, Ill.