The third way in currency overlay
Is currency hedging worth it? Like many investors, the Lens has always been tempted to ignore the risk created by swings in FX.
However, the Lens began to question this after a business breakfast held by CAMRADATA and ETS Factory recently. ETS Factory uses artificial intelligence in its suite of investment strategies, which includes currency overlay. So the topic of conversation was about enhancing long-term value with active FX hedging – a subject that, like many investors, the Lens had preferred to ignore for a long time.
The fundamental question is whether any real value is to be had in the active management of the foreign exchange risk that inevitably stems from international equity or bond mandates. The Lens concedes ignoring currency risk could be dangerous yet trying to forecast currency movements feels much like tossing a coin, so our belief was there were only two things that could be done with FX.
The first is to ignore it in the belief that it’ll all ‘come out in the wash’ eventually. This is what many institutional investors do.
The second approach would be to hedge currency exposure in its entirety so that a portfolio ends up with no currency risk whatsoever. That is what the Lens had always believed was right.
But in doing this, there is no upside return from the currency element, so this brings us to the third solution. This is about more actively chasing an additional return by looking at currency exposure in more detail to understand underlying risks, before implementing a currency overlay strategy that helps to improve the risk/return characteristics of the portfolio.
Put another way, the strategy hedges against undesirable movements and looks to take advantage of favourable trends, enhancing a portfolio return.
Interestingly, research in 2018 showed that active currency overlay delivered risk-adjusted returns on a par with hedge funds chasing absolute returns from FX.
The Lens suggests investors take a close look at their approach to FX before the next cycle in emerging market investing gets into full swing.