Lesson Eight: Currency Hedging (Check Your Reserves)
Hedge ratios must differ for reserve, non-reserve currencies.
July 19, 2010
Choosing whether or not to hedge foreign currency exposure is a decision (like many in investment management) where there is no clear right or wrong answer. Your choice is as much a function of objectives, beliefs and risk tolerance as it is empirical evidence. Those that hedge 100%, or 50%, often cite the objective of reducing short term volatility. Those that choose not to hedge believe it’s a zero sum game in the long-run and that the cost of hedging isn’t worth it.
The experience of 2008 and 2009 did not provide a clear answer. The policy of hedging certainly didn’t reduce the short-term pain in 2008 as returns on unhedged foreign equities for Canadian domiciled investors were much better than hedged (MSCI World Ex- Canada unhedged vs. hedged was -25.8% vs. -41.0%). Was this a one-time random event or is there a fundamental reason this might be a lasting relationship? A recent Harvard business school paper (Global Currency Hedging, published September 5, 2007, revised January 2009, John Y. Campbell, Karine Serfaty-de Medeiros, and Luis M. Viceira) may offer some insight into this question.
The authors make the argument that hedge ratios should differ between reserve currencies and non reserve currencies and it is a very convincing argument with a lot of intuitive appeal.
The basic idea, from a Canadian perspective, is that the hedge ratio vs. the U.S. dollar should be lower than the hedge ratio on other major currencies. This is because the U.S. dollar is the global reserve currency, at least for the foreseeable future, and it will always get a flight to quality, or risk aversion rally when there is stress in global financial markets. This makes the global reserve currency unique when setting an optimal hedge ratio.
The lesson learned is that for Canadian investors, there may be a strong case for a lower hedge ratio on the U.S. dollar than other foreign currencies. In times of financial market stress a strengthening U.S. dollar will partially offset negative equity market returns.
The timing of any change in hedge ratios is a tactical decision and should be done very carefully, but very much as a separate decision from the long-term policy hedging decision.