The yen reached ¥153 against the dollar on Wednesday, its strongest since February, as markets began to price in a Bank of Japan (BoJ) interest rate rise later this month.1 For a sterling investor holding Japanese shares, it is a reminder that currency movements can have as much influence on returns as company performance.
For many investors, the decision to hedge currency exposure is made when a portfolio is first constructed and is rarely revisited. Yet the decision warrants more careful consideration, because the right approach for bonds is not necessarily the right approach for equities.
In an earlier article, we explored the key terminology and approaches related to currency management. In this week's Brief, we look in depth at why currency is commonly hedged in bond portfolios, why the case for hedging equities is less compelling, what hedging actually costs, and when a selective hedge may be justified by the evidence.
For a sterling investor, the expected return from US Treasuries or German Bunds may only be a few percentage points a year. Yet the value of the dollar or euro against sterling can move by 10% or more over the same period. Consequently, the currency risk will have a greater influence on the investment outcome than the bond itself.
Perold and Schulman made this argument in 1988, describing currency hedging as a "free lunch" because it removes volatility without, on average, reducing returns.2 Later research by the International Monetary Fund (IMF) reached a similar conclusion: for bonds, fully hedging foreign-currency exposure reduced risk substantially in almost every case studied, regardless of the investor's home currency.3 On balance, we believe this remains the right approach for developed market government bonds, whose job in a portfolio is to be predictable.
Equities are different because companies tend not to be passive holders of a single currency. Many large businesses earn revenues, incur costs and hold assets across several countries. Toyota, the world’s top-selling automaker, reports that each one-yen move against the dollar changes its annual operating profit by roughly ¥50 billion, and it runs a hedging programme of its own to manage the exposure.4 The same is true across the major exporters in Switzerland, Germany and the UK, as well as US technology companies that dominate global indices, all of them earn much of their revenue outside the dollar.
Currency exposure is therefore already reflected, at least in part, in a company’s earnings and share price. When a currency strengthens, shares in export-oriented companies tend to fall as overseas earnings translate into less when converted back into their home currency. Conversely, domestic businesses and importers tend to benefit. Therefore, when an investor decides to hedge equity exposure, they hedge an exposure that companies have partly hedged already. As share prices are typically more volatile than currencies over the long term, hedging currency exposure reduces overall risk less in equity portfolios than in bond portfolios, whilst still incurring the same practical costs.
There is another consideration for sterling investors. Research by Campbell, Serfaty-de Medeiros and Viceira found that the best hedge ratio depends on how a currency behaves when equity markets fall.5 The dollar and the Swiss franc tend to rise in periods of stress. Holding these currencies unhedged can therefore help cushion portfolio losses at difficult times. Sterling, by contrast, has tended to weaken alongside global equities, as it did in 2008, 2016 and 2022.5 For a UK investor, an unhedged overseas holding is worth more in sterling terms in exactly those periods, which is a diversification benefit that hedging would remove.
None of this means that equity currency exposure should never be hedged. Fischer Black's 1989 paper on "universal hedging" argued that some level of hedging can be appropriate for all investors, and the practical solution is to hedge when the evidence is strong.7 In practice, the case is strongest when several conditions point in the same direction. These include when a currency appears expensive against longer-term valuation measures and its central bank is moving towards lowering interest rates while others are holding steady. The US dollar has met some of these conditions at points over the past two years.
By contrast, Japan has offered a particularly clear example of why maintaining unhedged equity exposure is compelling. In July, The Economist's Big Mac index suggested that the yen was around 50% undervalued against the dollar. The Bank for International Settlements' broader measure, which compares the yen with the currencies of Japan’s trading partners and adjusts for inflation, also placed it close to its weakest level since the early 1970s.8,9
At the same time, persistent inflation gave the BoJ reason to continue raising rates while other central banks were pausing or cutting rates. There was little evidence to justify hedging away a currency that cheap, even though the interest rate gap meant a sterling investor could have earned a positive return from doing so. The yen’s recent strength in the past fortnight has reinforced that view.
Currency hedging in equities is often treated as a fixed investment policy. In reality, it is an active portfolio choice that can affect both returns and diversification. Hedging all foreign-currency exposure removes much of the effect that exchange-rate movements have on portfolio returns. Leaving it unhedged means currency valuation movements will affect the investment’s worth in sterling — positively or negatively. These are, therefore, important decisions that should be considered deliberately.
Our starting point is to leave equity currency exposure unhedged. The companies in which we invest already manage some of their own currency risk.
Foreign currency has tended to help a sterling portfolio when markets fall, and hedging carries a cost. The yen has been a useful test of that discipline. During the year, a sterling investor would have been paid to hedge yen exposure, which would have made this easy choice tempting. However, given its relative cheapness on several measures, paired with Japanese interest rates moving in its favour, these factors underscored the case to remain unhedged. This has been a regular topic in our investment committee, and the past fortnight has shown the value of taking the time to assess each currency on its own merits.
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