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Emerging Market Currencies — To Hedge or Not to Hedge?

At Swan Glob­al Invest­ments we are quite excit­ed about the prospects of our newest invest­ment offer­ing, the Swan Defined Risk placed on Emerg­ing Mar­kets (EM).

Our time-test­ed Defined Risk Strat­e­gy (DRS) has a suc­cess­ful track record (See the Swan DRS Select Com­pos­ite dis­clo­sure) of hedg­ing down­side mar­ket risk and prof­it­ing from the volatil­i­ty of U.S. large cap equi­ties. With its his­tor­i­cal­ly high­er volatil­i­ty and down­side risk, emerg­ing mar­kets may be a the­o­ret­i­cal­ly even bet­ter can­di­date for the DRS income and hedg­ing process. Swan per­formed exten­sive back­test­ing on the the­o­ry and our research sup­port­ed our the­o­ry that DRS when applied to EM. Swan released our Emerg­ing Mar­kets fund offer­ing at the end of 2014.

That said, cur­rent mar­ket con­di­tions have a lot of peo­ple ask­ing about our stance on hedg­ing cur­ren­cy risk. With the U.S. dol­lar cur­rent­ly in one of its peri­ods of strength against many oth­er cur­ren­cies, investors are ask­ing about Swan’s thoughts on active­ly hedg­ing out cur­ren­cy expo­sure. The short answer is we believe the costs of cur­ren­cy hedg­ing out­weigh the ben­e­fits, so we do not hedge cur­ren­cy expo­sure.

The rea­sons against hedg­ing cur­ren­cy risk, espe­cial­ly in emerg­ing mar­kets, are both philo­soph­i­cal and prac­ti­cal.

One of the main philo­soph­i­cal rea­sons relates to the core objec­tive of the DRS itself- hedg­ing against major mar­ket sell-offs.

The DRS is always hedged against major mar­ket cor­rec­tions, and many of the recent peri­ods of dol­lar strength came dur­ing peri­ods of emerg­ing mar­ket cri­sis.

The “Asian con­ta­gion” and LTCM cri­sis of 1997–98, the Dot-Com bust new_article of 2001-02, and the finan­cial cri­sis of 2007-08 were all times when a “flight to qual­i­ty” saw large emerg­ing mar­ket sell-offs cou­pled with dol­lar strength. In oth­er words, weak­ness in EM cap­i­tal mar­kets are high­ly cor­re­lat­ed to weak­ness in EM cur­ren­cies. But because the DRS is hedged against mar­ket sell-offs, there is poten­tial pro­tec­tion in place dur­ing peri­ods of emerg­ing mar­ket weak­ness.

A sec­ond philo­soph­i­cal point has to do the nature of cur­ren­cy mar­kets them­selves — they go up and they go down. A recent humor­ous pair of con­tra­dic­to­ry head­lines from the Wall Street Jour­nal on April 6, 2015, seen on the right, helps high­light the futil­i­ty of fol­low­ing the lat­est pop­u­lar opin­ion.

No one knows exact­ly which way the cur­ren­cy mar­kets are going to move on any giv­en day, week, or month. Anoth­er core phi­los­o­phy of Swan and the DRS is that we are long-term investors with the goal of out­per­form­ing over an entire mar­ket cycle. Oppor­tunis­ti­cal­ly plac­ing or remov­ing cur­ren­cy hedges runs counter to our phi­los­o­phy of not try­ing to time the mar­ket.


On a relat­ed note, emerg­ing mar­ket cur­ren­cy appre­ci­a­tion can be both a great source of returns and diver­si­fi­ca­tion. The above graph illus­trates the per­for­mance of the hedged ver­sion of the MSCI Emerg­ing Mar­kets index ver­sus the unhedged ver­sion on a rolling, 12-month basis. The green bars rep­re­sent peri­ods when the hedged index out­per­forms, while the red bars are the times when being unhedged is prefer­able. Cur­rent­ly we are in a peri­od of dol­lar strength. But it is worth point­ing out, over the last ten years it has cer­tain­ly been more advan­ta­geous to remain unhedged.

While hedg­ing against down­turns is cer­tain­ly a key com­po­nent of DRS, so is par­tic­i­pat­ing in upward moves in the mar­ket. One of the rea­sons why we are so excit­ed about Emerg­ing Mar­kets is the poten­tial for long-term returns exceed­ing those of devel­oped mar­kets. Just as emerg­ing mar­ket down­turns tend to coin­cide with peri­ods of weak­en­ing EM cur­ren­cies, bull mar­kets in emerg­ing mar­kets are inclined to fea­ture cor­re­spond­ing appre­ci­a­tion in EM cur­ren­cies. Hedg­ing out cur­ren­cy expo­sure entire­ly would remove the upside poten­tial of cur­ren­cy appre­ci­a­tion from the equa­tion.

