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To hedge or not to hedge?

Photo: Shutterstock

Photo: Shutterstock

2018 has been characterised by a number of political and economic risks which have impacted capital markets negatively. From the threat of trade wars, to divided European governments, to shifting economic policy by central banks; these are just a few of the headwinds that investors have been faced with, and the market has acted accordingly.

As is typical during turbulent periods, the dollar has rallied considerably against all major and especially emerging market currencies. Currency exposure is an element in an investor’s portfolio that is often overlooked at his/her own peril.

When investing in an asset which is not denominated in your domestic currency (in our case the Euro), the position is affected by both the capital fluctuations in the asset as well as the currency in which it is denominated, or asset return plus currency return.

In fact, assets that are based in emerging market currencies typically would command a greater level of expected return than assets in developed countries, due to its’ risk and interest rates expectations.

Taking a practical example, when a European investor is taking a position in an equity instrument that tracks the performance of the S&P 500 Index, the return to a European investor is the performance of the index itself, coupled with the movement in the EUR/USD exchange rate.

Unhedged exchange rate movements cut both ways, and the decision about whether or not to hedge these exposures is an individual one. As a broad industry rule of thumb, foreign currency equity exposure is left partially unhedged, while a fixed income portfolio is expected to be chiefly hedged.

Hedging comes at a cost, varying by the type of instrument used to hedge and the magnitude of the hedge (partial hedges cost less). Hedging is typically done via options, futures, forwards or even exchange traded notes that are typically leveraged towards a currency.

The starting point in your decision whether to hedge in full, partially or not is the level of risk you are willing to take. As intimated above, currency movements can have a dramatic effect on your total return, therefore it is down to the investor to determine how much exposure to a currency he/she is comfortable with. If the foreign asset exposure is only a small portion of your global portfolio, then it may not be worth the cost of hedging it.

The duration of your investment horizon plays an important part in the decision making process. In the long run, currency movements tend to revert towards the mean, therefore taking a long term perspective, it may not be worth the while incurring hedging costs if you can bear the interim volatility.

Nowadays investors have more cost effective ways of having direct hedged exposure to foreign assets via pre-hedged asset classes in collective investment schemes as well as exchange traded funds (ETFs) which are inherently currency hedged.

Currency prediction is known to be one of the more challenging fields of financial management, which lends to the reason why many professional investors tend to use hedging techniques to avoid unexpected losses.

Disclaimer: This article was issued by Simon Psaila, financial analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

 

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