As institutional investors look to European and Asian stocks to diversify their portfolios, currency hedging will become an increasingly important part of portfolio management, say two foreign exchange experts.
Mark Galant, founder and CEO of Gain Capital, Warren, N.J., and Ray Dalio, president and chief investment officer at Bridgewater Associates Inc., Westport, Conn., while acknowledging they have products to pitch that can help with hedging foreign currency exchange risk, say foreign investing will play an important role this year.
That's because while many investors have known for several years they owned too many growth stocks - specifically hot technology companies - they didn't mind because the returns were so high.
"Even though it was theoretically the wrong thing to do, it had been profitable for the last five years," Mr. Galant said. "Well, last year it came back to bite them, and now you're looking at a lot of people trying to figure out what they should do."
One solution appears to be taking some of the money previously assigned to growth stocks and sending it overseas to buy stock in foreign companies. In its annual survey of retirement plan sponsors, Pensions & Investments found slight increases in allocations to international equities among public and union retirement plans in the year ended Sept. 30. Corporate plans' allocations to international equities declined slightly last year (P&I, Jan. 22).
Mr. Galant, whose firm specializes in electronic foreign exchange trading, said he believes 2001 will be the year of portfolio diversification. Plan sponsors will look more to international equities and alternative investments like foreign exchange.
For international equities, currency hedging is important because even if an investor picks the right foreign stock and gets a good return on the investment, the currency in which the stock is traded could move against the dollar. That could cause investors to lose all the money they made on the stock performance and more when they change the foreign currency back to U.S. dollars, Mr. Galant said. "Any time you invest overseas you bring with it foreign currency risk, and the best way to get rid of that risk is to simply hedge it away," he said.
Currency hedging works like this: Say a money manager thinks a foreign currency will weaken against the dollar between the time of an investment and the time to exchange the foreign currency earned from the investment. The manager would buy a futures contract on the foreign currency, effectively locking in an exchange rate ahead of time. That way the manager doesn't lose profits by holding a devalued foreign currency.
"The currency loss in many cases can swamp the equity gain," Mr. Dalio said.
Conversely, if the manager thinks the currency will strengthen against the dollar, there's no need to buy a futures contract because the foreign currency will be worth more vs. the dollar.
The dollar has been strong vs. foreign currencies, particularly the yen and the euro, but signs of a slowdown in the U.S. economy have led to fears of a weaker dollar. Given that scenario, currency hedging may not be as necessary, particularly for an investor with an eye toward a longer-term foreign investment, said Ron Madey, director of Towers Perrin's U.S. asset consulting practice.
"The common view is that it (foreign exchange risk) works out over time," Mr. Madey said. "Not all the literature supports that, but it is the common view. If you're taking a one-year view, all that changes. Then equity exposure should be hedged because currency risk can affect overall returns."
Mr. Dalio, whose company manages $33 billion, $24 billion of which is in currency overlay programs, said as investors have become more savvy about investing internationally, their foreign allocations have grown.
Generally, when foreign equity exposure is less than 10% of the portfolio, currency risk is immaterial. It's when the exposure rises above 10% that currency hedging becomes necessary, he said.
As companies become more global - Mr. Dalio uses DaimlerChrysler AG as an example - the percentage of international equity holdings will logically rise.