INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES: Currency Conundrum Assessing the Currency Hedge Decision for Institutional Investors

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1 INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES: Currency Conundrum Assessing the Currency Hedge Decision for Institutional Investors By Philip M. Fabrizio, CFA INTRODUCTION Over the past few years, the U.S. dollar has appreciated significantly against many major foreign currencies. This divergence has created meaningful performance differences between the returns on international equity investments as measured in local currencies and returns on those same investments when translated back to U.S. dollars. Amidst this backdrop, the topic of currency hedging as a tool to mitigate or take advantage of the effect of currency impacts on international equity investments performance has reemerged as a popular topic in the investment community. This paper will highlight how currency impacts a U.S. equity investor s total return on an international investment as well as explains the basic mechanics of how portfolio managers employ currency hedging as a device to mitigate the effects of currency movements. More importantly, it will present analysis and recommendations to clients on how the Institutional Investment & Fiduciary Services practice of Arthur J. Gallagher & Co., Gallagher Fiduciary Advisors, LLC ( Gallagher ), views the currency hedging decision for institutional investors. THE EFFECT OF FOREIGN CURRENCY MOVEMENTS ON INVESTMENT RETURNS Often an afterthought of U.S.-based investors, the effect of currency on international manager performance has once again come into greater focus. U.S. dollar appreciation against major currencies such as the Euro and the Yen has had a profound effect on international portfolio returns for U.S. dollar-based investors since early For instance, in that year the MSCI EAFE Index returned +5.9% in local currency terms but lost -4.9% in U.S. dollar terms, a nearly 11% point difference attributable to a strengthening dollar against various currencies. The divergence was still significant although not as pronounced in 2015, as the MSCI EAFE Index gained +5.3% in local currency but lost -0.81% in U.S. dollar terms. AJG.COM

2 While currency movements are a daily part of global financial markets, recent divergence in central bank policies around the world has amplified such moves over recent periods. Between the Federal Reserve raising interest rates in the U.S., quantitative easing in Europe and Japan, and China s recent move to allow the renminbi to float more freely, the impact of central bank actions on currency exchange rates will likely remain front and center for investors. Against this backdrop, currency hedging has re-emerged as a popular topic in the investment community as investors revisit the debate around the merits of currency management strategies. COMPONENTS OF TOTAL RETURN ON A FOREIGN INVESTMENT A domestic investor s return on a foreign investment is composed of two components, as seen in Figure 1 below: Figure 1: Total Return = Local Return on Security + Return of Underlying Currency As U.S.-based investors have experienced recently, a weakening foreign currency relative to the U.S. dollar will negatively impact the currency portion of a U.S. investor s total return on a foreign security denominated in that foreign currency. Figure 2 highlights a simplistic example of how an international investment can be affected by both the return on the security as well as its underlying currency: Figure 2: Example of Total Return on a Foreign Investment for a Domestic Investor Year 0 USD/EUR Exchange Rate 1 USD/1 EUR Year 1 USD/EUR Exchange Rate 1 USD/1.1 EUR Return on Currency (EUR, 1 Year) -10% Local Return on Security (1 Year) 0% 1-Year Total Return -10% 2 AJG.COM

3 While the actual return on the security in the example above was flat, the total return for a U.S. investor was negative due to the Euro depreciating by 10% against the dollar. In this example, a foreign security (denominated in Euros) was initially purchased when the exchange rate was $1:1. If, at the end of one year, the security was sold and then converted back to dollars, the Euro could now buy only $0.90 per 1 of investment as the currency had depreciated by 10%. APPROACHES AND COSTS OF CURRENCY HEDGING Given the additional layer of return that currency brings to an international investment, domestic investors may choose to hedge this component of return back to their home currency. This may be done passively, with the aim of completely eliminating the currency effect, or actively, in which only part of an investment is hedged in an attempt to achieve a favorable currency return. While the latter approach is utilized in various investment strategies, this paper will focus solely on currency hedging for the purposes of completely removing the effect of currency movements from an equity investment s total return. Most passively executed currency hedges are implemented using one-month forward contracts that are readjusted at the end of each month to neutralize the effect of underlying currency exposures. For instance, to hedge the currency risk associated with a foreign stock, an investment manager would enter into a forward contract that sells the foreign currency in a notional amount equal to the foreign stock exposure. As a result, the overall currency exposure is neutralized; if the foreign currency of the stock being held depreciates, the value of the forward contract increases by a similar amount (and vice versa). However, as with most additional investment services, increased costs accompany currency hedging. The two primary costs from such a transaction are: 1. Transaction Costs In the form of commissions and/or the difference in the bid-ask spread of the forward contract 2. Interest Rate Differentials Paying (or receiving) the difference in interest rates of the currency being sold against the currency being bought 3 AJG.COM

