Investors Are Right To Worry About FX Volatility

There has been a lot of focus recently on the huge inflows - $42.6 billion – flowing into currency-hedged ETPs in 2015, with $37.7 billion flowing into U.S. products and $4.9 billion into European products. These flows highlight that investors are increasingly concerned by the potential impact of currency volatility on their portfolio’s risk/return profile.

Arguably, they are right to be concerned. Currency volatility is on the rise – the variability of EUR/USD returns has increased, from a relatively stable 3 percent in September 2014 to highs of 15 percent in April 2015.

Posing Risks To Investment Returns

While lower than in major equity indices, currency volatility is nevertheless causing investors to take a closer look at their currency exposure. What they are finding is that in addition to representing an investment opportunity, currencies can also pose risks to investment returns. Investors are considering whether currency risk is worth taking and if it is the type of exposure they (or their clients) want in their portfolio. In turn, many investors are deciding to hedge that risk, either by buying currency-hedged ETPs or by investing directly in currency ETPs.

The principle is fairly simple: investing in foreign assets (those denominated in any currency other than the one in which an investor has the majority of its assets and liabilities) results in currency exposure. As a result, almost all portfolios are exposed to some level of currency risk. The decision to hedge that risk may or may not reflect an investor’s view that one currency is over or under-valued relative to another. It represents a realisation that as currency volatility increases, returns from the currency can overwhelm the returns from the underlying asset. For many investors, this is an undesirable outcome. In such cases, FX hedging can be a way to obtain “pure” exposure to the underlying asset and to meet investor expectations.

For example, a European investor buying commodities, U.S. treasuries or U.S. equities is taking USD risk. One needs only to take a quick look at the S&P 500 from the perspective of a Euro-based equity investor in the 12 months ending April 2015. A total return of 32.33 percent looks very attractive, but considering that 21.77 percent of those returns came from the currency, the question of whether this is solely an equity investment has to be asked.

Beware Strengthening Currencies

Admittedly, the above table also shows the downside of currency hedging: if the currency strengthens in the investor’s favour, the hedge will seriously impact performance. The cost of the stable exposure to “pure” U.S. equities would have been 21 percent of returns had an investor hedged the EUR/USD over the period.

Some investors may also be hedging currency risk to reflect a view in the underlying currencies as well. For example, a Euro-based investor with Dollar denominated assets and who recognises the general potential for currencies to revert to the mean over time may view the recent appreciation of the dollar as an attractive entry point for hedging purposes.

Currencies and currency hedging can satisfy a wide array of objectives in an international portfolio and can serve as useful tools to refine exposure and manage risks. Investors may not always want to be hedged or to hedge every foreign investment. Indeed, in a low volatility environment, the currency hedge may impose additional costs with little upside. Naturally, when executing a hedging strategy, investors should clearly define their goals, including both their views on the relevant currencies as well as the need to reduce friction from currency volatility.

Townsend Lansing is head of short/leveraged and FX platforms at ETF Securities