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 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 ETF.com’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.
- DRS market-hedging offers protection during “flight to quality” sell-offs.
- While EM-denominated investments are currently underperforming, investments in EM with currencies unhedged have historically outperformed more frequently and to a greater degree.
- 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.
About 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 swanglobalinvestments.com. 017-SGI-042715