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Hedge trimming – Effective currency hedging is a great deal easier said than done

02/06/2015

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

With the dollar strong, the euro weak and sterling to be found at various points in between – depending, seemingly, on which way the wind is blowing – it is only to be expected we should occasionally receive questions here on The Value Perspective as to whether we ever think about hedging currencies in our global portfolios.

We certainly do think about it – a lot – and devour all the academic literature there is on the subject. The snag is, we do not find the literature very helpful. This is in part because most of it focuses on the US dollar-sterling exchange rate – academics tending to be based in the US and those two currencies having the longest time series – and yet we are most interested in hedging sterling exposure overseas.

Just as importantly, we have never really found the arguments, either for or against, currency hedging particularly compelling – at least we never did until we read a paper by Catherine LeGraw of GMO. At the risk of spoiling the ending for you, it is called The case for not currency hedging foreign equity investments.

For what it is worth, our own feeling on currency hedging has always been that it is far easier said than done. Just think for a moment about what it is you are actually looking to hedge with an investment – these days, any large company is likely to have operations around the globe and to have its profits and its losses, its assets and its debts in a variety of different currencies.

As such, to hedge your exposure effectively, you would need to understand all of the company’s different currency positions – not to mention all the interrelations between its own hedged positions and its balance sheet. As we say, it is very easy to ask the question as to why we do not hedge our global portfolios but the reality of what this actually entails is significantly more challenging.

As it turns out, LeGraw reaches a similar conclusion – only more articulately and with the addition of an extra point. “In the age of globalisation, most companies have multi-currency costs and revenues,” she says. “Shorting the local currency on top of the equity investment” – in other words, what most people would see as hedging – “does not hedge an exposure, but rather adds new risks to the investment.”

As a further consideration, globalisation means the world is now much more integrated than it used to be. In 1992, points out LeGraw, 60% of sales for developed international companies were domestic – today that figure has dropped below 35%. So, even if in the past academic papers have identified reasons why hedging was worthwhile, today the world is a totally different place.

Of course, you can find exceptions to the rule. If, for example, you owned a business with a purely domestic focus – in other words, all its revenues, costs and debt were in the same currency – then the company would presumably rise or fall with its home economy and it may therefore be sensible to hedge the currency.

But even then there are caveats. Say you found an interesting business in Greece with a predominantly domestic focus – and they certainly do exist – while, in a different era, you may well have hedged the drachma, that option is no longer available. You could still short the euro of course – but that would offer you no benefit whatsoever in the event of, for instance, Greece leaving the euro. We could postulate that, in that environment, the euro may go up, the company’s value may go down and you would then lose on both sides of your ‘hedged’ trade.

Conversely, there are times when UK investors might actually want to go long an overseas company’s domestic currency. Say you like the look of a European exporter – the traditional hedge would be to short the euro and yet, as the GMO paper points out, exporters earn the vast majority of their revenues abroad.

“Exporters may actually benefit from a fall in the home currency as their products become more competitive abroad,” it continues. “By the same logic, exporters can be hurt by the appreciation of the home currency as their goods become relatively more expensive. For that reason, an investor could rationally hedge the currency exposure of exporters by taking a long position in the home currency.”

As a final point, we would note that hedging comes at a price and, like most prices, that will rise and fall in accordance with supply and demand. The chances are, if it has occurred to you to hedge, it will have occurred to many others too and the price is unlikely to be attractive. The cost of hedging roubles, for example, became a great deal more expensive – if it were even possible at all – after the Ukraine crisis began in early 2014.

If hedging demonstrably took risk off the table, investors could be forgiven for considering it but, in the majority of cases, it does not. To quote GMO one more time: “Overall, a broad, diversified allocation to international stocks would not have an easily definable currency exposure. Yes, there are some domestically-oriented companies with closer ties to their home currency, but they are offset by exporters who have negative exposure to their home currency. It is not possible to hedge an exposure that is not there.” Nor, indeed, one you cannot calculate.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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