ISSUE BRIEF Currency Hedged Indexes Why Currency Returns and Currency Hedging Matter JULY 2015 The growth of international investing makes it important to understand the impact of currency movements. Institutional investors particularly those holding global equity portfolios are exposed to currency risk when investing abroad. Deciding whether to hedge currency depends on an investor s circumstances, including risk tolerance, investment horizon and views on currency markets. Those wishing to minimize currency impacts often hedge their foreign currency risk without altering their underlying equity exposure. Such investors may find MSCI Hedged Indexes useful for measuring the equity performance of an MSCI parent index while accounting for currency effects. See Why Currency Returns and Currency Hedging Matters. An Update on the MSCI Hedged Indexes for further details. KEY OBSERVATIONS Investing in foreign companies when the corresponding foreign currency depreciates reduces the gains from foreign investments. Conversely, if the foreign currency appreciates, then gains from the foreign investment are enhanced. In the short run, exchange rates can deviate substantially from the equilibrium rate for Visit msci.com/research a variety of reasons, including central bank decisions, changes in inflation, the balance of trade and the demand for a country s assets. Hedging currency risk can significantly reduce the volatility of equity investments and provide risk control by allowing investors to separate currency risk from their equity asset allocations.
The Impact of Currency Returns on Foreign Investments Currency returns (and exchange rates) are relevant to investors because they have a direct impact on the value of any foreign investment. Consider a U.S. investor who purchased shares of Daimler AG, the German auto manufacturer, in April 2014 and then sold those shares in May 2015, as shown in Exhibit 1. In U.S. dollars, the investor lost $178 or -1.85% on Daimler AG. In euros, however, there would have been a profit of 23.21%. The depreciation of the euro over this period resulted in a reduction of the U.S. investor s profit. This example shows that investing in foreign companies at times when the corresponding foreign currency (here, the euro) depreciates, reduces the gains from that investment. Conversely, if the foreign currency appreciates, the gains from the investment are enhanced. EXHIBIT 1 A SIMPLE EXAMPLE ILLUSTRATING THE IMPACT OF EXCHANGE RATES ON FOREIGN INVESTMENTS Number of Shares Price (EUR) Total Value (EUR) Exchange Rate (EUR/USD) Price (USD) Total Value (USD) Purchase Date: April 2014 100 69.72 6,972.00 1.38 $96.16 $9,616.00 Sell Date: May 2015 100 85.90 8,590.00 1.10 $94.38 $9,438.00 Profit (%) 23.21% -1.85% To illustrate the importance of currency for investors, Exhibit 2 shows the currency exposure of the MSCI All Country World Index (ACWI). From the perspective of a U.S. based investor, nearly 50% of exposures in the MSCI ACWI are in foreign currency investments. So if an investor allocates to foreign equities based on their weight in the MSCI ACWI, nearly 50% of the portfolio will be impacted by currency movements. In general, investors with short to medium horizons should take into account the currency impact of their foreign investments. In the example above, the 20% decline in the EUR/USD exchange rate from 1.38 to 1.10 had a significant effect on the investment return. Exhibit 3 shows the annualized average returns of various foreign currencies relative to the U.S. dollar. Positive returns result from a strengthening of the foreign currency relative to the dollar. EXHIBIT 2 CURRENCY EXPOSURE OF MSCI ACWI* * Data as of May 29, 2015 USD 50.8% EUR 10.5% JPY 7.9% GBP 7.1% HKD 3.9% CAD 3.5% CHF 3.2% AUD 2.4% KRW 1.6% TWD 1.4% Other 7.6% 2
EXHIBIT 3 NOMINAL EXCHANGE RATE RETURNS FOR SELECTED CURRENCIES (ANNUALIZED AVERAGES, %) January 1971 to May 2015 1971-1979 1980-1989 1990-1999 2000-2015 Euro - - - - 2.34 Swiss Franc 3.87 11.75 0.35-0.32 4.75 Japanese Yen 3.68 4.56 5.27 3.44 1.94 Canadian Dollar 0.04-1.64 0.09-2.20 3.16 Australian Dollar -0.11-0.16-3.33-1.82 4.12 British Pound -1.01-0.96-3.14 0.04 0.14 Source: MSCI, WM/Reuters Exchange rate fluctuations can be considerable depending on the time period. Since 2000, for example, most currencies have appreciated relative to the U.S. dollar particularly the Swiss franc and Australian dollar. In contrast, the U.S. dollar rose relative to major currencies in the 1990s (Exhibit 3). In Exhibit 4 we highlight various exchange rates to illustrate how substantial exchange rate movements can be over time. EXHIBIT 4 NOMINAL EXCHANGE RATES OVER TIME (USD/JPY, USD/EUR, USD/CAD) Source: MSCI, WM/Reuters 3
