FEATURE | HEDGE OF LEAST REGRET
HEDGE OF LEAST REGRET
Benefits of Managing International Equity Currency
Risk with a 50-Percent Hedging Strategy
By Rober t Whitelaw, PhD, and Salvatore J. Bruno
T
he potential benefits of international
equity investing include participation
in the fortunes of many of today’s
global industry leaders and greater portfolio
diversification than can be derived by investing in U.S. securities alone. Approximately
two-thirds of global equity market capitalization resides outside the United States,
as do almost half of the top 100 firms by
market capitalization. Still, many U.S. investors appear to be underweight international
equities in their portfolio allocations.
For those seeking exposure to international
equities, it is important to understand how
exchange-rate movements can affect equity
returns in these markets. Currency hedging
offers a way to invest internationally while
managing against the risk a stronger U.S.
dollar can impose on foreign-based equity
returns. However, hedging also can reduce
those returns when the U.S. dollar falls.
History shows that the better-performing
strategy can vary from year to year and is
difficult to predict. What’s more, the
best-performing strategy in one equity
market might not be the best approach in
another market during the same time
period. In either case, whether investors
utilize a fully hedged or non-hedged strategy, it is important to understand that they
are effectively making a currency call that is
inherently difficult to time.
Fortunately, there is an alternative to the allor-nothing approaches many investors have
taken historically to hedging currency exposure in their international portfolios. A balanced 50-percent currency-hedged portfolio
Figure 1: Global Equity Market Capitalization vs. U.S. Mutual Fund and
ETF Equity Assets
Equity mutual fund assets April 2015
Equity ETF assets June 2015
26%
28%
72%
74%
Domestic equity
World equity
Sources: Investment Company Institute, Bloomberg, and ETF.com
may offer a reasonable alternative approach.
In fact, our research shows that half-hedged
portfolios reduce the potential risk of misreading extreme currency movements, in
either direction, while lowering the inherent
volatility in certain key markets, offering a
hedge of least regret across a broad range of
currency scenarios. In addition, we believe
an exchange-traded fund (ETF) structure
offers an efficient and attractive vehicle to
implement a 50-percent currency-hedged
international equity strategy.
A Strategic Allocation, Still Skewed
by Home-Country Bias
The case for international equities as a
strategic long-term portfolio allocation
remains compelling. Approximately twothirds of today’s global equity market capitalization resides outside the United States,
including some of the world’s most
famous—and most profitable—brands.
Non-U.S. industry leaders can be found in
a variety of industries, including pharmaceuticals, semiconductors, telecommunications, automobiles, oil and gas, food and
beverage products, and retail.
According to the latest National Association
of College and University Business Officers
(NACUBO)–Commonfund Study of
Endowments, the average allocation by
participating institutions to international
equities in 2014 was 19 percent, up from
18 percent in 2013. The share of equity
mutual fund assets in domestic equities is
74 percent compared to 26 percent for
world equities, with a similar breakdown in
ETFs (see figure 1). Yet, many U.S. investors
continue to exhibit a clear home-country
bias in their asset class allocations.
The proper allocation to international equities will vary by investor, but the benefits
generally center on enhanced portfolio
diversification and access to dynamic
MARCH / APRIL 2016
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
35
FEATURE | HEDGE OF LEAST REGRET
investment opportunities not available by limiting one’s opportunity set to only U.S. securities. Moreover, now may be an attractive
time to consider increasing one’s allocation to international equities. The six-year bull market in U.S. equities has escalated S&P 500
Index valuations above the historical average. In contrast, international equity valuations remain below the historical average, and in
some markets, such as Japan, valuations are near the low end of the
historical range (see figure 2). Add in easy monetary policies for
many of these countries, and a long-term investment thesis begins
to emerge.
S&P 500 Index
25
20
Average: 14.93
15
Currency—The Other Source of Risk and Return
International equity investing typically captures two return
streams for U.S. investors: equity market returns and currency
returns. Although average currency returns of developed countries are widely believed to revert toward zero percent over very
long time horizons, fluctuations can be dramatic during shorter
periods. Figure 3 illustrates the calendar year total returns for the
FTSE Developed International ex North America Index in local
currency compared to U.S. dollar returns, as well as the cumulative impact that currency movements had on performance.
The wide gaps in some of these years substantially increased
volatility and materially affected returns, at times negatively and,
at others, positively.
10
The Currency Conundrum
Currency hedging can help manage the risks of large currency
movements, but the extremes of either 100-percent hedged or
100-percent unhedged strategies introduce an inherent view on
the direction of the U.S. dollar.
10
5
1985
1990
1995
2000
2005
2010
2015
MSCI All Country World Index
30
25
Average: 16.55
20
15
5
1990
1995
2000
2005
2010
2015
MSCI Japanese Equity Index
The challenges around this are twofold. First, a fully hedged portfolio historically has curtailed returns when the U.S. dollar weakened, relative to international currencies, whereas an unhedged
portfolio historically has underperformed when the U.S. dollar
strengthened.
