| A full FX hedging might not be the way to go |
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| 25/09/2005 | |
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The 50% currency hedge implemented by many institutional investors is "naïve", says Dutch investment consultancy Compendeon. However, long-term investors should not apply a 100% hedge to their portfolio since a currency risk exposure also carries significant benefits. Erik L van Djik and Harry Geels, respectively CIO and senior investment manager at Compendeon, remind that a Russell/Mellon 2004 study reported that 39% of investors did not cover their currency exposure at all, 34% applied a 50% currency hedging policy and 14% all their currency risk. So, they ask, why are hedging policies so different across the board and is there an optimal hedge ratio? About the pervasive 50% ratio, they say: "Because of the omnipresent emotion regret, of which the international investor is all too familiar, a naïve hedge ratio became common practice amongst many investors." Basing their reflection on the work French business school HEC professor Bruno Solnik, they argue that this ratio has become widely applied because of a feeling of regret after the implementation of a wrong currency hedging policy. "The emotion regret plays an important role, and when this emotion is allowed to dominate, it can lead to irrational behaviour." One of the alternatives, a 100% hedge, would not necessarily be well-advised either they say, pointing to a 2003 study by Kenneth Fischer and Meir Statman that found the returns of hedged and non-hedged portfolios between 1988 and 2002 were roughly the same. Benefits Currency risk, point out the authors of the report, comes along with its own benefits. "Foreign currencies provide a source of diversity against budgetary, fiscal or monetary risks in one's own country. A good example might be local inflation, which usually has a negative impact on local interest rates and leads to a weakening of the currency", they say, supporting their rationale with Bruno Solnik's own research. This leads them to a clear-cut conclusion: "in spite of the inherent volatility and risks associated with currencies, diversity offsets these negative attributes for the local portfolio." They add that whereas currencies are highly susceptible to fluctuation in the short-term, they all have an equally high tendency to return to a long-term average, and that a portfolio of currencies should be hedged accordingly. "There is another good reason one shouldn't hedge completely; currency trading is a zero sum game. The profit gained on one currency is a loss suffered on another", they explain. In turn, for long-term multi-currency investors, a 100% currency hedge should be avoided. "This costs too much and rules out benevolent volatility, or the diversification benefits currencies can bring. With a quantitative model one can determine how much he or she should hedge in a particular country", think the two Compendeon experts. They rather advise to apply hedging selectively to currencies which have the "less diversification potential", while avoiding outright an exhaustive or "naïve" hedging policy such as the 50% hedging policy. Such an approach, they say, should lower the cost of the hedging programme while making it more efficient. Compendeon's own hedging model showed that for developed countries a hedging advice of 25% to 45%, while a portfolio of emerging country assets should be hedged between 50% and 75%. J.L. |
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Articles of the same Topic : Currencies |
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