Take the measure of currency risk in portfolios
- The continuing strength of the dollar deserves attention in determining portfolio exposures
- The dollar cycle tends to be long term, and investors need to consider their investment time horizons
- The typical international fund could see a noticeable negative impact from a strengthening dollar
The strength of the dollar, which has risen to new multi-year highs in early 2017, combined with an uncertain outlook for many international markets, gives investors reason to pause and consider how best to move forward with a non-U.S. allocation.
Dollar cycles have historically lasted long periods
Recently, Matt Beaudry, Senior Investment Director at Putnam, shared an insight on the importance of considering the time horizon of a non-U.S. allocation.
Beaudry emphasizes that exchange rate cycles tend to be long term, and longer than many investors realize. Since the late 1970s, the typical length of a dollar strengthening or weakening phase has been five years or more, with a full cycle lasting about 10 years. The implication is that, while U.S.-based investors might choose to hedge dollar risk, hedging is less necessary for investors with longer horizons, such as retirement investors.
How dollar cycles can influence hedging strategies
The case is often made, and we would agree, that investors considering an investment horizon of 30 years or more should think about currency risk somewhat differently. For portfolios with a horizon of a few decades, choosing whether or not to hedge the currency risk does not have a material impact on returns, and likely improves diversification. However, there can be periods of 5–10 years in which the difference in returns of a hedged and unhedged portfolio is meaningful. The chart below highlights the difference in returns of an investment in international developed market equities, represented by the MSCI EAFE Index, depending on whether the investor chooses to take the currency risk or hedge it.
Chart 1 makes a few things apparent. First, there is a clear tendency for the performance difference to revert to the mean. As a result, arguably, decades-long hedging has a minimal impact. Second, there are substantial periods of time in which there are clear performance differences between an unhedged and a hedged investment in the MSCI EAFE Index. In many cases the performance difference can be as large as +/– 5%–10%.
Impact of the U.S. dollar on international fund performance
Additionally, a deeper analysis of international developed managers as categorized by Morningstar reveals a strong negative relationship between the manager returns and the return of the U.S. dollar.
To better understand this relationship, we built a sample of every international equity fund that had at least $50M in assets under management (AUM) and 60 months of history, and was categorized by Morningstar as either a Foreign Large Blend, Foreign Large Growth, or Foreign Large Value fund. This yielded a sample of 1,305 funds. Next, looking at the past 60 months through 2016, we regressed the returns of each fund in the sample versus a multi-factor model, controlling for equity risk, interest rates, and the U.S. dollar.
The results confirmed the negative relationship has persisted over the past 5 years, with the average fund in the sample having a beta* of -0.90 to the U.S. dollar.† In other words, for every 1% change in the value of the dollar, the average international equity manager could move in the opposite direction by 0.9%, or 90 basis points.
Next, to get a better sense of the distribution betas to the U.S. dollar (see Chart 2), we sorted the funds in the sample by decile. We find that approximately 95% of the funds in the sample have a value that is more negative than -0.65. This means that for the vast majority of these funds, investors are indirectly betting against the U.S. dollar.
Consider currency risk in the short or intermediate term
Our analysis indicates that a non-U.S. allocation can carry significant currency risk in the short or intermediate term. Depending on one’s time horizon, this risk can have a material impact on investor returns across international investments, as evidenced above. Furthermore, when looking at a sample of foreign large-cap funds, it becomes apparent that many come with an imbedded bet against the U.S. dollar. Investors with shorter time horizons may be wise to consider the impact currency can have on the broader portfolio, or to incorporate strategies that take active views across currencies as part of their investment process to counteract this effect.
* Beta measures volatility in relation to the fund's benchmark. A beta of less than 1.0 indicates lower volatility; a beta of more than 1.0, higher volatility than the benchmark. It is a historical measure of the variability of return earned by an investment portfolio. For fixed-income and equity funds, risk statistics are measured using a 3- and 5-year regression analysis, respectively. For funds with shorter track records, "since inception" analysis is used.
† Source: Putnam Investments. Our analysis considered the Morningstar universe of Foreign Large Blend, Value, and Growth funds, with at least $50M in assets under management and five years of history, which produced a sample of 1,305 funds. Multivariate (three-factor) regression was run over the past five years as of December 2016, controlling for equity (MSCI EAFE Index in local currency), duration (Bloomberg Barclays U.S. Treasury 7–10 Year Treasury Index) and currency (U.S. Dollar Index). MSCI EAFE Index is an unmanaged index of equity securities from developed countries in Western Europe, the Far East, and Australasia. You cannot invest directly in an index.305406