80
Unfortunately, it is notoriously difficult to predict currency
movements, which can make it challenging to anticipate when a
currency-hedged or -unhedged strategy might be the better option.
Figure 4 compares the annual relative gain/loss of currency-hedged
and -unhedged returns for the FTSE Developed Europe Index in
each of the past 30 years. The fully currency-hedged returns underperformed slightly more than 50 percent of the time.
30
Second, whereas a fully hedged currency position often is assumed
to help mitigate volatility, it actually can increase an investment’s
risk profile, depending on the specific dynamics of the underlying
currencies. Figure 5 shows how various degrees of currency hedging affected index volatility across the 10-year period ended in
2014. Increasing the currency-hedged percentages steadily
reduced volatility in the developed European and the broader
developed international markets; however, the reverse held true
for Japanese markets.
36
Figure 2: Historical Price-to-Earnings Ratio Averages
70
60
50
Average: 27.61
40
20
10
0
1990
1995
2000
2005
2010
2015
Source: Thomson Reuters Datastream, New York Life Investments as of March 31,
2015. P/E ratio measures the average ratio of market values and per-share earnings
for companies in each index. A forecast of earnings 12 months ahead, based on a
survey of analysts, is used. There is no guarantee that the forecast will be realized.
The variation in these results is due to differences in correlation
between the currency return and the equity market return in
local currency. This correlation has been strongly negative for
Japan; therefore, the unhedged currency exposure has provided a
natural hedge against fluctuations in the Japanese stock market.
Hedging currency risk effectively reduces this natural hedge, and
thus, volatility rises as the currency hedge percentage increases.
INVESTMENTS&WEALTH MONITOR
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
FEATURE | HEDGE OF LEAST REGRET
40%
20%
30%
15%
Index Return
20%
10%
10%
0%
5%
–10%
0%
–20%
–5%
■ FTSE Developed ex North America — Local Currency
■ FTSE Developed ex North America USD
–30%
–40%
–10%
▲ Cumulative Foreign Currency
–50%
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Cumulative Currency Effect
Figure 3: Comparison of FTSE Developed International ex North America Returns in Local Currency vs. USD,
January 2004–December 2014
–15%
2014
Source: Morningstar, January 1, 2004–December 31, 2014. Past performance is no guarantee of future results.
Figure 4: FTSE Developed Europe Index 100% Hedged vs. Unhedged Currency, 1985–2014
Hedge “Gain/Loss”
(100% Hedged Return—
Unhedged Return)
40%
Hedged strategy was better 13 out of 30 years (Strong US$)
30%
20%
10%
0%
–10%
–20%
–30%
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
2001
Unhedged strategy was better 17 out of 30 years (Weak US$)
–40%
Source: The hedged FTSE Developed Europe Index is used from 2005–2014. For 1985–2000, the MSCI Europe Index (with estimated hedging costs and FX impact incorporated) is
used. For 2000–2004, the FTSE Developed Europe Index with estimated hedging costs and FX impact is used. Past performance is no guarantee of future results, which will vary.
An investment cannot be made directly into an index.
Figure 5: Volatility as a Function of Fraction Hedge, 2004–2014
21%
20%
Volatility
19%
■ FTSE Developed ex North America
■ FTSE Developed Europe
■ FTSE Japan
18%
17%
16%
15%
14%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Hedge Percentage
Source: FTSE, as of April 30, 2015. Volatility is measured by standard deviation,
which measures how widely dispersed a fund’s returns have been over a specified
period of time. A high standard deviation indicates that the range is wide, implying
greater potential for volatility. Past performance is no guarantee of future results,
which will vary. An investment cannot be made directly into an index.
The correlation has been positive in the markets covered by the
other two indexes, which means that currency exposure has added
to equity risk and hedging this exposure has reduced volatility.
The Hedge of Least Regret
Addressing currency risk, however, does not require an all-or-none
approach. Our research into the interaction between currencies
and equity returns shows that a neutral 50-percent currency hedge
on an international equity portfolio can offer a pragmatic balance
for buy-and-hold investors. It can help gain international equity
exposure and mitigate the effect of exchange-rate fluctuations,
without being actively bullish or bearish on the direction of the
U.S. dollar or foreign currencies.
Because the relationship between volatility and the amount of hedging is not linear in nature, there likely will be times when a 50-percent currency hedge captures a large percentage of the long-term
risk reduction benefits of a fully hedged or unhedged portfolio.
MARCH / APRIL 2016
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
37
FEATURE | HEDGE OF LEAST REGRET
A 50-percent currency-hedged international
equity strategy also may help to provide a
stabilizing effect on relative performance.
