“If you want to become a millionaire by trading currencies, then start with a billion dollars” – Anonymous.
We investors like to live in denial, even when something stares us in the face and jumps up and down for attention. We let inertia drive the investment outcome and sometimes take unnecessary risks.
Most institutional investors have a globally diversified portfolio and thus are exposed to meaningful foreign currency exposures. This FX exposure brings with it currency translation risks that potentially adds increased volatility to the portfolio return, and may or may not have an incremental return expectation. However, we accept this embedded currency risk, and the potential impact on our portfolio, simply because that is how we have always done it.
Investors in the US are particularly prone to accepting this uncompensated risk whereas investors in other regions are more likely to manage this currency risk. This may be because investors outside the US have a higher proportion of their assets invested in non-base denominated currencies (i.e. currencies that are not their own), and the proportional currency risk is higher.
US investors should pay attention to currency risk especially if their global asset exposures are more than a third of their total assets. This represents a significant portion of any portfolio that is exposed to currency risk and thus should be managed appropriately.
There are three key steps necessary to manage currency risk:
- Separate the investment decision to invest in international assets and the investment decision to take on the appropriate currency risk.
- Do not assume that your international equity manager or your custodian is an expert in managing currency risks
- Decide on the appropriate level of currency risk to hedge and outsource the implementation to a fiduciary currency manager
The third step above may require some further clarification. Whether we hedge 100% of the currency risk or none at all (the case of inertia) or somewhere in between is a challenging question. If we knew whether USD would strengthen or devalue relative to other currencies, the decision to hedge USD or not would be simple. But like any investment or risk management decision the hedge ratio has to be determined based on your desired investment outcome, risk tolerance and long term return assumptions. Most consultants and clients choose a 50% hedge ratio, which has been referred to as “regret minimization” hedge ratio.
This is my “I don’t know the answer” hedge ratio. I don’t know what the right hedge ratio is. It may be different for each investor. If your liabilities are in USD then perhaps your currency risk should be closer to zero and thus your hedge ratio may need to be closer to 100%.
Currency risk like any other risk in your portfolio has to be explicitly identified and managed as needed. We may choose not to hedge the currency risk but that should be an explicit decision rather than implicit action.
If it walks like a risk, quacks like a risk, it probably is one!! Manage it.