Hedging currency exposure increases tail risk in equity portfolios by increasing the notional exposure, “and therefore the magnitude of possible return or loss,” according to a GMO white paper released Monday.
The paper’s author, Catherine LeGraw, argues against hedging currency in equity portfolios. She cited decreased volatility reduction over time as companies have become more global; higher correlations between U.S. equities and hedged equities; and higher leverage – “which can lead to higher tail risk.”
The recent example of Switzerland is cited when the Swiss National Bank ditched its peg to the euro in mid-January and the Swiss franc skyrocketed. A hedged portfolio had 200% notional exposure – and for the month of January the MSCI Switzerland (local currency) fell more than 14% over two days, while the unhedged index was up 2.6% in USD.
The paper also examined rolling seven-year returns of the MSCI EAFE from 1990 to 2015 and the MSCI Switzerland index between 1971 and 2015 and concludes that for both indexes, evidence shows more tail events occurred (both negative and positive) for hedged portfolios compared to USD counterparts.