Why Hedge Currency Risk? One of the best-known tenets in economics is that over the long-term, there is an equilibrium between any two currencies. According to purchasing power parity (PPP), exchange rates between currencies are in equilibrium when the purchasing power of each is the same in the two countries concerned. PPP would imply that currency hedging is not worthwhile since exchange rates should revert back to this equilibrium rate. In reality, exchange rates can deviate substantially from this equilibrium rate, especially in the short run. The decision to hedge against currency risk depends on whether the investor wants to be exposed to exchange rate movements. When a U.S. investor decides to buy Daimler AG stock, for example, is it just investing in Daimler, or in both Daimler and the EUR/USD currency return? For investors in foreign equities who do not want to take a position on currencies, one solution is to hedge currencies as long as the costs associated with hedging are minimal. A VARIETY OF DRIVERS CAN IMPACT EXCHANGE RATES OR CURRENCY RETURNS IN THE SHORT RUN CENTRAL BANK DECISIONS CHANGES IN INFLATION BALANCE OF TRADE CROSS-COUNTRY CAPITAL FLOWS When central banks raise interest rates, bonds and other local assets appear more attractive relative to foreign countries. The local country s currency will appreciate as its assets are purchased by foreign investors. If investors anticipate higher inflation in the near future, they will expect the central bank to raise interest rates to combat this, which will cause the local currency to appreciate. If the demand for a country s goods from foreign buyers increases, its domestic currency will appreciate. Similarly, if domestic consumers import an increasing share of goods from abroad, their currency will depreciate. The more attractive a country s financial assets, the more global demand there is for that country s currency, all else being equal. Assets can change in their attractiveness (independently of interest rates) due to a country s regulations, policies and financial health as well as investor sentiment. Hedging Currencies We have shown that currencies fluctuate significantly over time. Now, we examine the impact of hedging foreign equities through the lens of the MSCI Hedged Index Methodology, which can be applied to any MSCI index. The MSCI Hedged Indexes include all the securities and weights of the corresponding unhedged MSCI parent index, enabling investors to measure the impact of hedging currency, while holding equity exposure constant. MSCI s straightforward index methodology combines the performance of a monthly currency forward contract with the return of an unhedged MSCI parent index. See MSCI Hedged Indexes, MSCI FX Hedge Indexes, and MSCI Global Currency Index Methodology for further details. 4
CONSTRUCTING THE MSCI HEDGED INDEXES INVOLVES THE FOLLOWING STEPS: We confine this analysis to the U.S. investor perspective and illustrate the behavior of the MSCI Hedged Indexes for a U.S. dollar base currency. Exhibit 5 shows the returns of selected global equity indexes with their currencies hedged back to the U.S. dollar. The historical performance of the MSCI Hedged Indexes is compared to their unhedged parent indexes. From May 2005 to May 2015, almost all MSCI Hedged Indexes overperformed their unhedged counterparts. And in 2014, when the U.S. dollar strengthened substantially, the MSCI Hedged Indexes generated much higher returns than their parent indexes. EXHIBIT 5 A COMPARISON OF HEDGED AND UNHEDGED RETURNS FOR A U.S. DOLLAR-BASED INVESTOR (Average Annualized Returns of MSCI Hedged Indexes and their Unhedged Parent Indexes, Gross Monthly Returns) May 2005 - May 2015 December 2013 - December 2014 Hedged Unhedged Hedged Unhedged MSCI EAFE 7.41% 6.05% 6.13% -4.48% MSCI Emerging Markets 9.06% 9.10% 2.47% -1.82% MSCI Canada 8.41% 7.67% 10.62% 2.22% MSCI Japan 6.56% 4.56% 8.83% -3.72% MSCI EMU 7.41% 5.11% 5.35% -7.73% MSCI ACWI* 18.20% 15.71% 9.45% 4.71% MSCI ACWI ex USA 7.55% 6.50% 5.62% -3.44% MSCI Europe 7.71% 6.12% 5.30% -5.68% * From September 2011 - May 2015. 5
Hedging Currency Risk Reduces Volatility Another important rationale for hedging currency risk is that it can significantly reduce the volatility or risk of an equity portfolio, in addition to impacting foreign investment returns. As demonstrated in Exhibit 4, currencies fluctuate considerably over time. This has a significant impact on the volatility of an investor s portfolio. Exhibit 6 displays the standard deviations (or volatilities) of hedged and unhedged MSCI index returns. MSCI Hedged Indexes show generally lower volatility than the unhedged MSCI parent indexes. EXHIBIT 6 RISK OF UNHEDGED VERSUS HEDGED INDEX RETURNS (Annualized Standard Deviation of Currency Hedged MSCI Indexes and Unhedged (USD Return) MSCI Indexes, Gross Monthly Returns) May 2005 - May 2015 December 2013 - December 2014 Hedged Unhedged Hedged Unhedged MSCI EAFE 14.43% 18.19% 6.95% 9.73% MSCI Emerging Markets 17.78% 23.62% 9.20% 13.60% MSCI Canada 13.89% 21.63% 7.64% 12.45% MSCI Japan 19.37% 15.59% 12.70% 9.07% MSCI EMU 16.96% 22.99% 9.56% 13.60% MSCI ACWI* 9.27% 11.55% 7.13% 8.81% MSCI ACWI ex USA 14.33% 18.86% 6.56% 10.08% MSCI Europe 14.65% 20.02% 8.24% 12.19% * From September 2011 - May 2015. CONCLUSION As investors continue to embrace foreign equities, the impact of exchange rates (currencies) and the decision whether or not to hedge currency remains critical. Currencies and their returns can fluctuate considerably over time and can have a meaningful impact on realized returns and volatility. Investors in foreign equities who do not wish to take a position on currencies should consider hedging currency risk. This allows an investor to make a direct investment in a foreign company without currency risk. Hedging currency risk can also significantly reduce the volatility of equity investments. 6
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