Portfolio management requires many decisions. One decision that many investors don’t give much thought to is how much of their financial net worth should be in their “home” currency. For example, if you’re living a cross border lifestyle, or have assets in two or more countries, how should you manage the different currencies you have in your portfolio? At Cardinal Point, we think about this a lot. The portfolios we manage are internationally diversified, and many of our clients invest in, and spend money in, more than one country.
When buying foreign stocks and bonds, you are really making two investment decisions. First, you are deciding to make the investment. Second, you are deciding to buy the currency. Or you can make the investment but “hedge” the currency. If you like the company but not the currency, then a professional manager would buy the company but hedge the currency risk. Hedging can be done in several ways though the concept is always the same. The end goal is to immunize the currency movement so that you are only exposed to the movement of the investment and not that of the currency as well.
All investment managers investing outside their “home” country are faced with currency hedging decisions. Cardinal Point is unique because we invest from two different countries and have clients that live and work in both. Not only do we have to make the currency hedging decision as it relates to the foreign content in portfolios, but we also have to consider how our client’s capital will be able to maximize returns and minimize risk when they may need retirement income in the other currency.
In order to explain how Cardinal Point approaches currency hedging from our unique vantage of serving investors in the U.S. and Canada, we will start with the basics that all portfolio managers should consider when investing in foreign stocks and bonds.
A Short History of Currency Hedging in Portfolios
When international investing first started, only very sophisticated investors like huge pension funds could hedge currency. The costs of hedging were too high and the types of products that allowed for it were underdeveloped. Currency hedging became more prevalent in the 1970s with the development of publicly available options and futures. In the early 1990s, some believed that you shouldn’t hedge your stocks because not doing so resulted in greater diversification.
One of the classic studies that was done in this area was Froot 19931. Kenneth Froot did research on portfolios and found that hedging the currency of a foreign stock portfolio did not decrease the variability as was previously believed. In fact, a stock portfolio that left the currency “un-hedged” had lower volatility.
This led to the concept that currency volatility actually reduces the volatility in foreign stocks. The concept goes something like this.
- The return path of the currency moves independently from the return path of the stock.
- So, if you pair the time series of the return of the stock with the time series of the return on the currency, you will get a time series with lower volatility than the return of the stock by itself.
This is similar to the concept that investing in two stocks will be less volatile than one because there are some days when the stocks will move in opposite directions. For stocks, the currency exposure can act as a further diversifier. The volatility of a portfolio of two or more foreign stocks can actually be reduced if the currency is left “un-hedged” in the portfolio.
This relationship can vary over time and can also change depending on which currency is the “home” currency. For Canadian investors, holding un-hedged U.S. stock positions can benefit from the USD strength that often accompanies broad market sell offs. But in times of CAD strength, the currency hedge can boost returns. It is tough to know in advance if the hedge will help or hurt, so we look to minimize the uncertainty by partially hedging stocks depending on the goals for the portfolio.
For bonds, the standard theory is different. The volatility in fixed income is much lower than equities. In fixed income, the addition of currency exposure may add greater volatility. The actual direction or return of the currency in any given year may far exceed the return of the underlying fixed income asset (bond or bond fund). Therefore, it is generally recommended that you hedge out your currency exposure of your fixed income. It has been the case over long periods of time that currency volatility can both help and hinder your portfolio returns. The rationale for currency hedging fixed income is because the currency volatility can swamp the income returns. Fixed income is supposed to reduce portfolio volatility, so we should not have currency exposure in bonds.
Cardinal Point’s Philosophy on Currency Hedging in Portfolios
Because we have investors in both Canada and the U.S., we had to rethink the conventional wisdom about hedging to your “home” currency. Many of our clients have spending needs in both countries. We believe it is important to think about the future portfolio cash outflows when developing a hedging strategy.
Literature on currency management is surprisingly thin on whether to hedge or not based on future cash outflows from portfolios. The idea of tying investment decisions to future cash outflows is known as an Asset Liability Management (ALM). There is a whole body of literature about managing with an ALM framework for pension plans. But very little of that relates to hedging currency with the specific intent that the income you earn matches the currency of future cash outflows. All literature on hedging or not hedging looks at risk vs. return of the decision and does not relate to the currency of future cash outflows.
We talk to clients about currency needs as part of their investment policy statement and portfolio construction process. Where appropriate, we encourage clients to keep their portfolio denominated in a manner that balances their future income needs. If currency exchange is needed, we have resources to help them convert their currency at more competitive exchange rates. We do not receive any financial compensation from recommending currency exchange providers, and we have negotiated competitive currency exchange rates with custodians on behalf of clients.
We deploy some currency hedging in most portfolios. Most of the bond exposure is hedged back to the currency of the portfolio, and some of the stock exposure is typically hedged. Currency management is one of the many ways we provide additional value to our clients. By taking a systematic approach to currency management, we believe our clients are more likely to have successful investment outcomes.
1 Froot, Kenneth A., 1993, Currency hedging over long horizons, NBER Working Paper No. 4355.