Managing Currency Risk in Investment Portfolios Capital markets have become increasingly global in recent decades, providing opportunities for U.S. investors to share in the potential gains (and losses) on securities issued in a wide variety of markets outside the United States. But owning these securities in a diversified portfolio introduces risk in the form of additional price variability due to changing values of the currencies in which they are denominated. Such volatility is commonly termed “currency risk”. This paper briefly explores the topic of currency risk and discusses our approach to taking and managing this particular risk in clients’ investment portfolios. March 2015 Roughly 50% of global equity capitalization (total market value) today is comprised of stocks that trade in markets outside of the U.S and are denominated in currencies other than the U.S. Dollar (USD). A similar statistic applies to the global bond market, in which about 53% of current total market value is in non‐U.S. dollar denominated bonds. The flexibility to invest in a broader set of international securities is a net positive for investors; it offers an opportunity to earn higher returns than may be available in U.S. markets. But owning securities that are denominated in currencies other than the U.S. Global Equities by Underlying Currency
Dollar also introduces the possibility of losses created by a decline in currency value that is U.S. Dollar
independent of “local market” changes in Euro
15%
security prices. This particular investment risk 1
3%
is commonly termed currency risk . Japanese Yen
4%
British Pound
4%
For many investors, the recent sharp plunge in 50%
Canadian Dollar
the value of the Euro in relationship to the U.S. 8%
dollar has provided an all‐too real example of Hong Kong Dollar
how fluctuating currencies can adversely 8%
Swiss Franc
impact portfolio values. For example, in 2014 10%
All Other (24)
equities in the 10 European country markets denominated in Euros returned +5.2% to Euro‐
based investors but returned ‐7.6% on a U.S. dollar basis because the Euro’s value dropped from $1.38 to $1.20 (‐13%). A further 12% drop to $1.05 in early 2015 continued this unfavorable trend, offsetting much of the price gains on European stocks for U.S. investors. Currency Risk in a Portfolio Context The values of individual currencies exhibit substantial variability. Historically, their price movements have exhibited about 60%‐75% of the riskiness of equities. Although at times it feels to investors as if all currency values are moving in sync (e.g., in 2014 when virtually all major currencies declined versus the U.S. dollar), across longer time periods the movement of currency values is not highly correlated. This means that baskets of currencies – for example, the seven currencies from the 16 markets comprising the MSCI Europe equity market benchmark – are somewhat less variable than are the individual currencies. And the low correlation between currency Price Riskiness*
prices and security prices generally means that Equity Market
Local Currency
In USD currency risk is not wholly accretive to equity risk. As Europe
15.6%
9.1%
17.6% shown in the table at left, for example, the overall risk Asia/Pacific
17.5%
8.9%
19.8% to U.S. investors on investments in European market Emerging
21.2%
7.6%
23.3% equities (17.6%) has been less than the sum of these United States
14.9%
n/a
14.9% markets’ equity risk (15.6%) and currency risk (9.1%). Global Equities
15.5%
3.9%
17.1% Note also that currency risk in a market‐weighted, globally diversified (all U.S. and non‐U.S. securities) * annualized standard deviation of monthly prices
equity portfolio has historically been only 3.9% annualized. This means that currency fluctuations will most often reduce (or increase) annual global equity portfolio returns within a +/‐ 4.5% band annually. Comparatively, returns on global equities excluding currency risk can be expected to vary within a +/‐17.9% range of their expected long‐term total return2. 1
A fundamental premise underlying our strategic asset allocation framework is a belief that currency risk is one of five principal categories of risk that investors (and their advisors) can choose to take in portfolios. The other four risks: equity risk, interest rate risk, credit risk, and commodity risk. 2
