There is no consensus on optimal currency hedging policies for international equity portfolios, and many investors forgo active currency management. Mean–variance optimization (MVO) offers one theoretical solution but tends to produce unrealistic portfolios. In this study, the authors propose a modified portfolio mean–variance optimization (MPMVO) framework that provides a transparent, robust, and practical hedging solution.

The authors’ approach includes theoretical and empirical elements. They start by considering the theory of currency hedging. They decompose an MVO portfolio into three constituent parts: an initial equity portfolio, a currency hedging portfolio intended to minimize equity volatility, and a portfolio designed to generate high risk-adjusted returns. This is the framework of their MPMVO. They then look at different approaches that can be taken for hedging and alpha seeking. The first is a comprehensive “optimized” approach that makes use of the ability of currencies to hedge both equity risk and each other. This could imply, for example, taking offsetting short and long positions in currencies that are correlated with each other but have inverse relationships with equity returns. The second is a simpler “robust” approach based on the popular investment styles of carry, momentum, fundamental momentum, and value.

The authors find that a hedging portfolio is best achieved using the optimized approach. The benchmark unhedged portfolio produced an average volatility of 16.5% across the G-10 currencies, and the fully hedged portfolio, 14.9%. The robust approach improved this further to 14.3%. However, the optimized approach was the standout performer, with average volatility of 12.7%, although this reduction in risk came at the expense of returns.

Conversely, the authors find that the robust approach is more effective for the alpha-seeking portfolio. Compared with the optimized approach, it produced improved risk-adjusted returns (measured by Sharpe and Sortino ratios), lower maximum drawdowns, and lower leverage and turnover—making it more feasible in practice.

While currency hedging of global equity portfolios typically reduces volatility, according to the authors, it often curtails expected returns. This study suggests that the authors’ MPMVO framework does not encompass the same trade off. The reason is that the investor combines two currency portfolios—a hedging portfolio, which minimizes risk, and an alpha-seeking portfolio constructed using well-documented investment styles, such as carry—and can select different methodologies to construct each one. In the authors’ words: “The MPMVO framework judiciously chose to hedge international equities with currencies that did not offer expected return opportunities and took diversifying positions in currencies that did.”