As discussed earlier, there has been a frequent, often unpredictable, rotation between
when a 100-percent currency-hedged or
completely unhedged approach has outperformed. Table 1 highlights that the 50-percent hedged route offers a more prudent
return path that consistently delivers more
balanced returns between these two
extremes. These returns also highlight that
the U.S. dollar does not always move uniformly across global currencies. For example, during 2008–2013, a 100-percent
hedged approach was never the strongest
Figure 6: Developed Europe Volatility as a Function of Fraction Hedge, 1985–2015
19.00 %
18.50 %
18.00 %
17.50 %
Volatility
Figure 6 illustrates how 50-percent currency
hedging, applied to the FTSE Developed
Europe Index over the past 30 years, lowered volatility by 80 percent, versus leaving
currency risk completely unhedged.
17.00 %
A 50% hedge provides
much of the long-term
risk reduction of a 100%
hedged portfolio. In this
case, it reduced 80%
of volatility.
16.50 %
16.00%
15.50%
15.00%
14.50%
14.00%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Hedge Percentage
Source: FTSE, as of April 30, 2015. Volatility is measured using standard deviation, which measures how widely dispersed a fund’s returns have been over a specified period of time. A high standard deviation indicates that the range
is wide, implying greater potential for volatility. Past performance is no guarantee of future results, which will vary. An
investment cannot be made directly into an index.
Table 1: Calendar Year Returns for Unhedged, 50% Hedged and 100% Hedged
Annual
Index
FTSE Developed ex North America (NA)
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
13.85
27.64
12.85
–43.18
34.03
9.11
–12.05
18.55
21.98
–4.61
FTSE Developed ex NA 50% Hedged to USD
21.63
24.02
9.86
–41.32
31.10
8.34
–11.83
18.35
23.81
0.43
FTSE Developed ex NA 100% Hedged to USD
29.81
20.31
6.90
–39.61
27.97
7.32
–11.78
18.06
25.59
5.64
FTSE Developed Europe
10.05
34.92
14.88
–45.93
37.34
4.40
–11.16
20.21
26.22
–5.65
FTSE Developed Europe 50% Hedged to USD
17.69
28.51
11.38
–42.04
33.92
6.85
–9.98
19.03
24.47
–0.27
FTSE Developed Europe 100% Hedged to USD
25.70
22.21
7.91
–38.23
30.24
8.95
–9.04
17.65
22.62
5.32
FTSE Japan
24.96
5.61
–4.77
–28.58
5.81
15.40
–13.55
8.08
27.32
–3.29
FTSE Japan 50% Hedged to USD
36.07
8.68
–5.73
–35.84
7.41
7.31
–15.65
13.86
39.78
3.11
FTSE Japan 100% Hedged to USD
47.96
11.72
–6.79
–42.65
8.51
–0.48
–17.76
19.69
53.16
9.72
n Best performance n Worst performance
Source: FTSE, as of April 30, 2015. Past performance is no guarantee of future results. Index performance is not intended to predict or project any specific investment. It is not
possible to invest directly in an index.
Table 2: Advantages of Implementing 50% Currency Hedging with One ETF
38
Single 50% Currency-Hedged ETF
Equally Splitting Assets between a Fully
Hedged ETF and a Fully Unhedged ETF
Initial transaction costs
Required for one ETF
Doubled
Annual trading costs
Lower
Higher due to ongoing reallocations
Rebalancing tax implications
Automatic rebalancing within a single portfolio
Potentially higher due to ongoing need to sell
shares of one ETF to buy shares of the other
Statements
Streamlined single line item
Multiple line items
Efficient allocation across
hedging strategies
Professionally managed, automatically ongoing,
and completely transparent
Potentially inefficient due to limited investor
research resources
Potential to make a wrong call if not allocated
properly at any given time
INVESTMENTS&WEALTH MONITOR
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
FEATURE | HEDGE OF LEAST REGRET
performer in the same year for both European and Japanese equity
markets.
ETFs Offer Efficient Implementation
ETF innovation makes it easy to access a 50-percent currencyhedged international equity strategy that fits comfortably into any
size portfolio through a single product offering. While replicating a
50/50 approach can be achieved by equally investing in two ETFs,
one fully hedged and one fully unhedged, but this presents several
unnecessary challenges such as higher investment costs and greater
administrative complexity. Table 2 highlights some of these drawbacks and why a single-ETF strategy may make more sense. Plus,
investors still benefit from the liquidity, transparency, low cost, and
tax efficiency of ETF investing.
A Timely Positioning Move?
