Risk Considerations for Currency Hedging of Global Equity ... - TD

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Risk Considerations for Currency Hedging of Global Equity Portfolios from a U.S. Investor's Perspective

By Philip Gendreau and Yuriy Bodjov

Investing in foreign stocks can provide significant diversification benefits and can be a source of positive expected returns. However, U.S. investors need to be careful because while currency exposures from equity investments are not expected to be a source of added value, they can be a source of added risk. Currency fluctuations could have a dramatic impact on the performance of international investments. This article analyzes the role of currency hedging in managing the risks of foreign equity investments and possible ways to reduce currency risk.

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Two sources of risk when investing in global equities

An investor who allocates a share of his portfolio to foreign equities gets exposed to two sources of risk: local equity market risk and currency risk. These risks are not independent and are actually quite often correlated. Failure to take that relationship into account can result in a significantly higher risk than anticipated.

The U.S. dollar is usually considered a defensive currency. It tends to depreciate relative to other currencies when equities are doing well and appreciate during market turmoil as investors rush to "safe havens." Other currencies such as the Japanese yen and the Swiss franc also exhibit similar behavior.

Distribution of Monthly Returns for the U.S. Dollar Index

Strong up market Strong down market

-15%

-10%

-5%

0%

5%

10%

15%

Source: Bloomberg. Distribution of monthly returns from January 2000 to April 2018. Strong up (down) market is defined as months when the MSCI World appreciates (depreciates) by at least 5%.

When measured against the USD, most other currencies are cyclical, meaning that they tend to amplify both positive and negative equity returns. When equities are doing well, returns on foreign investments tend to be higher for U.S. investors due to the appreciation of the foreign currency. This comes at the expense of greater losses when equities fall.

Leaving the foreign currencies unhedged can significantly increase the volatility of returns for U.S. investors. For example, since January 2000 the annualized volatility of Australian equities has been around 13% in local term, but closer to 21% if we take the currency risk into account.

Annualized Volatility of Australian Equities

Unhedged volatility 30%

Local volatility

20%

3-year rolling standard deviation

10% 0%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Source: MSCI and TDAM. Annualized volatility from monthly returns on a 36-month rolling-basis. As of April 30th, 2018. New Thinking | For Institutional/Investment Professional Use Only. Not for further distribution.

PAGE 2

To lower the volatility from the foreign investment we need a strong negative correlation between the equity and the corresponding foreign currency. The covariance has to be negative enough to ofset the additional risk introduced by the unhedged currency. In other words, the currency has to be even more defensive than the USD. This has been the case only for the Japanese yen in the recent years and only by a slight margin. For all the other currencies there can be significant risk reduction benefits from hedging.

Correlation between Foreign Equity Markets and their Respective Currency

Period Last 5 years Last 10 years Last 15 years Last 20 years

Japan -0.60 -0.58 -0.52 -0.38

Switzerland -0.30 -0.01 -0.13 -0.17

Euro -0.19 0.33 0.22 0.12*

UK -0.12 0.19 0.13 0.00

Canada 0.28 0.58 0.54 0.48

Australia New Zealand

0.20 0.48

0.38 0.26

0.42 0.43

0.21 0.24

Source: MSCI and Bloomberg. Correlation measured from monthly returns of MSCI indices as of April 2018. *EUR data from January 2000.

Strategic hedging

If we use a risk model which takes into account the correlations between equities and currencies, we can calculate the optimal hedge ratio that would minimize the ex-ante (expected) volatility of hedged returns. This ratio can go from zero (no hedge) to 100% (fully hedged). By fully hedging the exposure to currency risk of international equities, U.S. investors get very close to the volatility experienced by local investors.

Annualized Volatility of Returns in Local Term and in USD

Local USD

Japan 17.6% 16.3%

Switzerland 13.6% 16.0%

Euro 17.8% 21.5%

UK 13.6% 16.5%

Canada 13.9% 20.0%

Australia 12.7% 21.3%

New Zealand 14.1% 21.3%

Source: MSCI and TDAM. Calculated from monthly MSCI indices returns from January 2000 to April 2018.

For cyclical currencies such as the Canadian and the Australian dollar, we believe that the optimal decision is always to fully hedge the currency exposure. Some other currencies are neither stably cyclical nor defensive from U.S. investor's viewpoint. For such currencies, the optimal ratio is unstable and influenced by short term variations. Nevertheless, it is usually optimal to hedge it at least partially. The JPY is the only currency that the model is currently leaving unhedged, which is not surprising because the correlation between Japanese equities and the JPY over the last decade has been -0.58. However, up to 2007 the optimal hedge would have been close to 100%, as can be seen in the following graph.

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PAGE 3

100%

CAD

0% 100%

EUR

0% 100%

JPY

0%

Optimal Hedge Ratios

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Source: MSCI, Bloomberg and TDAM. The ratios are calculated on a 36-month rolling-basis from monthly MSCI indices and currency returns.

Some investors may be surprised to find out that the currency hedging policy actually afects the equity positions held in a low volatility portfolio. This is often missed. To achieve the lowest volatility, the weights allocated to countries and sectors have to adapt to reflect the hedging decision. For example, a fully hedged global portfolio would have less U.S. and Japanese equities and more in European and Canadian stocks.

Currency Hedging and Optimal Country Weights

50%

No Hedging

40%

Full Hedge

30%

20%

10%

0%

USA

EUR

JPN

GBR

Source: TDAM. Simulated country weights as of May 31, 2018.

CAN

OTHER DEV

EMERGING

Similarly, a fully hedged global equity portfolio would have more weight in the Consumer Staples and Energy sectors and less in the Industrials and the Information Technology.

