This paper explores the extent to which developed-market
currency exposures should form part of an investor’s strategic
asset allocation. The key consideration is how a currency
can diversify the rest of the portfolio, acting as a stabiliser in
times of stress. Some currencies are pro-cyclical, doing well
in times of economic expansion; thus, hedging exposures
to these currencies could be beneficial. Other currencies, in
contrast, earn their place in a portfolio due to their propensity
to rise during times of economic turbulence. We find a
modest exposure is sufficient: allocating around 20% of the
portfolio’s risk budget to these counter-cyclical currencies
provides diversification while keeping in check the risk that
currency movements might drive the overall portfolio return.
Investors are well versed in diversification, spreading their risk exposures across a wide range of investments. These exposures, offering returns at different times, then work to produce an overall return stream that is smoother than the underlying constituents. A particular challenge with casting the investment net wide is that many assets exist in different domiciles to that of the investor. Exposure to the currencies of these domiciles therefore enter the portfolio often as an afterthought.
The question then arises as to whether these foreign exchange exposures should be hedged or retained. On the one hand, these exposures are unintended and not expected to contribute materially to return (so: hedge); on the other, they are an additional source of risk and may be able to reduce volatility at the portfolio level (so: retain).
How do we approach this as a Solutions team? We start with a review of the importance of the currency decision for an investor’s returns, and contrast this with the observation that the hedging decision should have negligible long-run expected return. In the short run, however, the way a currency’s returns covary with asset returns is the key characteristic that determines how much of it should be retained rather than hedged. We apply this insight first to single-currency assets and then to portfolios, uncovering a simple risk-budgeting rule that works well across a wide range of portfolios and currencies.
Interested in learning more?
Download the full viewpoint to discover more.