Managing currency risk remains a controversial issue for institutional investors. At one end of the spectrum, you have many international equity funds who either do not hedge their currency risk or use an unhedged currency benchmark. At the other end, you have fixed income funds that use a currency overlay manager to manage their currency risk actively. To be sure, this is a gross generalization. There are equity funds that do manage their currency risk, whether on a passive or an active basis, and equally there are fixed income funds that make a deliberate choice not to hedge their currency risk. That said, it is the case that fixed income funds are generally more responsive to the idea of managing their currency risk separately and independently from the underlying than their equity fund counterparts, because currency risk empirically makes up a substantially higher portion of the average return volatility of a fixed income portfolio than for an equity portfolio. The figures are roughly 70% and 30% respectively, not least because equities are generally more volatile than bonds. When investing abroad however, there are two core principles concerning currency risk:
1. Investing in a country is not the same as investing in that country’s currency.
2. Currency is not the same as cash; the incentive for currency investment is primarily capital gain rather than income.
Like corporations, institutional investors face transaction risk when they make investments in a foreign currency. They also face translation risk on net assets if they spread their operations overseas. Whether or not it is done by the same individual, it is a core view of this blog that currency risk and underlying asset risk should be managed separately and independently from each other. The way currencies and underlying assets are analysed and the way they trade are both different from each other. Consequently, the way they should be managed should also be different.
Having decided to manage a portfolio’s currency risk, one then has to decide whether the aim is to achieve total returns or relative returns.