How Currency Management can Benefit the Investor | Mackenzie Investments

How Currency Management can Benefit the Investor

For many investors, currencies exposure is often an overlooked or unconsidered aspect of portfolio management. Reasons may include unfamiliarity with the asset class; an inability to execute currency trades as currency trading is not easily accessible to ordinary investors; a belief that gains and losses from currency movements will eventually cancel each other out; or a lack of explicit currency management as a key feature of most retail oriented investment products. Mackenzie’s Multi-Asset Strategies Team believes that currency management is an important investment tool that can be leveraged to reduce portfolio risk and potentially enhance returns. This whitepaper examines why currency management should matter to investors and highlights the Multi-Asset Strategies Team’s approach to incorporating currency management in their investment process.

Why Should Currency Management Matter?

Reason #1: Large Exposures. Many Canadian investors hold portfolios that are increasingly global in nature. For every dollar of non-Canadian exposure, investors are also investing in foreign currencies. Moreover, this currency exposure can be much more significant than any single foreign holding in their portfolio. Consider, for example, an investor holding a globally diversified equity portfolio that can be represented by the MSCI World Index. As shown in Table 1 below, the largest single stock in the index is Apple Inc. (2.3%). In contrast, the largest individual currency is the U.S. dollar at 62.7%. That single exposure to the U.S. dollar is 22 times the concentration of the largest foreign stock! Clearly, the direction of the Canada-U.S. exchange rate will have a significant impact on the Canadian-dollar-denominated returns of the MSCI World, and can often be much greater than the impact of Apple share performance on the portfolio.

Table 1. Top stocks and non-Canadian dollar currencies in the MSCI World Index

Name Weight(%) Name Weight(%)
Apple Inc. 2.3 U.S. Dollar 62.7
Microsoft Corp 2.1 Euro 10.6 Inc. 1.8 Japanese Yen 8.4
Johnson & Johnson 1.0 British Pound 5.9
JPMorgan Chase & Co 1.0 Swiss Franc 3.0
Notice that even the 5th heaviest weighted currency exceeds the heaviest weighted stock.
Source: Bloomberg as of November 30, 2018

Reason #2: Volatility. Foreign currency prices against the Canadian dollar are subject to large fluctuations. Chart 1 shows the annual percentage change in the spot price of the three most important currencies from a Canadian investor perspective versus the Canadian dollar over the past 10 calendar years. There are years when the selected currencies have risen or fallen more than 10%. This magnitude of volatility is not uncommon and can be observed repeatedly over longer time horizons as Table 2 indicates.

Chart 1. Annual % Change Against the Canadian Dollar

U.S. Stock Market Prices and Earnings trend together, 1973-2016

Source: Bloomberg

Table 2. Occurrence of a 10% or greater change in the spot price

Period since 1971 1989 1971
Frequency 5 12 22
Frequency (%) 11% 40% 47%
Source: Bloomberg, annual data ending December 31, 2018

Putting things into context, currency fluctuations can significantly enhance or detract from foreign asset returns. For example, in 2007 the S&P 500 returned 5.5%; however, a 14.4% depreciation of the U.S. dollar against the Canadian dollar led to a 10.5% loss for the Canadian investor. On the flip side, in 2015 the S&P 500 returned a modest 1.4%; however, a 19% appreciation of the U.S. dollar boosted the return to 21.6%. A comparison of the annual currency volatility of the G5 currencies against the Canadian dollar shows that they have historically fallen somewhere between bond and equity volatility over the last 29 years (Chart 2). Fortunately, active management of currency exposures can help reduce this source of volatility on portfolios.

Chart 2. Standard deviation of annual returns from 1989 to 2018

U.S. Stock Market Prices and Earnings trend together, 1973-2016

Source: Bloomberg, Morningstar
Note 1) Representative Indexes in local currency: Global Bonds - FTSE World Government Bond Index; Global Equities - MSCI World Index; US Equities – S&P 500

Reason #3: Managing Risk. Managing currency exposure is useful and often essential to risk management and should not be considered an unmanageable byproduct of foreign asset investing. Take, for example, a conservative investor holding Canadian government bonds (no currency risk), but would like to diversify globally. Assume that the investor has only two investment choices: a global bond product that fully hedges (i.e. eliminates) all currency exposure and one that does not manage currency at all (i.e. unhedged). What would be the most appropriate investment option for the client? Table 3 illustrates that from a risk perspective, the difference between the options can be quite dramatic.

