- Historically, currency movements in the emerging markets have been a modest but persistent headwind to returns for U.S. dollar-based investors. Our experience suggests that exchange rate fluctuations – potential gains or losses versus the U.S. dollar – are impossible to predict consistently across the full breadth of emerging market currencies over time.
- Seafarer’s measurement of historical currency risk for a well-diversified portfolio of emerging market equities indicates that the cost of sustaining a complete hedge exceeds the likely cost of risk. This finding suggests that hedging all currencies all the time does not preserve shareholder value in dollar terms, but rather gradually destroys it.
- To address the issue of currency risk facing Seafarer’s portfolios, we created a model which aims to identify currencies that may be at elevated risk for an extreme, adverse event (e.g., a material devaluation or capital account closure) sometime during the next three years.
- The outputs of our macro currency model are used as the basis for “risk budgets” that constrain our portfolios’ construction per currency.
A common belief about investing in the emerging markets is that one must have a “view” on each currency prior to investment in each country. In other words, one should have an investment process that contemplates future currency risks and rewards, distinct from the anticipated risk and return from stocks and bonds, and only then allocate capital to underlying securities accordingly. This belief is understandable, as emerging market currencies are often the source of pronounced portfolio volatility, and sometimes losses. However, Seafarer’s experience is that it is impossible to predict future returns from the breadth of emerging market currencies consistently over time: we are not able to do so, and we have yet to observe a professional investor or strategist who can either.1 Our research on currency risk has pointed in a different direction than the common view: despite all the clamor over currency risk that emanates from the emerging markets, the extent of that risk is not all that large in practice. It is certainly not large enough to undermine returns from emerging equities; nor is it large enough to warrant the cost of hedging continuously; nor is it large enough to justify the sensational and histrionic headlines that dominate the financial media, from time to time.2
Indeed, the available evidence of the past two decades indicates that currencies have imposed a modest (though persistent) drag on long-term investors’ return. Figure 1 provides a snapshot of the historical cost of currency risk over the past two decades. The table measures the average rate of return experienced by an investor in a diversified basket of emerging market equities (and it uses the MSCI Emerging Markets Index as a proxy for that conceptual basket). The table produces the results from a hypothetical investment exercise: what if you invested over a fixed horizon (1 year, 3 years, 5 years or 10) on a rolling basis, in that emerging equity basket?
Imagine you invested a lump sum on a given date, say $100, for a predetermined fixed period – 1 year, 3 years, etc. Now imagine you repeated that investment exactly one month later; and then again, one month later; and so on. Each column represents the average rate of return from that repeated exercise. The first row (A) represents a purely hypothetical result, in which your portfolio is invested in foreign stocks, but in which your investment returns were not impacted by currency movements at all – basically akin to having a mathematically perfect hedge on your portfolio, rebalanced daily, at no cost to you. The second row (B) represents the realized historical cost of currency risk – in other words, how much emerging market currencies added or detracted from your return when measured U.S. dollars. The final row (C) represents the actual returns from the equity basket when measured in U.S. dollars. It is no accident that your returns in row C equal row A plus row B.
Figure 1 indicates that over the past two decades, investors in a diversified portfolio of emerging market equities could expect that currency risk would cost them on average between 0% and 1% per annum (row B), versus an expected return from equities of 9% to 12% (row A). The empirical evidence suggests that diversification is a powerful form of insurance against currency risk: as long as your portfolio is reasonably diversified, currency risk is a manageable drag on your portfolio, and constitutes only a small fraction of the hypothetical returns available from emerging market equities.
|12 Months||36 Months||60 Months||120 Months|
|A. Mean total return, local currency termsa||12.4%||11.4%||10.7%||9.4%|
|B. Currency impact||0.3%||-0.4%||-0.7%||-1.0%|
|C. Mean total return, USD termsb||12.7%||11.0%||10.0%||8.4%|
- aMSCI Emerging Markets Total Return Local Currency Index.
- bMSCI Emerging Markets Total Return USD Index.
- Sources: MSCI, Bloomberg, Seafarer.
- Past performance does not guarantee future results. It is not possible to invest directly in an index.
Currency hedging (via financial derivatives) can potentially mitigate the impact of currency moves on investment returns. However, hedging is expensive, operationally difficult and not even possible for certain currencies. It has been our experience that the cost of currency risk, at least for our portfolios (ones that are diversified across regions and sectors), is substantially less than the cost of hedging such risk.
As the investment firm GMO highlights in a 2015 white paper, “currency management is a useful tool when done for the right reasons: because of a high-conviction view, or a desire to mitigate an identified risk exposure.”3 We agree with this view: provided you know which currencies to hedge when – perhaps because of a “high conviction view” – hedging selected currencies for limited periods might be worth the cost. However, this is predicated on having a reliable means to generate such “high conviction views” – and if you lack such means, hedging all currencies all the time might prove excessively costly, gradually destroying shareholder value when measured in U.S. dollars.
