Currency hedging in the emerging markets: All pain, no gain

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1 FEBRUARY 2017 TIMELY THINKING Currency hedging in the emerging markets: All pain, no gain Investors in foreign equities are exposed to potential risks from both the movement of securities prices and currency exchange rates. Over the past two years, the U.S. dollar has strengthened significantly against most developed and emerging market currencies, resulting in material performance headwinds for U.S. dollar-based investors. This, in turn, has led to a growing interest in hedging the effects of currency movements on developed international equity holdings. As a consequence, many investors also wonder if they should apply a similar program to their emerging market assets. Tim Atwill, Ph.D., CFA Managing Director Investment Strategy Parametric Portfolio Associates At Eaton Vance, we value independent thinking. In our experience, clients benefit from a range of distinctive, strongly argued perspectives. That s why we encourage our independent investment teams and strategists to share their views on pressing issues even when they run counter to conventional wisdom or the opinions of other investment managers. Timely Thinking. Timeless Values.

2 FEBRUARY 2017 TIMELY THINKING ALL PAIN, NO GAIN 2 Implementation issues A number of institutions have recommended hedging developed international equity mandates against currency fluctuations, typically using the argument that currency adds unrewarded volatility to international equity returns, or by pointing out the potential future weakness in the value of the euro. If an investor agrees with these arguments, the implementation of a currency hedge for developed equity portfolios is easily implemented, as a deep and liquid currency forward market exists in which to lay off such unwanted risks. Because of this abundant liquidity and current market conditions in developed economies, the cost to implement a currency hedge is relatively low. Currently, an investor interested in receiving hedged MSCI EAFE Index exposure would pay approximately 10bps in additional fees versus an unhedged exposure. When examining emerging markets currencies, challenges exist in both the availability and cost of currency hedging instruments. Trading volumes for emerging currencies are very small relative to those seen in developed currencies. This is a consequence of emerging market countries typically having lower levels of international trade and external investment than in developed economies, and as such, no natural market exists for currency forwards. In some cases, this lack of liquidity also reflects capital controls put in place by the governments of these countries which may go so far as to prohibit currency forward activity all together. For many small emerging market countries, and the majority of frontier market countries, their relative isolation from the global economy means a market for long-term currency forwards simply does not exist in any material size. In our experience, these barriers to efficient implementation mean that nearly a third of the countries in the MSCI EM Index cannot be effectively hedged. Pricing in such thin markets is also problematic, as it is very conditional on the size of the portfolio that is being hedged. When asking brokers how much they would charge to deliver a hedged MSCI Emerging Markets Index portfolio, we were simply told these implementation issues mean that no economical bids could be offered, and referenced the number of nondeliverable currency forwards such a mandate would involve, including such major constituents as Brazil, China and Korea. Nondeliverable currency forwards (NDFs) are tools used for those countries where currency cannot be held by a foreign investor. In such circumstances, no physical currency can be delivered at the expiry of a currency forward. This lack of physical delivery means that an arbitrage-free price is harder to enforce, and makes an NDF s price more sensitive to speculative trading activities. For those emerging market countries where a bid could be obtained, an additional cost of 50bps to 100bps was typical, with some countries much higher. This reflects the costs inherent in hedging country returns in these less-liquid markets. Currency impacts on emerging market returns For the sake of discussion, let s examine the question of how impactful currency movements have been to emerging markets returns. While we present both hedged and unhedged returns below, we wish to reiterate that the hedged returns presented are for the most part not achievable in practice, and do not include sizeable hedging costs. In Exhibit A, we present the historical returns for the MSCI Emerging Markets Index, on both a hedged and unhedged basis. 1 As Exhibit A shows, over the short term, currency has at times had a powerful impact on the returns of the index. The year-to-year volatility of this benefit is perhaps not all that surprising given the natural underlying volatility of the asset class, and the dramatic change in trade flows seen for these countries from one year to the next. Over the long term, however, the impact of hedging diminishes greatly, especially when considered as a percentage of the overall index return. Importantly, when compared with the high costs of a hedging 1 Throughout this paper, we will refer to the MSCI EM Index (USD) as the unhedged version of the index, and the MSCI EM Index (Local) as the hedged version. That is, the first reflects the changes in foreign currencies versus the U.S. Dollar, while the second ignores these impacts. While MSCI also promulgates a Hedged version of their EM Index, this set of returns reflects a mechanical method to hedging currencies via one-month currency forwards. This is a reasonable real-world proxy of a hedging program, but in emerging markets can lead to performance that is still materially impacted by currency movements.