Statistically, based on a 75% confidence interval for currency risk and for equity risk www.millcreekcap.com Mill Creek Capital Advisors, LLC Page 1 Periodic currency losses have, across time, been followed by offsetting periods of currency gains. During the last 40 years, these cycles (currency declines followed by rebounds) have played out across an average 3 to 5 years. This has meant that, unlike virtually all other risks assumed inside investment portfolios, the assumption of currency risk has historically not produced any positive long‐term total returns. Managing Currency Risk If currency risk is a source of uncompensated risk across a long‐term holding period, then investors and their advisors can elect to do one of the following:  Choose not to take direct currency risks by investing only in USD‐denominated investments3  Seek to eliminate currency risks by buying hedges (currency forwards and/or futures) to protect portfolio holdings against fluctuating currency values  Manage currency risks by limiting the percentage of portfolio assets exposed to non‐dollar currencies, and diversifying those risks across a variety of currencies We think that avoiding currency risks altogether unnecessarily curtails the universe of potentially profitable portfolio investments. Just as there are opportunities to shift portfolio assets within U.S. equity and bond markets in the pursuit of higher returns and/or lower risks, a broader set of similar opportunities exists in non‐U.S. markets. Currency risk, in our view, is a risk that should be taken within portfolios but managed so as to not potentially overwhelm total returns from other sources of risk across short time periods. As shown in the chart at right, global Range of 3‐Year Annualized Returns, 1994‐2014*
bonds and equities have produced Non‐U.S. Global Equities
Non‐ U.S. Global Bonds
similar ranges of short‐term returns (positive and negative) from currency risk4. Although most long‐only equity portfolio managers take currencies into account when evaluating prospective investments (i.e., they evaluate the match/mismatch between a company’s revenues and expenses), most of these managers choose not to hedge against currency fluctuations. Currency hedging is more prevalent in global or international bond portfolios, where currency risks can more easily subsume Median
Annualized
other sources (changes in price and income) of the asset class’ total return. Currency exposures within broadly diversified portfolios of international securities (equities and/or bonds) are typically both varied and variable. That is to say, in multi‐manager portfolios the mix of currency exposures in one manager’s portfolios is usually different than the mix in another manager’s portfolio. And managers’ currency exposures tend to change over time as the composition of their sub‐
portfolios change. 15.0%
12.5%
10.0%
7.5%
5.0%
2.5%
Currency
Equities‐USD
‐5.0%
Equities‐Local
Bonds‐USD
Currency
‐2.5%
Bonds‐Local
0.0%
*25th to 75th Percentile of Rolling 36 month outcomes, 1994‐2014
‐7.5%
3
We view ADRs (U.S. Dollar denominated shares that represent an ownership interest in non‐dollar denominated equity securities) as having currency risks similar to those of the underlying equity securities. 4
The currency risks of global equities and global bonds are highly correlated because the underlying exposures are primarily to the same currencies in similar (but not identical) weights. For the 20 year period shown, currency risk subtracted ‐74 basis points (‐0.74%) annualized from non‐U.S. bond returns and added +51 basis points (0.51%) to non‐U.S. equity returns. www.millcreekcap.com Mill Creek Capital Advisors, LLC Page 2 As an alternative to individual managers hedging currency risks, these risks could be hedged at the portfolio level. An advisor, for example, could aggregate the exposures of its individual managers and execute currency hedges against the collective currency risks. Client‐specific constraints aside, such a program would be fraught with implementation challenges. For example, the international managers with whom we currently have investments have exposures to between 16 and 24 currencies; collectively these managers currently own equities denominated in 36 non‐USD currencies5. Choosing whether to hedge all or some of these exposures – and how frequently to adjust these hedges for any changes in the composition of underlying portfolios and/or changing currency market relationships – is itself a risk‐
taking decision on the part of an advisor that may not altogether successfully eliminate currency risks. Accordingly, MCCA has chosen to not actively hedge clients’ non‐USD risk exposures6. Mill Creek Capital Advisors’ Approach Given that currency risk is a zero‐sum proposition (i.e., no net currency profit or losses are expected over a long‐term holding period), we believe that the most efficient way to manage the impact of currency risk on investment portfolio holdings is to:  Limit non‐USD portfolio exposures to no more than 40% of assets, and 