We believe a neutral 50-percent currency hedge makes particular
sense in today’s uncertain markets because it removes the need to
take an active currency view. Figure 7 shows that the bulk of international equity ETF assets and 12-month net flows is in fully
unhedged currency strategies. Consequently, the vast majority of
investors are making a clear currency call for a weaker U.S. dollar,
whether they know it or not. Moreover, most of the 12-month net
flow increases into currency-hedged ETFs occurred after the recent
large U.S. dollar gains, which indicates that many of these investors
might have been chasing returns and may not have fully benefited
from the hedge when it was most needed to protect foreign-based
equity returns; their portfolios also now may be more vulnerable to
any U.S. dollar declines. Now may be an opportune time to reallocate away from both of these types of currency hedging extremes
into a more balanced approach.
Figure 7: Assets under Management and 12-Month Net
Flows, as of May 2015
Assets ($B)
$700
$600
$500
■ Hedged
■ Unhedged
$64
$597
$400
$300
$200
$100
$0
International ETFs
$25
$41
$20
$20
Europe ETFs
Japan ETFs
12-Month Net Flows ($B)
$140
$120
$100
$80
$60
■ Hedged
■ Unhedged
$40
$81
$40
$20
$20
$0
–$20
$5
$3
–$1
International ETFs
Europe ETFs
Japan ETFs
Source: Morningstar Direct, May 29, 2015. Includes the following categories: International ETFs represented by Diversified Emerging Markets, Europe Stock, Foreign
Stock, Japan Stock, Misc. Regions, and World Stock Morningstar categories. Europe
ETFs represented by Europe Stock Morningstar category. Japan ETFs represented by
Japan Stock Morningstar category.
Appendix: Theory and Economics Applied in Our Research
Appendix: Theory
and Economics
Applied Risk
in Our Research
Conclusion
Correlations
and Currency
In the absence of strong convictions around the direction of the
The unhedged U.S. dollar (USD) return on an investment in a forU.S. dollar, euro, yen, and other global currencies, investors
intereignCurrency
currency equity
Correlations
and
Risk market is approximately:
ested in international equities may find the most practical way to
rUSD
rJPY + fJPY in a foreign currency equity market is
The unhedged U.S. dollar (USD) return on
an≈investment
address exchange-rate risk is through a balanced, fixed 50-percent
approximately:
currency hedge. As discussed in this article, a consistent applicaIn other words, the USD return on, for example, Japanese equities
rUSD to
+ f]PY tion of this disciplined approach has demonstrated clear advantages
(rUSD) is approximately equal
(JPY) return on Japanese
≈ rthe
]PY yen
in reducing risk exposure. It also provided steadier performance,
equities (rJPY) plus the currency return on JPY (fJPY). Thus, there is
compared to fully hedged or unhedged indexes (table 1),Inwhich,
by
athe
gain
in USD
if on,
the for
Japanese
market
rises and/or
The
other words,
USD
return
example,
Japanese
equitiesthe
(r JPY
) is rises.
approximately
equal to
their very nature, were shown to underperform and outperform
on
first
effect
is
obvious.
The
second
is
simply
because
the
investor
the yen (JPY) return on Japanese equities (r ) plus the currency return on JPY (f ). Thus, there
a relative basis as market conditions continuously evolved.
holds
to invest
in therises
Japanese
market.
thefirst
JPYeffect
is
is aFinally,
gain in USD
if theJPY
Japanese
market
and/orequity
the JPY
rises.IfThe
is obvious. The
accessing this strategy through a rules-based ETF portfolio
can
be
more
valuable
when
the
investment
is
exchanged
into
USD
at
themarket. If the
second is simply because the investor holds JPY to invest in the Japanese equity
a less costly and more efficient manner than dual-hedgedJPY
andisnonend of when
the investment
periodis than
it was at
theUSD
beginning
of the
more valuable
the investment
exchanged
into
at the end
of the investment
period,
the
investor
has
made
money
on
the
movement
in
the on the movement
hedged approaches. period than it was at the beginning of the period, the investor has made money
rate.
in the exchangeexchange
rate.
USD
JPY
JPY
Authors: Robert Whitelaw, PhD, is professor of finance and chairman
A simple application of basic statistics illustrates:
A simple application of basic statistics illustrates:
of the finance department at the New York University Leonard N. Stern
School of Business. Salvatore J. Bruno is executive vice president and
𝜎𝜎𝜎𝜎#'$%& ≈ 𝜎𝜎𝜎𝜎#'()* + 𝜎𝜎𝜎𝜎,'()* + 2𝜌𝜌𝜌𝜌#()* ,,()* 𝜎𝜎𝜎𝜎#()* 𝜎𝜎𝜎𝜎,()* chief investment officer at IndexIQ. Contributors: Adam Patti, chief
2
executive officer and founder of IndexIQ; and Kevin Disano,Inexecutive
equation,
σ2 of
is the return,
variance
thevolatility
return, σ or
is the
volatility
this equation,Inσthis
is the
variance
σ iof
s the
standard
deviation, and ρ is
or
standard
deviation,
ρ is the correlation
between
the JPY
vice president, chief portfolio strategist and head of the ETFthe
specialist
correlation between the JPY returnand
on Japanese
equities and
the currency
return on JPY.
return on Japanese equities and the currency return on JPY.
group at IndexIQ. All can be reached at [email protected].