From a prac­ti­cal stand­point, there are sev­er­al argu­ments against hedg­ing EM cur­ren­cies.

  • Hedg­ing emerg­ing mar­ket cur­ren­cies is very expen­sive. Regard­less of whether the dol­lar is appre­ci­at­ing or depre­ci­at­ing against EM cur­ren­cies, hedg­ing EM cur­ren­cies tends to be expen­sive and some­times not even pos­si­ble.
  • Vol­umes and liq­uid­i­ty in EM cur­ren­cies is a frac­tion of those Euro­pean euros, British pound ster­ling, and Japan­ese yen. There are 23 coun­tries in the MSCI EM index, all with their own cur­ren­cies. Chi­nese ren­min­bi, South Kore­an won, Tai­wanese dol­lar, South African rand and Indi­an rupee and South African make up the five biggest expo­sures in the index. None of them come close to approach­ing the liq­uid­i­ty of devel­oped coun­tries and the 18 oth­er con­stituents of EM index are even small­er. A recent worth­while read by Eaton Vance, “Cur­ren­cy Hedg­ing in the Emerg­ing Mar­kets: All Pain, No Gain” explained this con­di­tion well.

Anoth­er high­ly-rec­om­mend­ed dis­cus­sion about the imprac­ti­cal­i­ty of hedg­ing EM cur­ren­cies recent­ly appeared on’s web­site under the title “Cur­ren­cy Hedged ETFs Not All Cre­at­ed Equal.” (Sep­tem­ber 30, 2014). The author, Paul Britt, dis­cuss­es the impact that inter­est rate dif­fer­en­tials have on hedg­ing costs. While rates in the U.S. are at his­toric lows, many emerg­ing mar­ket inter­est rates are in the 6%-8% range, and some­times high­er.

If an investor desires to hedge out cur­ren­cy risk, that investor must also com­pen­sate the coun­ter­par­ty in the trade by pay­ing out the dif­fer­ence in rates. This cost, which Britt esti­mates as rough­ly 5% based on cur­rent con­di­tions, must be paid out regard­less of the actu­al direc­tion cur­ren­cies move. There­fore, hedg­ing will auto­mat­i­cal­ly have an esti­mat­ed up-front cost of 5%.

Any com­par­i­son you see between hedged and unhedged indices are the­o­ret­i­cal and do not include the actu­al trad­ing costs asso­ci­at­ed with imple­men­ta­tion. Refer­ring back to the Morn­ingstar graph show­ing the green bars when the unhedged index out­per­formed- an actu­al investor would not have been able to real­ize the full val­ue of those peri­ods of out­per­for­mance once the above costs were fac­tored in. The old com­pli­ance line “You can­not invest direct­ly in an index” is espe­cial­ly rel­e­vant when ana­lyz­ing hedged index per­for­mance.

To sum­ma­rize, with the dol­lar in a peri­od of strength rel­a­tive to emerg­ing mar­ket cur­ren­cies, it is cer­tain­ly rea­son­able to ask whether or not it makes sense to hedge against cur­ren­cy move­ments. How­ev­er, as one reviews the philo­soph­i­cal and prac­ti­cal rea­sons against cur­ren­cy hedg­ing, it is our con­clu­sion the costs out­weigh the ben­e­fits.

  1. DRS mar­ket-hedg­ing offers pro­tec­tion dur­ing “flight to qual­i­ty” sell-offs.
  2. While EM-denom­i­nat­ed invest­ments are cur­rent­ly under­per­form­ing, invest­ments in EM with cur­ren­cies unhedged have his­tor­i­cal­ly out­per­formed more fre­quent­ly and to a greater degree.
  3. Final­ly, the costs of hedg­ing EM cur­ren­cies due to illiq­uid­i­ty, unavail­abil­i­ty of hedg­ing instru­ments across the 23 mar­kets of the MSCI EM index, and inter­est rate dif­fer­en­tials are sig­nif­i­cant and would elim­i­nate a good per­cent­age of any gains.


Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsAbout the author: Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.


Impor­tant Dis­clo­sures: Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non­qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®). All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains.  This analy­sis is not a guar­an­tee or indi­ca­tion of future per­for­mance. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970.382.8901 or vis­it 017-SGI-042715

By |2018-10-02T15:11:31+00:00May 14th, 2015|Blog|Comments Off on Unique Approach to Hedging Emerging Market Currencies