Currencies can boost returns—but they can also decimate portfolios if their risk is not carefully managed. Investors’ ability to forecast foreign exchange (FX) movements is notoriously limited.
Trying to time currency swings is difficult, to say the least. The drivers that matter most for a given currency—from interest rate differentials and monetary policy to investment flows and investor sentiment—can change quickly. And currencies themselves can affect central bank policy and investment flows, as well as company fundamentals. Yet ignoring currency moves is not an option. The question then: How best to handle them?
We brought together BlackRock experts to map out our methods of identifying and managing FX risks for clients. The main takeaway from our discussions, as my colleagues and I write in our new Global insights piece Getting a Grip on FX: We generally see FX as a portfolio risk that needs careful assessment and management, rather than as an opportunity to generate additional returns.
Currencies are complicated, and we prefer hedging them in the medium to long term. We believe that, for most investors, taking FX risk is not rewarded over these investment horizons. Why hedge? With no clear return benefit over time, the key aim for many long-term investors is to reduce volatility. Currency moves can greatly increase the volatility of portfolio holdings. This is particularly the case for low-yielding fixed income assets, as the green bars in the Keeping a lid on volatility chart below show.
Unhedged bond holdings may double annualized portfolio volatility, our analysis shows. FX swings can swamp bond portfolio income, especially when yields are historically low. It is a risk that cannot be ignored. The impact is less for equities relative to overall risk—yet still large. Currency risk adds significantly to overall portfolio volatility in eurozone and UK equities. The exception: Japan, due to the yen’s propensity to move in the opposite direction of the domestic stock market.
As a result, we advocate investors hedge most of their FX exposures in major developed markets (DMs). We favor fully hedging fixed income allocations and leaving a portion of equity holdings unhedged, especially for European investors.
We do see some room for taking FX risk in the short term, especially in emerging markets. But it’s important to keep in mind that this liquid, 24-hour global market is often the first to respond to unexpected events. Currencies are quick to react to breaking news or political shake-ups, as was on display last year in the British pound’s immediate reaction to the UK Brexit vote: The sharp decline priced in potential future economic pain.
However, few currencies jump out to us as screaming buys or sells, according to a FX scorecard created by our Global Fundamental Fixed Income that compares 29 currencies on 21 metrics across four categories. These categories reflect what we see as key drivers of currency moves: policies affecting interest rate differentials, investor sentiment and other technical factors, valuations and economic fundamentals. Indeed, few of our investment teams have high-conviction currency views at this juncture.
Read more on our FX scorecard, and on hedging currency risk in general, in our full Global insights piece Getting a Grip on FX.