Result: Risk increases as correlation increases.
Intuition: Mathematically, it is clear that the variance of the USD return increases as the
MARCH / APRIL 2016 39
correlation increases because the volatilities are both positive. The logic is that as the equity
marketAssociation
and the currency
movewith
increasingly
(i.e., they are increasingly likely to move in
© 2016 Investment Management Consultants
Inc. Reprinted
permission.together
All rights reserved.
the same direction), this increases the magnitudes of the movements in the USD returns because
correlations of earlier times. However, there has already been extreme volatility in eurozone debt
markets, and the correlations have switched back to negative when estimated using daily data in
the recent past.
FEATURE | HEDGE OF LEAST REGRET
Result: Risk increases as correlation increases.
Hedging and Risk
The currency-hedged USD return on an investment in a foreign currency, such as JPY again,
equity market is approximately:
r
≈ r – cost
USD
JPY
rUSD ≈ r]PY ‒ cost The USD return is simply the JPY return minus the cost to hedge
away the exchange-rate return. This cost is approximately the riskIntuition: Mathematically, it is clear that the variance of the USD
The
USD
return
is simply
the JPY
return minus
the cost
hedge
away the
exchange-rate return.
free
interest-rate
differential
between
the to
two
currencies.
If (annureturn increases as the correlation increases because the volatilities
Thisthe
cost
is approximately
the risk-free
interest
differential
two
alized) risk-free
interest rates
arerate
1-percent
lowerbetween
in USDthe
than
incurrencies. If
are both positive. The logic is that as the equity market and
cur(annualized)
interest
1 percent
lower
USD
inthe
JPY,
then
JPY, then
it willrates
cost are
about
1 percent
perinyear
to than
hedge
JPY.
If it will cost
rency move increasingly together (i.e., they are increasingly
likely risk-free
about of
1 percentUSD
per year
hedge
thethan
JPY.JPY
If USD
thanbeJPY
rates, then the cost
ratestoare
higher
rates,rates
thenare
thehigher
cost will
negative
to move in the same direction), this increases the magnitudes
be negativeand
andthe
thecurrency
currencyhedging
hedgingwill
willgenerate
generaterevenue.
revenue.The
Thevariance
varianceofof the hedged
the movements in the USD returns because these moveswill
are reinUSD return is approximately:
the hedged USD return is approximately:
forcing each other.
'
𝜎𝜎𝜎𝜎0,#
≈ 𝜎𝜎𝜎𝜎#'()* $%&
For the Developed Europe Index, we observe in the data that the
Thissince
equals theThis
variance
ofthe
thevariance
JPY equity
return.
intuition
thatintuition
the cost term varies very
correlation has risen (in fact gone from negative to positive)
equals
of the
JPYThe
equity
return.isThe
little
over time isrelative
tocost
either
currency
equity
Its variance
more than 100 times
the beginning of the financial crisis in Europe. One of the
primary
that the
term
varies or
very
littlereturns.
over time
relative toiseither
smaller;
we canorsafely
it for
where
differentials
economic reasons that account for this shift is the flight to
safety.therefore
currency
equityignore
returns.
Itsdeveloped
variance ismarkets
more than
100interest-rate
times
are small and vary
very therefore
little overwe
time.
When the crisis struck, and thereafter when there was significant
smaller;
can safely ignore it for developed markets
bad news (e.g., the European sovereign debt crisis), investors liquiwhere interest-rate differentials are small and vary very little over
Result: Hedging reduces risk.
dated riskier positions and demanded safe haven assets. The pretime.
mier safe haven assets are U.S. Treasury securities. This demand for
U.S. Treasuries is also a demand for USD (the currency). Thus, the
Result: Hedging reduces risk.
USD rose and foreign currencies fell in value. This fall in foreign
the equations
variancefor
of the
the variance
hedged and
unhedged
currencies coincided with the fall in the associated equityIntuition:
markets From
Intuition:
Fromfor
thethe
equations
of the
hedgedreturns,
and it is clear
that flight
the hedgedunhedged
variance is
smalleritas
driven both by the original bad news and by the subsequent
returns,
is long
clear as:
that the hedged variance is smaller as
out of these risky assets. This effect generates a positive correlation
long as:
𝜎𝜎𝜎𝜎,()*
between equity market and foreign currency returns. Reversals of
𝜎𝜎𝜎𝜎,'()* > −2𝜌𝜌𝜌𝜌#()* ,,()* 𝜎𝜎𝜎𝜎#()* 𝜎𝜎𝜎𝜎,()* → 𝜌𝜌𝜌𝜌#()* ,,()* > −
2𝜎𝜎𝜎𝜎#()*
this phenomenon produce the same positive correlation, when
both equities and currencies move back in the opposite direction.