3 FEBRUARY 2017 TIMELY THINKING ALL PAIN, NO GAIN 3 Exhibit A MSCI Emerging Markets Index, calendar year returns, 31/12/ /12/ Hedged Outperforms Unhedged 4 PERCENT (%) Hedged Underperforms Unhedged *Hedged Returns are represented by MSCI Emerging Markets Index (Local), Unhedged Returns are represented by MSCI Emerging Markets Index (USD). Source: MSCI, Parametric; as of 31/12/2016. program in the current market environment, paired with the operational challenges seen in many markets, the above performance benefit from hedging doesn t seem terribly compelling. However, Exhibit A masks how an emerging market investor s experience from hedging currency exposure would have been highly impacted by their actual entry and exit points. To demonstrate this, Exhibits B and C plot the 3-year annualized return of the hedged index versus the unhedged index returns, for each month-end from December 2002 to December 2016, for both MSCI EM and MSCI EAFE Index returns. A point above the line means the hedged index outperformed the unhedged index, while a point below the line means the hedged index underperformed. Optically, it appears that the impact of hedging currency in emerging market portfolios is highly dependent on the overall return of the emerging markets over that time period, while no such equivalent pattern exists in MSCI EAFE returns. Exhibit B shows that hedging currency hurts the emerging markets investor in a strongly upward-moving market, while it helps investors in a flat- to downward-moving market. Said another way, hedging currency in the emerging markets essentially waters down your market exposure, in that all returns are reduced in magnitude, resulting in a return profile similar to a portfolio with a beta significantly less than one. As such, a rough proxy for hedging your emerging markets exposure is to simply hold less emerging markets exposure. Interestingly, Exhibit C, which maps a similar relationship for developed markets, does not show a similar pattern that is, the direction of the underlying market does not appear to have a strong impact on whether hedging is beneficial or not. 2 There are many who argue that this is a natural dynamic in emerging market currency. These arguments typically state that a primary determinant of exchange rates in emerging markets is the capital flow associated with the sale or purchase of financial securities by foreigners. If a market is moving strongly downward, more equity sales occur, and the repatriation of these proceeds then puts an additional downward pressure on the currency exchange rate. A strongly upward market has the opposite dynamic. Another camp 2 On a side note, Exhibit C does appear to show that for the vast majority of rolling three-year periods, hedging currency risk in international portfolios did not improve returns.

4 FEBRUARY 2017 TIMELY THINKING ALL PAIN, NO GAIN 4 Exhibit B Annualized three-year excess return, hedged versus unhedged MSCI EM Index Three-year period rolling monthly return, for each month-end from Dec to Dec % Hedged MSCI EM Index Return 40% 30% 20% 10% 0% -20% -10% 0% 10% 20% 30% 40% 50% -10% Unhedged MSCI EM Index Return -20% Sources: Parametric, MSCI, as of 31/12/2016. It is not possible to invest directly in an index. would say that emerging market equities have been a risk-on trade, so that periods of financial stress have generally resulted in falling prices in emerging market equities and a broad strengthening in the U.S. dollar. Regardless of the reason, we would simply state that the historical record strongly suggests that the hedging decision is closely tied with making a tactical market timing call on the overall emerging market return (i.e., hedging returns is equivalent to reducing exposure, which is making a call that markets will be weak to negative in the near future). We argue that it is hard to consistently make such predictive market calls, and, so naturally, we believe it is just as difficult to consistently make calls on when to hedge or not hedge one s emerging market exposure. We wish to reiterate that the hedged returns presented in Exhibits A, B and C do not reflect any cost for the hedging instruments or the ability to implement in all markets, but rather, they simply reflect the return streams with or without the impact of currency movements. Given the historically high cost and low liquidity of emerging market currency forwards, the above-stated results are nearly impossible to achieve, or would at the very least incur a very high cost in the current market environment. Conclusion While many investors are considering hedging the currency exposures in their developed international portfolios, we attempt to show that the decision to hedge emerging market portfolios differs from this in three keys ways. First, market instruments to hedge currency risk in emerging markets are either very expensive, or simply not available, for the majority of emerging market countries. Second, the benefit from hedging appears to be relatively muted over the long term, making the benefits from such a hedging program

5 FEBRUARY 2017 TIMELY THINKING ALL PAIN, NO GAIN 5 Exhibit C Annualized three-year excess return, hedged versus unhedged MSCI EAFE Index Three-year period rolling monthly return, for each month-end from Dec to Dec Hedged MSCI EAFE Index Return 50% 40% 30% 20% 10% 0% -20% -10% 0% 10% 20% 30% 40% 50% -10% Unhedged MSCI EAFE Index Return -20% Sources: Parametric, MSCI, as of 31/12/2016. It is not possible to invest directly in an index. questionable, especially given the high cost in the current market environment. And third, we note that the benefits from hedging in the emerging markets have historically had a strong connection with the returns of the broad market returns. This is a condition not present in the developed markets, and makes the decision to hedge an emerging markets portfolio essentially a market call on the direction of the emerging markets. Since we believe it is impossible to consistently make such predictions correctly, we find little evidence to motivate implementing a currency hedging program in the emerging markets.

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