To hedge (or not to hedge) currency moves

To hedge, or not to hedge, currency moves: that is the question. Terry provides our answer.

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.

FX piece blog chart

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.

Terry Simpson, CFA, is a multi-asset strategist for the BlackRock Investment Institute. He is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal. International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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