This summary gives a practitioner’s summary on the article “Optimal Currency Hedging for International Equity Portfolios,” by Jacob Boudoukh, Matthew Richardson, Ashwin Thapar, and Franklin Wang, published in the Fourth Quarter 2019 issue of the Financial Analysts Journal.
What’s the Investment Issue?
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.
How Do the Authors Tackle the Issues?
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 examine weekly data between 1981 and 2017 for the G-10 currencies: the Australian dollar, Canadian dollar, euro, Japanese yen, Norwegian krone, New Zealand dollar, Swedish krona, Swiss franc, British pound, and US dollar. They tabulate international equity returns over the 37-year period from the perspective of investors in each of the 10 countries holding an MSCI World ex-home-country portfolio, as well as a single global portfolio over the full MSCI World universe. For each country, they examine the efficacy of the optimized and robust approaches for constructing portfolios focused first on hedging and second on alpha seeking. These are compared with each other and with benchmark unhedged and fully hedged portfolios.
What Are the Findings?
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.The combined MPMVO framework produced the best performance of all. It exhibited lower average volatility, at 14.6%, than either the unhedged or fully hedged portfolios. While this was a little higher than that of the optimized approach, the combined MPMVO offered far better returns. Tying together the alpha-seeking and hedging portfolios led to a significant increase in Sharpe and Sortino ratios, thereby achieving both higher returns and lower risk.
What Are the Consequences for Investors and Investment Professionals?
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.”Particularly relevant to investment professionals is the contention that the MPMVO framework is not just a theoretical one—it can be implemented in practice. This is because it avoids many of the drawbacks of MVO by increasing transparency and prioritizing reasonable turnover, leverage, and tail properties.