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Smart Currency Hedging for Smart Beta Global Equities

QS RESEARCH GROUP

MAY 01, 2015

We investigate whether structurally hedging the currency risk of global equity products benefits long-term investors. Based on a 35 year back-test of 3 smart beta strategies from 6 currency perspectives, our answer is a qualified “yes”. Currency hedging was effective in reducing risk and generally improved medium to long-term Sharpe ratios, albeit at a small cost to average returns. It may not be the proverbial free lunch, but does appear a value meal from the risk-adjusted perspective that is most relevant in an asset allocation context. The most effective hedging strategy and the resultant benefits varied by investor domicile, the nature of the equity holdings, and over time. The benefits were strongest for defensive (low-volatility, non-cyclical) equity portfolios for investors from safe-haven currency zones, and least pronounced for cyclical equities held by investors using pro-cyclical currencies. For example, contrary to common belief, Australian and Canadian investors may yet gain from currency hedging, at least for some global equity strategies. Particularly since the Global Financial Crisis, being smart about how much of a portfolio’s currency exposures to hedge has been a key to avoiding perverse impacts.

US investors have shown an increased appetite for currency-hedged international equities. ETF market leader Blackrock launched currency-hedged international equity ETFs in February 2014, joining existing offerings by WisdomTree and Deutsche Bank. Net inflows in 2013 into the WisdomTree Japan Hedged Equity Fund totaled $9.7 billion, second only to the SPDR S&P 500 ETF. Much of these flows were driven by tactical considerations, according to media reports. These include “Abenomics” driving the yen down but export-driven Japanese equities up, as well as the prospect of normalization in the U.S. Federal Reserve policy strengthening the dollar. After these themes have played out, the question is whether structurally hedging currency risk benefits long-term global equity investors absent a directional view on exchange rates. Based on a 35 year back-test of 3 smart beta strategies from 6 currency perspectives, we find that the answer is a qualified “yes”. Currency hedging meaningfully reduces return volatility. It generally improved medium and long-term Sharpe ratios, albeit at a small cost to average returns. Currency hedging may not be Perold and Schulman’s proverbial free lunch, but does appear a value meal from a risk-adjusted perspective. The latter is what matters most in an asset allocation context, allowing increased exposure to global equities while maintaining the same level of total risk.

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