Table 3. Standard deviation of annual returns from 1989 to 2017

4.8% 11.1%
Unhedged global government bonds are more than twice as risky.
Source: Bloomberg, Morningstar
Note: Representative index is the FTSE World Government Bond Index in 1) local currency, 2) Canadian dollars.

Given the conservative nature of the investor and the investment, the more appropriate investment option is the currency hedged bond portfolio as the unhedged portfolio would be substantially riskier.

The bond example is straightforward. What happens if we diversify the portfolio to include equities? What would be the most effective way to manage currency when combining equities and bonds?

U.S. Stock Market Prices and Earnings trend together, 1973-2016

Based on historical returns, Chart 3A shows that decreasing the hedge ratio for global government bonds, i.e. increasing foreign currency exposure (blue line), led to increased risk. However, for equities, we see the opposite effect (orange line): risk declined as foreign currency exposure grew. This means that foreign currency exposure helped mitigate some of the volatility associated with foreign equity markets for Canadian investors.

U.S. Stock Market Prices and Earnings trend together, 1973-2016

Let’s assume that an investor would like to hold a balanced portfolio of 60% equities and 40% fixed income. Based on Chart 3A, an investor might reasonably think that the risk-minimizing position would be to hold 100% of their fixed income portion hedged and 100% of their equity unhedged. In fact, the light blue line in Chart 3B bears this out. Keeping the fixed income portion fully hedged and adjusting the hedge ratio for only the equity component, you can see that this combination led to one of the lowest risk portfolios. However, is this the optimal way to minimize risk? Can we reduce risk further?

U.S. Stock Market Prices and Earnings trend together, 1973-2016

It turns out that we can. In Chart 3C, we adjust the hedge ratio across both asset classes simultaneously (green line). As the chart indicates, managing currency exposure holistically at the total portfolio level leads to multiple portfolio combinations with even lower risk than the lowest option in Chart 3B. The lesson here is that an actively managed currency strategy can be an important way to reduce total portfolio volatility for investors that seek to benefit from asset allocations beyond Canada.

Charts 3A through C are simplistic illustrations of how currency management can help manage risk in a diversified portfolio and how a total portfolio approach to currency management can provide better results than more simplistic portfolio construction methods. To improve results further, even more can be done at the portfolio level, such as managing currency exposures independently rather than equally (for example, hedging USD at 10% and EUR at 25% vs. hedging both at 15%), or moving beyond simply hedging foreign currency against the Canadian dollar.

The key point that underlies the team’s entire approach is to use risk deliberately; or said differently, to avoid “risk wastage”. Risk should be viewed as a scarce resource in a portfolio – investors do not want too much of it, and the risks they decide to take should be productive. Unlike stocks, bonds and other assets that pay a risk premium as compensation for holding them over time (in the form of income, dividends and/or capital appreciation), it is not clear that there is a long-term risk premium associated with holding a currency. Whenever you are long a currency, you are short another – so why should one currency be expected to permanently appreciate versus the other? If this is the case – that there is no long-term return premium to currencies – then why allocate long-term portfolio risk? Why waste risk on something with no long-term return expectations?

A key benefit that arises from reducing risk through currency management is the freedom to keep the risk savings, in the form of a lower-risk portfolio for the same expected return, or to “spend” some of those savings by re-directing emphasis toward other investment activities that are expected to generate additional returns.

Reason #4: Enhancing Returns. Although currencies generate no long-term return premium, over the short to medium term, the currency market is inefficient, perhaps to a greater degree than other markets, due to the involvement of non-profit motivated participants such as central banks, corporations, and consumers. Because of this, Mackenzie’s Multi-Asset Strategies Team believes it is possible to take advantage of shorter-term dislocations in currency prices to add value (alpha). To determine whether to overweight, underweight, or remain neutral on a currency, the team uses a diversified approach to evaluate the attractiveness of each asset, incorporating several models belonging to one of three categories: valuation, macroeconomic and sentiment Valuation models attempt to value an asset with the intuition that undervalued assets tend to outperform overvalued assets. Macroeconomic models evaluate the stage of the business cycle, macro policies, and interest rate differences to help predict currency movements. Sentiment models aim to capture investor behavior patterns and detect early signs of a regime change. A diversified approach allows the Multi-Asset Strategies Team to take advantage of a broader range of models and scenarios.

U.S. Stock Market Prices and Earnings trend together, 1973-2016

To conclude, we believe that actively managing currency exposures is a key component in delivering robust performance over time. The most sophisticated institutions and pension plans around the world incorporate active currency management in their investment process and Mackenzie’s Multi-Asset Strategies Team delivers this feature to its investors.

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