The merits, or not, of hedging exchange rate risk in a strong dollar world

The elephant in the room that is most times overlooked is the impact of the constantly fluctuating exchange rate on an investment and the returns it delivers. Currency hedging – or removing exposure to the inherent random walk of the exchange rate provides a method to eliminate the impact of currency variations on an investment whilst still gaining exposure to offshore assets.

This year has been particularly unpredictable and much of the exchange rate volatility – and dollar strength - can be attributed to a basket of macro-economic events. The main events that have contributed to currency volatility include Russia’s invasion of Ukraine, China’s zero covid policy and the US Federal Reserve’s successive rounds of interest rate hikes.
Currency volatility affects all countries that have floating rate currencies and ultimately means that the value of your offshore investments are at risk when there is elevated exchange rate volatility. 

With the strong dollar effectively proving to be a one-way bet for much of this year, many investors are beginning to ask whether the time has come to shift at least some of their offshore allocation back to SA. Currency fluctuations have always complicated the decision on where to invest globally because exchange rate movements are unpredictable and driven by an array of different economic factors. These include things like the economic strength of a country, inflation, interest rate movements and the direction of capital flows. 

So far, most investors know that if you want to invest offshore, they will be taking on currency risk. Sometimes this is positive. For instance, if there is a risk-off event and the rand blows out (gets weaker), it can be good for rand-based returns because once you have converted the hard-currency returns back into rands, you’re earning much more. 

However, the reality is that more often than not we are not going to be experiencing tail-risk scenarios (as the one described above) and currencies do tend to revert to their fair value in the long-run. This means that the benefits of not hedging currency risk to take advantage of hard currency gains during rand selloffs will likely diminish in the long-run as the rand rebounds back to fair value, meaning it was not worth taking on the roller coaster journey of exchange rate risk. 

The chart below highlights that there is a strong case in favour of hedging the currency risk in bonds and credit and, in so doing, significantly reducing asset class volatility. In the fixed income space, namely bonds and credit, the risk of not hedging currency volatility is higher than it is in the equities and listed property space.

But does that mean we need to remove this risk and, if so, how? Investment managers can remove the currency risk in portfolios by using either futures/forward contracts on the currency or options to hedge an investment’s currency exposure. When using futures/forward contracts, the idea is to completely neutralise the impact of currency moves and it doesn’t cost much. You are still gaining the long -term interest rate differential (the difference in interest rates between two countries). So for example, if you’re a South African investor and you hedge your USD exposure, you don’t lose out when the rand depreciates, you just participate in a much smoother way. The example of developed market bonds is shown below. For a South African investor, over time you do benefit from the depreciation of the rand but it comes with volatility in performance over time (blue line).

If you put in place a currency hedge, you would, instead, be exposed to “dollar-like” (less volatile) risk but still get the benefits of a depreciating rand (terracotta line). 

When using option structures, investment managers focus on mitigating only the risk of a strengthening rand on your portfolio (in other words more of a one-way bet), and this does cost a bit more. The option’s structure depends on what the investor is hoping to achieve and various managers offer expertise in putting together the desired options contract.

From an overall portfolio vantage point, avoiding currency swings is critical from a risk perspective. The ability to hedge currency exposures has been beneficial in our multi-asset portfolios at Prescient. By using a currency hedging overlay in our models, we are able to increase our offshore exposure while still reducing the overall volatility of our portfolios for a smoother journey with much less SA concentration risk. 

By increasing our offshore allocation, we are able to gain exposure to a more expansive opportunity set of assets, which offers valuable diversification benefits. At the end of the day, we target the same returns as a fund that is not hedged against currency moves, but our investors are getting these at lower risk. Having said that, having the ability to currency hedge does not necessarily mean you have to use it, but it is beneficial to keep it in your toolbox when building optimal strategic asset allocation and tactical asset allocation positioning. 

Historically, investors have always retreated into safe-haven assets like the dollar during times of crisis because it is still the reserve currency of the world. But inevitably there will be exchange rate risks if you invest offshore – even if you are invested in the dollar. You need to be aware of these and ensure these are managed where it makes sense to do so.  DM/BM

Author: Shriya Roy – Quantitative Analyst at Prescient Investment Management.

Disclaimer

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