Portfolio Construction

Risk Without Reward: The Case for Strategic FX Hedging

Topics - Portfolio Construction Market Risk and Efficiency

Read Time - 30 mins

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Risk Without Reward: The Case for Strategic FX Hedging

AQR White Paper

Sharp losses associated with the rapidly rising value of the U.S. dollar — over $1 trillion for U.S. pension plans in unhedged portfolios between July 2014 and March 2015, according to Reuters — has sparked renewed interest in the question of optimal foreign currency hedging. While hedging would clearly have been beneficial for U.S. investors recently, what is the long term case for strategic currency hedging?

The analysis presented in this paper shows that:

  1. In the long term, foreign currencies have earned a very low level of return, consistent with economic intuition.
  2. The standalone risk of foreign currencies is not trivial, and typically about half that of domestic equities.
  3. The correlation between foreign currencies and domestic equity returns varies over time, but is positive on average and rarely significantly negative.

Given this, a volatility minimizing, or mean-variance optimizing investor would not favor an unhedged portfolio. While some amounts of currency risk can provide diversification benefits during certain time periods, the amount found in an unhedged portfolio is too great.

A more optimal allocation, achieved via a currency hedging program, would allow them to achieve a more desirable risk profile without a meaningful sacrifice in terms of expected returns.

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The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

 

Hypothetical performance results have many inherent limitations, some of which, but not all, are described herein. Hypothetical performance results are presented for illustrative purposes only.

 

Diversification does not eliminate the risk of experiencing investment loss.

 

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This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.