To Hedge or Not to Hedge? With Currency, It’s a Vital Question
With global markets growing more volatile, we’re often asked what we think are the most underappreciated risks that investors face today. One in particular stands out: currency risk—especially for non-US dollar–based investors.
To see what we mean, let’s consider the case of institutional investors in Asia. In recent years, many have begun to move away from narrow investment mandates and toward more flexible, well-diversified global multi-asset strategies—a move we think can help to generate consistent returns.
As part of this diversification trend, these investors have sizeable exposures to global currencies, with a significant proportion to the US dollar. Very few investors hedge that currency exposure appropriately, making portfolios vulnerable to unintended currency risk that can hurt performance.
One reason for the dollar’s dominant role in these portfolios might be that most global asset managers offer many investment services denominated in dollars. And the US accounts for a large share of global equity and bond indices, ensuring that the dollar plays a prominent role in global mandates.
Why are so many investors with liabilities denominated in their local currencies comfortable being long the dollar? Probably because doing so has boosted performance. Thanks to a prolonged rally, the dollar is hovering near a two-year high against a basket of major currencies—and soared against many emerging-market (EM) ones.
The dollar rally has had a lot to do with the relative strength of the US economy, which until recently allowed the Federal Reserve to raise interest rates above those in other advanced countries. With policy rates at zero or below, and with bond yields negative in the euro area and Japan, the dollar is still perceived by many to have more room to rise, despite the negative US current account and fiscal deficit.