Seafarer’s Macro Currency Model
Because our analysis indicates that currencies pose moderate but consistent headwinds to returns over time, we believe that it’s more important to mitigate risk from currencies than it is to try to profit from them – our goal is risk management, not return optimization. For this reason, we have designed a macro currency model which aims to identify currencies that might be at elevated risk for an extreme event over the near to medium term (i.e. the next 12-36 months). By “extreme event,” we mean either a rapid decline or devaluation (e.g. 15%+ versus the U.S. dollar) or the sudden imposition of restrictive capital controls (typically enacted to forestall an abrupt currency decline). The model constitutes only one small but important part of our portfolio construction process; it does not dominate our thinking, and it certainly does not tell us where it is attractive to invest next. The model only seeks to identify the relative risks of individual currencies, and we use the resulting information to budget such risks accordingly.
Currency moves can quickly overwhelm portfolio performance in the short term, a persistent problem for emerging market investors. In our view, the best way to manage currency risk is through portfolio diversification, and not over-indulging in any one currency or group of currencies. Our proprietary macro currency model is not a stand-alone construct: it does not provide recommendations regarding individual currencies. Instead, the model is purpose-built to be bolted onto our fundamental, bottom-up investment process. We use the model to create a “risk budget” (i.e. a maximum exposure) to guide our portfolio construction process. In our opinion, the model would have no practical purpose if not utilized to manage currency risk within the construct of a diversified portfolio of foreign securities. To be clear: this model is not a tool for foreign exchange timing or dedicated currency investing, but a tool used as part of our fundamental investment process.
Figure 2 offers a summary description of how the model works. The design of the model continues to evolve, and there are dozens of factors from a variety of official sources that are used to produce a maximum risk budget for each currency. The model anchors around three main categories of input factors, as detailed in Figure 2.
|Factor||Factor Inputs and Data Sources|
|Economic||Economic inputs for the model can be bucketed into three sub-factors: current account, foreign currency reserve, and financial stability. We use these factors to identify currencies that may hit potential speed bumps in the coming quarters due to one or multiple fundamental factors. Economic factor data used in the model include current account balances, fuel import dependency, foreign direct investment, currency reserves, and levels of external debt, among others.|
|Policy||Policy factor inputs are primarily sourced from the National Bureau of Economic Research and include data such as restrictions on commercial and financial credit, direct investment, and real estate. One aim of the policy factors is to identify the existence and extent of capital controls.|
|Flow||Flow factor inputs focus on foreign currency rate trends, inflation differentials, as well as equity and fixed income portfolio flows. The flow factor is essentially a momentum indicator to identify currencies that could be impacted by portfolio flows adjusted for inflation and currency trends.|
The model synthesizes these factors and the output results in risk grades for each currency. We then translate those grades into “budgets” that delineate a maximum exposure for each currency. The model does not output a projected exchange rate, or a rate of return, nor a specific time period in which price movements should occur. We acknowledge that our portfolios will always be exposed to substantial foreign exchange risk; what the model aims to do is identify currencies that might be at risk for a material negative event over the next 12-36 months and constrain exposure accordingly.
As emerging market investors, we know that returns will accrue based on the performance of the individual stocks in our portfolios and that the successful identification of stock opportunities requires a disciplined, fundamental, bottom-up research process. Predicting the future magnitude and direction of currency moves associated with those investments with consistent accuracy and precision is impossible in our experience. Our macro currency model is one tool that we employ to mitigate acute risks that could arise from overexposure to risky individual currencies. This model informs our portfolio management process, and it does so via the establishment of risk buckets for all the currencies represented in our portfolios. However, our best insurance against this risk is the most basic – and free – tool available: we start by trying to create a well-diversified portfolio. Our diversified portfolios have seldom bumped up against the currency risk budgets; nevertheless, we take comfort in the existence of these restrictions, which hopefully prevent over-indulgence in potentially problematic currencies.
Currency risks play a central role in both our investment research and portfolio construction processes. Without our macro currency model, we might be inadvertently tempted to overindulge in exposure to a given geography that appeared to be “cheap,” but which was actually plagued by a problematic currency. For example, we may identify a group of stocks that appear attractive via our fundamental research process, but their valuations embed an implied – but difficult to explicitly detect – discount for currency risk. Given the reality of foreign currency headwinds and volatility in the emerging markets, this model is an important arrow in our quiver.Andrew Foster Kate Jaquet
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- We have occasionally observed strategists or investors that have made the “right call” on a particular emerging market currency over a limited window of time. However, being right about one currency, once, over a specific period, is in our view indistinguishable from chance, and thus does not constitute the basis for a long-term investment strategy. If the reader should know of a strategist or investor that has executed consistently successful currency strategy across the full breadth of emerging currencies over the long term, please inform us: we are sincerely interested to learn more.
- Anyone recall the terrifying “Taper Tantrum?” What happened to that, exactly?
- Catherine LeGraw, “The Case for Not Currency Hedging Foreign Equity Investments: A U.S. Investor’s Perspective,” 14 April 2015.