Hedging always reduces risk if the correlation is zero or positive.
Hedging always reduces risk if the correlation is zero or positive. Even if the correlation is
Even if the correlation is negative, it would have to be less than
negative, it would have to be less than approximately ‒0.25 (assuming currency volatility is half
In Japan, however, we observe that the correlation is negative. This approximately –0.25 (assuming currency volatility is half equity
equity volatility) in order for the unhedged strategy to be lower risk. Basically, unless the
has been driven by the unconventional monetary policycurrency
by Japan’sreturnvolatility)
in orderinfor
unhedged
strategy
to be
lower
risk. equity return,
moves strongly
thethe
opposite
direction
of the
local
currency
central bank (nicknamed “Abenomics”). Quantitative easing
(QE)
Basically,
unless
the
currency
return
moves
strongly
in
the
opposite
adding currency risk increases overall risk.
and related policies are designed to force down interest rates.
direction of the local currency equity return, adding currency risk
These policies have multiple effects, but two are of primary
inter- and Returns
increases overall risk.
Hedging
est for our findings. First, by reducing interest rates, they make
has a minimal long-term effect on average returns.
bonds less attractive to foreign investors, reduce demandResult:
for theHedging
Hedging and Returns
currency, and make the currency weaker. Second, local investors
Result:
Hedgingabove,
has a minimal
effect on
returns.
Intuition: From
the equations
it is clearlong-term
that the hedged
andaverage
unhedged
return will be
(and to some extent foreign investors) substitute from low-interest
equal, on average, if the average hedging cost equals the average return on the foreign currency.
bonds to other assets such as equities. This pushes equityThis
markets
From
the equations
above, itinterest-rate
is clear thatparity
the hedged
is exactlyIntuition:
the condition
referred
to as uncovered
(UIP).and
While UIP does
higher, which generates a negative correlation. Again, reversals
of
unhedged
return
will
be
equal,
on
average,
if
the
average
hedging
not hold in the short term, there is increasing evidence that it does hold in the intermediate to
this phenomenon produce the same negative correlationlong
when
cost
equals does
the average
returnreturns.
on the The
foreign
currency.
This isis that both currency
term. Thus,
hedging
not sacrifice
economic
intuition
both equities and currencies move back in the opposite direction.
exactly
the
condition
referred
to
as
uncovered
interest-rate
parity differentials
returns and interest-rate differentials are driven, in the longer term, by inflation-rate
(UIP).
While
UIP
does
not
hold
in
the
short
term,
there
is
increasacross the two currencies. High inflation currencies both depreciate (referred to as purchasing
What are the implications going forward? Monetary policy
is diffipower
parity oring
PPP)
and have
(this is an implication
of the Fisher effect).
evidence
thathigher
it doesinterest
hold inrates
the intermediate
to long term.
cult to predict. In the short run, one might expect Japan and the
Thus, hedging does not sacrifice returns. The economic intuition is
Partial Hedging
Risk
eurozone to continue loose monetary policy, but the United
thatand
both
currency returns and interest-rate differentials are driven,
When hedging a fraction ω of the currency risk (for example 50 percent), the return is
Kingdom already is implementing a less-aggressive stance.
in the longer term, by inflation-rate differentials across the two
approximately:
Eventually, world markets should return to a more normal regime
currencies. High-inflation currencies both depreciate (referred to
rUSD ≈parity
– wand
)f]PY + whigher
(cost) interest rates
r]PY + where investors might expect to see a return to the negative correlaas purchasing power
or(1 PPP)
have
tions of earlier times. However, there has already been extreme vol(this is an implication of the Fisher effect).
atility in eurozone debt markets, and the correlations haveThe
switched
variance of the return is approximately:
back to negative when estimated using daily data in the recent past.
Partial Hedging and Risk
𝜎𝜎𝜎𝜎#'$%&
≈ 𝜎𝜎𝜎𝜎#'()*
+ 1 − 𝑤𝑤𝑤𝑤ω 'of
𝜎𝜎𝜎𝜎,'the
+ 2(1 − 𝑤𝑤𝑤𝑤)𝜌𝜌𝜌𝜌#()*
𝜎𝜎𝜎𝜎#()* 𝜎𝜎𝜎𝜎,()* When
hedging
a fraction
(for
example
,,()*
()* currency risk
Hedging and Risk
50 percent), the return is approximately:
The currency-hedged USD return on an investment in a Result:
foreign There is substantial hedging-associated risk reduction from only partial hedging.
rUSD ≈ rJPY + (1 – w)fJPY + w(cost)
currency, such as JPY again, equity market is approximately:
Intuition: Note that in the variance equation the hedging weight appears as a squared term
multiplying the currency return variance. Therefore, for example, for 50-percent hedging the
coefficient on the currency variance is only 0.52 = 0.25. In essence, this eliminates 75 percent of
40 INVESTMENTS&WEALTH MONITOR
the currency risk with a 50-percent hedge.