4 Transaction costs for developed currencies are currently a fairly cheap component, amounting to potentially a few basis points per year. The more prominent cost is the interest rate differential between the two currencies being hedged. While developed currency interest rates at the moment are low 1, currencies in emerging market countries yield much higher rates, which makes hedging such countries currencies much more expensive. Another consideration is the frequency with which the hedge is being adjusted: as the frequency increases so do the transaction costs. Finally, on top of the costs related to the transaction, an investment manager utilizing currency hedging will typically charge a higher management fee than a comparable unhedged strategy would incur, due to the added resources required to manage such a strategy. Thus, an institutional investor considering currency hedging should assess the potential impact that such a strategy will have on affected funds and the overall portfolio. According to Gallagher, the most basic question around hedging centers on whether absolute and/or risk-adjusted performance results from hedging are worth: the actual transaction costs; the greater due diligence required on a hedged or currency overlay manager; and the added complexity of exposures in the investment and the overall portfolio. CURRENCY HEDGING AT THE INDIVIDUAL ASSET CLASS LEVEL Using the MSCI EAFE Index as an example, Figure 3 highlights the performance of this index on an unhedged and a 100% hedged basis (to the U.S. dollar) over various time frames since the hedged index s inception in (Note that our analysis will focus on hedging developed international currencies mainly because the costs for hedging less liquid, emerging market currencies are too significant to be given serious consideration, in our opinion). 1 As of 5/1/16 4 AJG.COM

5 Figure 3: MSCI EAFE Unhedged vs. Hedged Performance 3-Year 5-Year 10-Year 15-Year Since Inception MSCI EAFE (Unhedged) 5.01% 3.60% 3.03% 3.54% 5.95% MSCI EAFE (100% Hedged) 12.02% 7.75% 3.81% 2.91% 6.38% Absolute Difference 7.01% 4.15% 0.78% 0.63% 0.43% Source: Morningstar. Returns are annualized and as of 12/31/2015. The chart above shows that the hedged index in the short-to-intermediate term has greatly outperformed the unhedged index. For instance, over the trailing five-year time period the unhedged index lagged its hedged counterpart by over 400 basis points. Of course, different time period examinations yield varying results, as the U.S. dollar over time has experienced periods of both appreciation and depreciation relative to other major currencies (Figure 4). However, we observe that as time periods extend, the overall difference in performance between the unhedged and hedged index narrows significantly. The difference between the two indexes since the inception of the hedged index stands at 43 basis points. This provides support for the belief that the movement of currencies against one another is a zero-sum-game over long periods of time. Figure 4: Ten-Year Price Movement of Euro and Yen to the U.S. Dollar Euro per U.S. Dollar 1 Japanese Yen per U.S. Dollar Source: Factset 5 AJG.COM

6 These historical patterns lead to two distinct opinions when considering hedging an international investment. First, hedging in the short term may appear to be a viable strategy if the investor has strong conviction in the direction of a currency. Clearly, U.S. investors hedged back to the dollar would have achieved better results in their international investments in recent periods, if they had the foresight to begin hedging against the dollar s strong rise that began in Of course, as with market timing in general applied to any asset, Gallagher believes it is fairly difficult to predict currency movements consistently over an extended time period, making this type of active hedging proposition very challenging. The alternate course is to not hedge at all, which is supported by the fact that, as seen above, over longer periods of time the effects of currency movements are typically negligible. For clients with a long-term investment time horizon, we believe these are important considerations. While a currency-hedged approach over extended periods of time has shown minimal performance impact relative to an unhedged approach, many investors cite volatility reduction as a potential benefit to the hedged approach. Here again, we believe this may hold true for shorter periods of time, but the effect diminishes over prolonged periods of time. Figure 5 shows the volatility of the MSCI EAFE unhedged and hedged index over various time frames since inception of the hedged index: Figure 5: MSCI EAFE Unhedged vs. Hedged Standard Deviation 3-Year 5-Year 10-Year 15-Year Since Inception MSCI EAFE (Unhedged) 12.64% 14.99% 18.48% 17.46% 16.49% MSCI EAFE (100% Hedged) 11.39% 12.16% 14.78% 14.86% 14.60% Absolute Difference 1.25% 2.83% 3.70% 2.60% 1.89% Source: Morningstar. Data is annualized and as of 12/31/2015. The chart above shows that the movements of the U.S. dollar versus a basket of developed international currencies can add volatility to an international investment over shorter time periods; as such, hedging may offer a benefit if a primary goal of an investor is volatility reduction. For instance, over 10 years there is a sizable discrepancy in volatility between the hedged and unhedged indices. We again observe, however, that the difference in results between the indices is reduced as the time period lengthens. 6 AJG.COM

