Currency hedging — should we bother?

February 9, 2012

Currency hedging — should we bother?

Maybe not as much as you think, if we are talking purely from a equity return point of view — according to the new research that analysed 112 years of the financial assets history released by Credit Suisse and London Business School this week.

Exchange rates are volatile and can significantly impact portfolios — but one can never predict if currency moves erode or enhance returns. Moreover, hedging costs (think about FX overlay managers, transaction costs, etcetc).

For example, the average annualised return for investors in 19 countries between 1972 (post-Bretton Woods) to 2011 is 5.5%, hedged or unhedged. For a U.S. investor, the figures were 6.1% unhedged or 4.7% hedged (this may be largely because only two currencies — Swiss franc and Dutch guilder/euro — were stronger than the U.S. dollar since 1900).

“The impact of hedging on returns (as opposed to risk) is a zero sum game. The profit a German investor makes on Swiss assets if the franc appreciates is offset by the loss the Swiss investor incurs on German assets… Averaged over all reference currencies and countries, the mean return advantage to hedging both equities and bonds was zero, both over 1900-2011 and 1972-2011.

LBS’ Elroy Dimson and Paul Marsh, who presented the report at a briefing this week, were keen to emphasise hedging has its use. Mainly, it does reduce volatility, hence risk.

However, the study showed that the benefits of hedging on volatility did shrink; On average, hedging reduced equity volatility by 15% over 1900-2011, but by only 7% over 1972-2011. For bonds, the figures were 36% and 30%.

“The benefits of hedging have shrunk, and for equities, the risk reduction of 7% over the last 40 years is less than half that obtainable from international diversification. Investing in the world index, rather than just domestically, would on average have reduced volatility by 20%,” the study said.

“For long-term investors, the risk reduction benefits of hedging rapidly decline. This is because currencies tend to converge towards reflecting relative inflation rates. It is also because hedging introduces a new form of risk, namely, a bet on real interest rates at home versus abroad. Even over relatively brief multi-year horizons, we have seen that hedging on average leads to an increase in the volatility of real returns, and is on average counterproductive.”




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