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
Partial Hedging and Risk
When hedging a fraction ω of the currency risk (for example 50 percent), the return is
approximately:
FEATURE | HEDGE OF LEAST REGRET / THE RATIONALE FOR PRIVATE EQUITY
rUSD ≈ r]PY + (1 – w )f]PY + w (cost) The variance of
thevariance
return isofapproximately:
The
the return is approximately:
𝜎𝜎𝜎𝜎#'$%&
≈
𝜎𝜎𝜎𝜎#'()*
+ 1 − 𝑤𝑤𝑤𝑤
' '
𝜎𝜎𝜎𝜎,()*
+ 2(1 − 𝑤𝑤𝑤𝑤)𝜌𝜌𝜌𝜌#()* ,,()* 𝜎𝜎𝜎𝜎#()* 𝜎𝜎𝜎𝜎,()* THE RATIONALE FOR PRIVATE EQUITY
Continued from page 22
a new marketplace for certain types of PE investment securities,
There hedging-associated
is substantial hedging-associated
risk reduction
from
Result: There Result:
is substantial
risk reduction from
only partial
hedging.
only partial hedging.
designed to provide regular liquidity options for investors.
Intuition: Note that in the variance equation the hedging weight appears as a squared term
multiplying theIntuition:
currency Note
returnthat
variance.
for example,
for 50-percent
the platform will be available to a special kind of mutual fund,
in the Therefore,
variance equation
the hedging
weight hedging
NPM’s
essence, return
this eliminates
of known as an “interval-like” fund. Investors will be given
coefficient on appears
the currency
varianceterm
is only
0.52 = 0.25.
as a squared
multiplying
theIncurrency
vari- 75 percent
sometimes
the currency risk
with
a 50-percent
hedge. for 50-percent hedging the coefficient the opportunity to sell interests in monthly auctions through a proance.
Therefore,
for example,
on the currency variance is only 0.52 = 0.25. In essence, this eliminates 75 percent of the currency risk with a 50-percent hedge.
cess designed to generate robust activity and fair pricing.
All funds traded through NPM’s platform will be Investment
Company Act of 1940 registered, and thus subject to Securities and
Result: In terms of risk reduction, there is an optimal hedge ratio
Exchange Commission oversight and regulation. The funds also
that
depends
on
the
correlation
and
the
relative
volatilities
of
the
Result: In terms of risk reduction, there is an optimal hedge ratio that depends on the correlation
and the relativelocal
volatilities
of equity
the local
currency
equity
return return.
and the currency return. must have elected tax treatment as a regulated investment company,
currency
return
and the
currency
meaning that tax reporting occurs through a Form 1099 and, thereIntuition: It is simple to show (taking a derivative) that the amount of hedging that results in the
Intuition: It is simple to show (taking a derivative) that the amount fore, that the fund does not generate unrelated business income and
lowest volatility is approximately:
is not subject to Employee Retirement Income Security Act of 1974
of hedging that results in the lowest volatility is approximately:
plan assets issues. All buyers of fund interests on the NPM platform
𝜌𝜌𝜌𝜌#()* ,,()* 𝜎𝜎𝜎𝜎#()* + 𝜎𝜎𝜎𝜎,()*
𝑤𝑤𝑤𝑤 =
must be accredited investors.
𝜎𝜎𝜎𝜎
,()*
NPM expects to launch its new marketplace later in 2016, a signifiIf the correlation is zero, then 100-percent hedging provides miniIf the correlation
is zero,
100-percent
providesthe
minimum
As the
cant step forward for investors seeking liquidity of positions in primum
risk. then
As the
correlationhedging
turns negative,
optimalrisk.
fraction
tocorrelation
turns negative,hedge
the optimal
fraction
to hedgeIf is
below
100 percent.
local currency
equity
vate equity investments.
is below
100 percent.
local
currency
equity Ifreturns
are
returns are twice
as volatile
as currency
returns
andand
the correlation
is ‒0.25,
then 50-percent
twice
as volatile
as currency
returns
the correlation
is –0.25,
hedging is optimal.
Conclusion
then 50-percent hedging is optimal.
There are no bargains out there these days, and no easy answers for
This material is provided for educational purposes only and should not be construed as investrobust portfolio growth over the next many years. But, overall, valuaThis material is provided
fororeducational
purposes
and should not be construed as investment advice or an offer
ment advice
an offer to sell
or to buyonly
any security.
tions are lower in private market transactions than they are in public
to sell or to buy any security.
All investments are subject to market risk, including possible loss of principal.
securities, and manager intervention offers a better chance of exiting
All investments are subject to market risk, including possible loss of principal.
positions
Currency
exchange
ratesvolatile
can be and
very volatile
and can
changeand
quickly
and unpredictably.