7 Moreover, given the typical limited allocation to international assets in investors total portfolios, institutional investors managing a portfolio designed to continue into perpetuity need to consider whether the cost of hedging is worth the reduction in volatility over the long-term. This makes the argument for currency hedging to reduce volatility less compelling in our view. CURRENCY HEDGING AT THE TOTAL PORTFOLIO LEVEL When analyzing the impact of hedging the currency exposures of international investments for a U.S. investor at the total portfolio level, consideration should also be given to how the overall diversification of the plan is influenced. This analysis should be directly linked to how much U.S. dollar exposure a portfolio has. For most U.S.-based institutional investors, the majority of their portfolios are denominated in U.S. dollars. Introducing foreign currency into the portfolio can add an additional layer of diversification that may not be achieved with a strictly U.S.-dollar portfolio. As an example, according to Morningstar, the total correlation of the MSCI EAFE hedged index to the S&P 500 Index since inception of the hedged index is The unhedged index over that same time had a slightly lower correlation with the S&P 500 Index of This indicates that there is incremental value in having exposure to multiple currencies because of the added diversification. For investors with most of their investments denominated in U.S. dollars, this should be an additional consideration when analyzing the hedging decision. More broadly speaking, the overall exposure of a plan to international currencies should also be reviewed. While institutional portfolios vary in their design and exposure, typical institutional clients non-u.s. dollar exposure may range anywhere from 10% 25% of an overall portfolio. At the lower end of this range, we do not believe that hedging in the short term will add a meaningful impact to overall portfolio performance when weighed against the costs and additional complexities incurred, and may in fact be detrimental from a diversification standpoint, as noted above. However, as a portfolio s overall non-u.s. dollar exposure increases, greater scrutiny around the currency hedging decision may be warranted given the larger impact it may have on total portfolio performance and volatility. 7 AJG.COM

8 MANAGER UNIVERSE A final point of consideration is the availability of institutional-quality international investment managers who utilize currency hedging in their portfolios. In our experience, only a select few managers will either partially or fully hedge currency back to the U.S. dollar. In fact, according to investment manager database provider evestment, out of all EAFE and ACWI ex-u.s. equity strategies listed in their database, only 8% of managers employ some form of currency hedging. Factors cited by the investment managers as reasons why they typically exclude currency hedging from their portfolio construction process include the difficulty in predicting currency movements, the additional resources required to hedge and the reduction in the manager s core focus on security selection. Currency overlay managers, who work exclusively to hedge an investor s currency exposures (actively or passively), independent of the actual investment managers, may be hired as an alternative. However, these managers still face the issues previously discussed, and require an additional cost for the service they provide. CONCLUSION The rally of the U.S. dollar against a number of international currencies, since 2014, has caused many domestic investors with international exposure to pay greater attention to the currency effect on the total return of their investments. Large short-term discrepancies in performance and volatility between investments in local currency and U.S. currency terms have highlighted the benefit that could be added by hedging international currencies back to the U.S. dollar. While there may be a short-term advantage to such a strategy, especially if investors correctly predict the direction of the U.S. dollar, Gallagher believes institutional investors should weigh the costs and added complexity of hedging against the impact it will have at the overall portfolio level. Further, investors with a longer term focus should also assess whether the hedging decision will create a meaningful impact on performance, measured on an absolute or risk-adjusted basis over a prolonged period of time. Gallagher s research has shown that performance and volatility effects of currency hedging are minimal over extended periods and may also reduce the diversification benefit received from exposure to multiple currencies. Gallagher encourages investors to approach the topic with a long-term focus and assess the impact at both the manager and total portfolio level. 8 AJG.COM

9 GALLAGHER S COMMITMENT TO INSTITUTIONAL INVESTORS Gallagher s Institutional Investment & Fiduciary Services practitioners combine committed expertise and broad resources in helping organizations meet the needs of their investment goals. With a focus on positioning your organization s funds for success, our analysts continually research new and innovative plan design concepts, keeping you aware of the latest industry trends and regulatory/ and legislative agendas. About the Practice Philip M. Fabrizio is an Area Vice President with the Institutional Investment & Fiduciary Services practice of Arthur J. Gallagher & Co. (Gallagher Fiduciary Advisors, LLC), focused on improving the investment program of your benefit plan and other investment pools. Gallagher s Institutional Investment & Fiduciary Services practice is a group of established, proven investment professionals who provide objective insights, analysis and oversight on asset allocation, investment managers, and investment risks, along with fiduciary responsibility for investment decisions as an independent fiduciary or outsourced CIO. Philip M. Fabrizio, CFA Area Vice President Institutional Investment & Fiduciary Services Phil_Fabrizio@ajg.com PHILIP M. FABRIZIO, CFA Area Vice President 2016 Gallagher Fiduciary Advisors, LLC Investment advisory, named and independent fiduciary services are offered through Gallagher Fiduciary Advisors, LLC, an SEC Registered Investment Adviser. Gallagher Fiduciary Advisors, LLC is a singlemember, limited-liability company, with Gallagher Benefit Services, Inc. as its single member. Neither Arthur J. Gallagher & Co., Gallagher Fiduciary Advisors, LLC nor their affiliates provide accounting, legal or tax advice. 9 AJG.COM