Impact of Currency Hedging on Optimal Sector Weights

20% 15%

No Hedging Full Hedge

10%

5%

0% Consumer Consumer Discretionary Staples

Energy

Financials

Health Care

Source: TDAM. Simulated sector weights as of May 31, 2018.

Industrials

Info Tech

Materials Real Estate Telecomm Utilities

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PAGE 4

Currency hedging for low volatility portfolios

We have seen that hedging currencies can make foreign investments less risky. We believe this is even more important for investors in low volatility strategies. Low volatility portfolios are typically more sensitive to the risk introduced by unhedged currencies. To understand this, consider for example an investor who buys short term bonds in another country. Nearly all the risk of their position comes from the foreign currency and the hedged position would have a much lower volatility, no matter the correlation between the bonds and the currency. At the other extreme, currency risk only has a marginal impact on foreign investments in very speculative securities. The following graph illustrates this point.

Standard deviation

19% 18% 17% 16% 15% 14% 13% 12%

0%

Optimal Hedge Ratio for Japanese Equities

Full index Low vol

Source: MSCI, Bloomberg and TDAM. The annualized

volatility is calculated from January 2000 to April

2018. The low volatility index is composed of securities

20%

40%

60%

80%

100% in the bottom volatility quintile (rebalanced monthly).

Hedge ratio

The hedge ratio that would have minimized the volatility of an investment in the MSCI Japan Index from 2000 to 2018 was around 25%. However, if the investor was interested only by the least volatile stocks of the index, the optimal hedge ratio would have been much higher: close to 60%.

Currency hedging: an example

Consider an investor with a diversified international portfolio, for example, MSCI World ex. USA. The investor has three options concerning the management of exchange rate risk: leaving the currencies unhedged, fully hedging the exposure, and trying to hedge strategically based on correlations between currencies and equities. In the context of a multi-currency portfolio, we aim to exploit the covariance between currencies and equities to find the optimal hedge ratios. The following table shows the results that could have been obtained under the three diferent hedging policies.

Backtest of the Currency Hedging Overlay

Unhedged

100% hedge

Strategic hedge

Return

8.6%

8.3%

8.8%

Volatility

16.3%

13.2%

12.9%

Source: TDAM, MSCI, Bloomberg. Backtests performed on monthly returns of the MSCI World Index ex-US in USD from January 2003 to April 2018. The optimal hedge ratios are calculated on a 36-month rolling-basis with data starting in January 2000. Only 6 currencies which account for more than 90% of the index are hedged (JPY, CHF, EUR, GBP, CAD & AUD). The roll yield is taken into account. No transaction costs. For further information on the backtest please refer to the disclosures on page 7 of this document.

Note that the strategic hedge only tries to minimize volatility and its superior return is only incidental. Still we can see that currency hedging would have had a positive impact on risk-adjusted returns.

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PAGE 5

Roll yield

Another factor that is important to take into account when implementing a currency hedge is the forward premium. According to the covered interest rate parity, the forward premium of an exchange rate is approximately equal to the diference between the interest rates of two countries. For example, interest rates in the U.S. are currently higher than in Switzerland. That means that the forward exchange rate (USD/CHF) is going to be higher than the spot exchange rate. To hedge CHF exposure, a U.S. investor would have to short the forward contract, collecting the forward premium.

Investors from the U.S. currently have a significant advantage compared to investors from other countries when it comes to currency hedging. Interest rates in the U.S. have recently been trending up faster than in other countries resulting in attractive roll yields when hedging many currencies.

Forward Premiums for Currencies Quoted Against the USD

JPY

CHF

EUR

GBP

CAD

AUD

NZD

Annualized forward premium

2.01% 3.26% 2.73% 1.70% 0.79%

Source: Bloomberg. Annualized forward premiums from 1-month forward rates as of June 29th, 2018.

0.14%

0.03%

The Federal Reserve has already raised interest rates twice this year and two more quarter point hikes are expected by the end of 2018. Other central banks such as the European Central Bank and the Bank of Japan are more dovish. Positive roll yields can then be expected for a while for U.S. investors.

Conclusion

We have seen how currency hedging can help in reducing the risk of foreign investments and how a quantitative approach based on correlations between currencies and equities can help in achieving optimal results. We have also demonstrated why hedging foreign exchange risk is particularly advisable for low volatility strategies. Given the attractive roll yields presently available, the optimal approach to portfolio selection would be to take into account the forward premium and hedging decisions directly during the portfolio optimization stage instead of adding a currency overlay to the pre-allocated portfolio. More "risky" foreign investments may become more attractive when considering how hedging can reduce volatility and what the roll yield adds to the portfolio's alpha.

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PAGE 6

Backtested Performance Information

The backtested performance results on currency hedging presented herein is for illustrative purposes only. The source of the data and assumptions used for this backtest is the monthly returns of the MSCI World ex-US in USD returns from January 1 2003 to April 30 2018. The optimal hedge ratios are calculated on a 36-month rolling-basis with data starting in January 2000. Only 6 currencies which account for more than 90% of the index are hedged (JPY, CHF, EUR, GBP, CAD & AUD). The roll yield is taken into account. No transaction costs.

These results have not been verified or audited. Further information on methodologies or calculations used to achieve these results can be requested. Backwards looking assumptions benefit from hindsight and are achieved with no real market risk and are not an indication of actual outcomes, returns or projections. Backtested performance does not reflect actual trading or management and is not predictive of actual results. Actual results may be materially diferent from the results portrayed in the returns presented and an investor can incur significant loss.

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