Currency exchange
rates can
be very
can change
quickly
unpredictably.
Therefore, the value
of an at a profit than does passive security selection. I think
Therefore,
an investment
may also go up or
down
quickly and
investment may also
go upthe
or value
downofquickly
and unpredictably,
and
investors
mayunpredictably,
lose money. Foreign securities
the comparative returns of the past will hold up going forward (for
can be subject to greater
risksmay
thanlose
U.S.
investments,
including
and investors
money.
Foreign securities
can currency
be subject fluctuations,
to greater risks less
than liquid
U.S. trading markets,
structural reasons), and I also think that an ever greater percentage
greater price volatility,
political
and economic
instability,
publicly
information,
and changes in tax or
investments,
including
currency fluctuations,
lessless
liquid
trading available
markets, greater
price volatility,
of new economic value creation will occur on the private side.
currency laws or monetary
These
risksless
are publicly
likely to
be greater
for emerging
markets
political andpolicy.
economic
instability,
available
information,
and changes
in tax than
or in developed
markets.
currency laws or monetary policy. These risks are likely to be greater for emerging markets than
For index definitions,
please markets.
visit IQetfs.com/indexes
in developed
So, yes, for those not already invested in PE, it is indeed time for a
Consider the Funds’
investment
objectives,
and charges and expenses carefully before investing. The
serious look.
For index
definitions,
please visitrisks,
IQetfs.com/indexes.
prospectus and the statement of additional information include this and other relevant information about the Funds
and are available Consider
by visiting
IQetfs.com
or calling
888-934-0777.
Readand
theexpenses
prospectus
carefully
the Funds’
investment
objectives,
risks, and charges
carefully
before before investing.
Bob Rice is managing partner at Tangent Capital, a contributor
investing.
The
prospectus
and
the
statement
of
additional
information
include
this
and
other
For more information: 888-934-0777; IQetfs.com
to Fox News and InvestmentNews, and author of The Alternative
relevant
® information about the Funds and are available by visiting IQetfs.com or calling 888MainStay Investments is a registered service mark and name under which New York Life Investment Management
934-0777. Read the prospectus carefully before investing.
Answer,
LLC does business.
MainStay Investments, an indirect subsidiary of New York Life Insurance Company,
New a Wall Street Journal bestseller. Contact him at
®
an indirect
York, NY 10010,MainStay
providesInvestments
investment
products
and services.
® isadvisory
a registered
service mark
and name IndexIQ
under whichisNew
York Life wholly owned
[email protected].
subsidiary of NewInvestment
York Life
Investment
Management
Holdings
LLC.
ALPS
Distributors,
Inc. (ALPS) is the
Management LLC does business. MainStay Investments, an indirect subsidiary of
principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal
Endnotes
York Life
Insurance
Company,
New York,
NY 10010,
provides
investment
advisoryAve.,
products
underwriter of theNew
mutual
fund.
NYLIFE
Distributors
LLC
is located
at 169
Lackawanna
Parsippany,
NJ
1. In Avi Sharon, “Patient Capital, Private Opportunity: The Benefits and Challenges of
® isaffiliated
an indirectwith
wholly
owned subsidiary
of NewLLC.
York Life
Investment
and services.
IndexIQ
07054. ALPS Distributors,
Inc.
is not
NYLIFE
Distributors
NYLIFE
Distributors LLCIlliquid
is a Alternatives,” Blackstone, https://www.cfainstitute.org/learning/products/pubManagement Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the
Member FINRA/SIPC.
lications/contributed/altinvestment/Documents/patient%20capital%20private%20opETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of
portunity_blackstone.pdf. Sharon obtained cash-flow data from Robert S. Harris, Tim
Jenkinson, and Steven N. Kaplan, “Private Equity Performance: What Do We Know?”
the mutual fund. NYLIFE Distributors LLC is located at 169 Lackawanna Ave., Parsippany, NJ
Journal of Finance 69, no. 5 (October 2014): 1,851–1,882.
07054. (Effective April 1, 2016, the address for NYLIFE Distributors LLC will be 30 Hudson
2. Cambridge Associates, “U.S. Private Equity Index and Selected Benchmark
Street, Jersey City, NJ 07302.) ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors
Statistics,” June 30, 2015, http://40926u2govf9kuqen1ndit018su.wpengine.netdLLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.
na-cdn.com/wp-content/uploads/2015/10/Public-USPE-Benchmark-2015-Q2.pdf.
3. See James Kynge and Jonathan Wheatley, “Emerging Markets: Redrawing the World
Map,” Financial Times (August 3, 2015), citing a report by the IMF; http://www.ft.com/
intl/cms/s/2/4a915716-39dc-11e5-8613-07d16aad2152.html#axzz43AjRHfLX.
MARCH / APRIL 2016
© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
41