This piece is from our monthly Shareholder Yield Letter released on 2023-12-12. Sign up here to receive it in your inbox on the first Tuesday of every month.

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Addressing a common concern among global investors, this month we delve into the query that often arises once you embark on international investment waters – “How do I manage currency risk?”

Prior to addressing that, let's review the modifications made to the portfolio.

Portfolio Adjustments

Acquire Four

Four new recommendations have been ushered in this month, in light of the MSCI World index surpassing its 200-day simple moving average.

The initial addition is a Swiss building materials firm possessing a shareholder yield of 8.6%, buybacks of 4.8%, and yielding a dividend of 3.8%.

The second is a highly reputable German automotive manufacturer offering a shareholder yield of 9.4%, buybacks of 1.1%, and a compelling dividend yield of 8.3%.

Next in line is a Norwegian aluminum enterprise delivering a shareholder yield of 10.0%, buybacks of 0.9%, and a 9.1% dividend yield.

The final addition is a British-based banking institution presenting a shareholder yield of 8.0%, buybacks of 5.8%, and a 2.2% dividend yield.

How should you address currency risk?

“What is the best approach to currency risk?”, a query frequently posed.

Unquestionably, this query aligns with the prevalent inclination to favor domestic investment, which was addressed in last month’s newsletter. It's essential to recognize that when you invest beyond your domestic currency you inherently assume currency risk.

Understanding the Mechanism of Hedging

Prior to delving into the findings on currency hedging, it's imperative to comprehend how to mitigate currency risk.

To hedge currency risk, one should procure the foreign currency and allocate the borrowed funds into that particular market.

For instance, if you reside in a zone where the currency is Euro and seek to invest in Japan, refraining from exchanging Euros for Japanese Yen is advised when you are .

To neutralize the Yen risk, you borrow Yen and utilize the borrowed amount to purchase shares in the Japanese market. When you divest, you repay the borrowed Yen, with only the profit or loss necessitating conversion to Euro.

However, there are costs associated with borrowing as part of this process. Although some brokers facilitate this effortlessly, they do levy substantial charges. Additionally, you are required to pledge your portfolio as collateral for the loan, given that the broker necessitates security to cover non-payment of the loan.

The interest rates on Yen loans are minimal, yet even with a broker charging a mere 2% annually, a 3-year investment tenure would entail a 6% cost.

Thus, it comes with a notable expense.

Research on Currency Hedging

Upon exploring independent research on currency hedging, two insightful reports were uncovered.

In the third quarter of 2015, GMO (www.gmo.com) unveiled a compelling quarterly report titled: Just How Bad Is Emerging, and How Good Is the U.S.? and Give Me Only Good News!

The report scrutinized the 20-year returns of emerging markets, which were notably dismal.

Here's an excerpt from the report (emphasis added):

Is it merely a currency issue?

Indeed, the depreciation of currencies has significantly contributed to the losses in emerging equities over the past few years. Notably, in the 12 months concluding on September 30, the local returns on emerging stocks stood at -7.1%, whilst currency fluctuations resulted in a 13.1% loss. This might tempt one to consider hedging currency exposure in emerging markets. However, history suggests that this is not a favorable practice.

In fact, it appears to be particularly ill-advised, as illustrated in Exhibit 3.

This chart is truly compelling. Over the period since 1995, the modest real returns of +3.0% in U.S. dollars for emerging equities dwindle to a dismal +0.9% real. Thus, the notion of currency hedging takes a severe hit! 

Source: www.gmo.com Just How Bad Is Emerging, and How Good Is the U.S.? and Give Me Only Good News!

Hedging in emerging markets proved detrimental

Over the 20-year duration of investing in emerging markets, hedging currency risk proved to be disadvantageous. Although the newsletter does not advocate emerging market entities, this research finding holds significance.

Further Insights on Currency Hedging

In 2007, The Brandes Institute, a segment of the esteemed value fund manager Brandes Investment Partners, published a research dossier titled: Currency Hedging Programs: The Long-Term Perspective.

This analysis delved into 34 years of data to assess the efficacy of currency hedging.

The outcome of the report is encapsulated in the ensuing chart, depicting the impact of hedging currency risk on your portfolio:

Source: Brandes Institute – Currency Hedging Programs: The Long-Term Perspective

Interpreting the Chart

What insights can be drawn from this intricate chart?

#1 Recent movements are poor predictors of future shifts.

This is particularly relevant amidst turbulent currency upheavals. The disparity between the small white line (Most recent Quarter Result) in the chart and the median value (represented by a black dot) is indicative of this. In most instances, placing undue emphasis on the most recent currency movement (such as the preceding quarter in this context) has the potential to culminate in significant missteps, given the possibility of an ensuing opposite currency movement.

#2 Currency fluctuations exhibit substantial amplitude over one-year periods (evident in the tall bars under 1 Year), but their magnitude diminishes remarkably over five and ten-year durations (reflected in the considerably shorter bars).

Being ready for enduring periods of offsetting losses or gains is crucial, especially if you choose not to hedge. Large currency movements can have a significant impact on your investments.

#3 Pay attention to the base currency you are dealing with, as some currencies are more prone to volatility than others. Observe how towering the bars representing different currencies are.

#4 Hedging becomes more impactful if your investment horizon is shorter than five years. After this period, the influence of hedging gains and losses diminishes (as indicated by the smaller 10-year bars), but it does not vanish.

For instance, an investor based in the US who hedged currency risk over the span of 34 years would have suffered an average annualized loss of 1.8%. Such a considerable pull on performance could have just as easily been a profit.

The fact of the matter is no one can predict this. It remains uncertain.

To Summarize

What do these two research papers teach us?

• Hedging against currency risk in emerging markets turned out to be unfavorable
• Hedging currency risk in developed countries may result in a slight positive or negative return over 10 years, larger gains or losses over 5 years, and even more over one year.
• Both studies highlighted a substantial behavioral risk associated with currency movements. It involves the peril of attempting to forecast future currency movements based on the very recent past, typically 1 to 3 years, particularly after incurring significant currency losses. The risk lies in hedging your currency exposure right when the currency starts to reverse course, leading to substantial currency losses.

My Approach towards Managing Currency Risk

Considering:

• The expenses involved,
• The relatively small portion of my portfolio invested in various currencies, and
• The fact that currency movements tend to balance out over extended periods,

I opt not to hedge against currency risk.

Simplicity is Key

Another reason for not hedging is my endeavor to simplify and systematize my investing practices as much as possible.

Hedging currency risk is something I refrain from, particularly when it is expected to marginally affect my investment returns over time.

If Hedging is Your Preference – Here's How to Go About It

Your perspective may differ, and that's perfectly fine. There is no definitive right or wrong here, given the uncertainty of currency movements.

If you choose to hedge, you must make a decision and stick to it – consistently hedge. Failing to do so will likely lead you to initiate hedging after suffering extensive currency losses, just as the currency starts to reverse.

Your Shareholder Yield analyst extending its best wishes for prosperous investing!

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