Own broadly diversified portfolios of non‐USD securities that are not highly exposed to a single currency or to a few currencies. The basis of MCCA’s recommendation that non‐USD (currency exposed) holdings be limited to no more than 40% of assets is an outcome of our analytical work on “Efficient Frontiers”. In investing parlance, an efficient frontier depicts a series of asset combinations offering the highest expected risk‐adjusted returns (more simply, it shows which portfolio mixes produce the best returns for the least amount of risk). The chart below depicts an efficient frontier for global equities based on MCCA’s forward‐looking forecasts of asset class returns, risks, and return correlations7. The chart illustrates the thought process underlying MCCA’s approach: Asset Allocation, Risk and Reward
 At a minimum, 20% of equity 100% U.S. Equities
portfolio assets must be invested in non‐U.S. equities to produce any meaningful risk‐reduction benefit Higher
80/20
70/30

Beyond 40% in non‐U.S. assets, overall portfolio risks are greater than a U.S.‐only portfolio and expected returns are less than a U.S.‐only portfolio. 60/40
100% Non‐ U.S. Equities
At 20%‐40% in non‐U.S. assets, overall portfolio risk is reduced at a modest “cost” (give‐up) in expected portfolio annual returns Annualized Return

Lower
Lower
Annualized Risk
Higher
5
MCCA non‐U.S. equity portfolios at December 31, 2014; for ADRs, currency exposure based on currencies of the underlying securities. 6
One exception: we consider hedging portfolio currency exposures on relatively shorter‐term tactical asset allocations that are principally exposed to a small set of country markets/currencies and where products (ETFs, ETNs, or mutual funds) exist to take such positions on a hedged basis. 7
Based on forecast returns and risks for U.S. and Non‐U.S. Equities from MCCA’s Strategic Asset Allocation model as of December 31, 2014 www.millcreekcap.com Mill Creek Capital Advisors, LLC Page 3 Historically we allocated 25‐30% of most clients’ equity portfolio assets to non‐U.S. equities between 2007 and 2013. With our strategic models more recently estimating that non‐U.S. risk assets may produce better risk‐adjusted returns in the near‐term, we have been allocating 35% of most clients’ equity assets to non‐U.S. equities (20% to developed markets; 15% to emerging markets) since early 2014. Across the 36 non‐U.S. dollar currencies to which these portfolios were exposed on December 31, 2014, the Euro (5.9% weight), British Pound (4.1%), and Japanese Yen (2.2%) were the three largest. In a typical 60% Equity/ 40% Fixed Income balanced portfolio, these exposures were further watered down to 3.5%, 2.5% and 1.3% of assets8. Large currency declines across the second half 2014 and at the start of 2015 detracted somewhat from overall client portfolio returns but affected these returns much less than they did representative USD‐denominated global capital market indices. Return impacts were also less than were returns produced by those advisory firms whose investment programs were more exposed to currency risks generally and to declining developed markets currencies in particular. Know The Risks Investors can elect whether to take currency risk in their portfolios. As with the other types of investment risk to which portfolio assets can be exposed, it is important to know not just the magnitude of this particular risk but also how it potentially interacts with other portfolio risks. At Mill Creek Capital Advisors, we believe that the opportunities available in global capital markets justify taking currency risk in a deliberate and measured fashion. Mill Creek Capital Advisors, LLC March 2015 This publication has been prepared by Mill Creek Capital Advisors, LLC (“MCCA). The publication is provided for information purposes only. The information contained in this publication has been obtained from sources that MCCA believes to be reliable, but MCCA does not represent or warrant that it is accurate or complete. The views in this publication are those of MCCA and are subject to change, and MCCA has no obligation to update its opinions or the information in this publication. While MCCA has obtained information believed to be reliable, neither MCCA nor any of their respective officers, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. Unless otherwise noted, all market and price data is through February 28, 2015. Data used in the preparation of this report was drawn from a variety of sources, including MSCI, Citicorp, Zephyr Associates and Bloomberg LP. 8
MCCA clients were not invested in global bond portfolios exposed to currency risks. Particularly in the current low yield environment (e.g., 1.0% yield on the Citicorp World Government Bond Index) it is our view that an unhedged global bond portfolio subject to currency risk prospectively offers little near‐term prospect of positive total returns to U.S. investors. www.millcreekcap.com Mill Creek Capital Advisors, LLC Page 4