Peeking Through the Hedge

Yes, We’re Going There

Here at DWS we have devoted an extraordinary amount of time to analyzing the role that currency plays in a portfolio (because we think it’s very important, not because we don’t have anything better to do!). And we have also made considerable efforts to share our thoughts on this topic with our clients, and the industry more broadly. Indeed, we created what we believe is an original and straightforward framework to help answer this very question (see the Bibliography). 

Of course, there remains very vibrant debate about this topic, and there is also the considerable practical difficulty that many investors have (and often remind us of) which is that they benchmark to an unhedged index (i.e. one with full international currency exposure). In this note, we don’t propose to go through either the empirical case for hedging, or the framework. Instead, we want to share a finding that we believe is rather interesting, but, yes, we will be the first to admit, is quite “in the weeds” of currency hedging.  

Until now it wasn’t necessary to go this deep, partly because our time and attention was focused on the broader topic of the hedging framework, and partly because we never felt there was any real appetite in the industry to delve much deeper. Interestingly, this seems to have changed. Over the last several years we have noticed a far greater familiarity and comfort with the intricacies of currency exposure, and we have broached the topic in this paper without noticing any eyes glazing over. Accordingly, we think it’s about time we discuss – strap yourselves in – the fact that risk reduction occurs at a different rate, depending on the hedge ratio one applies. 

Now that statement of course needs a lot of unpacking, but we promise that all will become clear. Firstly, we hope you agree, as we have often claimed, that the easiest way to think about an unhedged international allocation (and we will assume to equities, but it could be any asset not traded in US dollars), is as a two-asset portfolio. One asset is the equity, and the other is the currency it trades in. And, crucially, we argue that, for an unhedged investor, the weights on those two assets are 100% each, and not 50% each as one might assume (and is normal for a two-asset portfolio). 

Why is this uniquely the case for currency? It is simply because the equation for an international return to a US investor is the equity return multiplied by the currency return (not added). An example will clarify. If an investor held half their money in US stocks, and half in US bonds, and each returned 10%, then the portfolio return would simply be 10%. However, if that same investor held all their money in unhedged Japanese stocks, then, if the stocks were up 10%, and the yen were also up by 10%, now their portfolio return would be 21% (based on this simplified, illustrative example, which does not reflect actual or expected performance). Essentially, it’s the difference between adding returns, and multiplying returns, and currency is almost unique in operating this way. 

If this all seems trivial, then we congratulate you, because it wasn’t to us! And part of the reason for this, is that, if you recall reading about expected returns in a finance textbook, examples are almost always given (at least in our experience) for two assets that add up to 100% (and not 200% as is the case with currency). This matters very much, because it means one needs to retrain one’s finance brain to operate in this world.