Don’t currency hedge your equity portfolio – Monevator

Don’t bother currency hedging your equity portfolio. Especially not if you live in the UK. It’s what old-timers call a Texas hedge: one that increases both risks and costs.

Of course, with Sterling plunging in the past few days – for what, if I was being polite, I’d describe as idiosyncratic UK political reasons – my opinion might smack of recency bias.

But I’ve been banging this same drum for decades.

Later on I’ll recall what happened during the Covid pandemic, safely insulated from the heat of the latest made in Westminister mayhem. 

But first a few basics.

What is a currency-hedged equity portfolio?

You’re a UK-domiciled investor. You measure your portfolio’s return in British pounds (GBP).

Let’s say you buy a London-listed ETF that tracks the S&P 500. (Ticker: IUSA, for instance).

The share prices of companies in the S&P 500 are denominated in US dollars (USD).

You’ve therefore now got two exposures: to the prices of the stocks, and to changes in the GBP/USD exchange rate.

If you want to eliminate the exchange rate risk, you can buy an equivalent currency-hedged ETF. (Ticker: GSBX, say). This ETF uses a financial instrument (a derivative) to bet against the USD.

As a result you now only have exposure to the price change of the stocks in the S&P 500, not to the currency as well.

Why do some people claim hedged is less risky?

Well, that’s just common sense, surely. Taking one risk must be less risky than taking two risks added together?

Right?

You’ll also hear: “Your future liabilities are in GBP. So you want to hedge all your cash flows back into GBP”.

If you accept these arguments, then the debate is whether the reduced risk is worth the extra expense of the currency hedging. Obviously the currency hedges cost money, because you don’t get owt-for-nowt. But it’s cheap – only costing a few basis points a year. 

However I’d argue you really shouldn’t currency hedge your equity portfolio because of: 

1. The existence of holistic ‘natural’ hedges
2. The relationship between currency values and inflation
3. The correlation structure between currencies and equities during bad times

Reasons (1) and (2) apply wherever you live.

Reason (3) depends on the correlation between your currency and global equity markets. This one depends on where you live.

Natural hedges

Your own home, the Net Present Value (NPV) of your earned income, the NPV of your state pension, and any defined benefit pension rights are all denominated in your home currency.

Most of your unhedged equity portfolio probably won’t be denominated in your home currency. But your portfolio is also likely a lot smaller than those other assets.

In that case I’d suggest you actually want exposure to other currencies. This is more diversifying, and holistically, it reduces risk.

By contrast hedging reduces your level of diversification across all your assets. And, as you probably know, diversification is the only free lunch in finance.

The other natural hedge is within the equity portfolio itself.

Hedged products hedge against the listing currency. But this is often not the actual economic exposure.

For example I’d argue a US company which earns most of its profits overseas is not really a US dollar-exposed company.

For the same reason, the FTSE100 usually goes up when Sterling falls. That’s because most of the FTSE 100’s earnings are actually in USD.

Inflation

The relationship between currency movements and inflation also causes a natural hedge.

Since the UK imports pretty much everything – including labour – a lower value of GBP increases inflation in the long run.

But at the same time, a lower value of GBP would boost the value of your (unhedged) foreign portfolio. Just when you’d want it to offset higher inflation – how convenient!

What about the other way round?

If GBP rises, then sure, the value of your foreign portfolio will fall. But inflation will be lower in the future thanks to the stronger pound, and the value of your house, salary, and so on will be higher in terms of global purchasing power.

Correlation: risk-on / risk-off

Is your home currency a ‘risk-on’ or a ‘risk-off’ currency?

If your home currency is a risk-on one, then its value will rise when times are good and fall when times are bad – just like equities usually do.

Hedging can therefore increase the size of your portfolio drawdown rise even more (because GBP has fallen).

Which is great because that will give us more money to rebalance into equities.

Like everything in markets and investing, you can’t bank on this neatly happening every time without fail. But that’s typically what we’ve seen in the past.

My vote? Don’t hedge your bonds, either.

King dollar

Personally I skew my liquid investment portfolio towards foreign assets and I never hedge currency exposure. Most of my foreign assets are in USD.

As well as the reasons above for not currency hedging, I also have my own personal biases.

After decades of working in financial markets I just can’t think of GBP – a currency used pretty much exclusively on a small, isolated, increasingly irrelevant island with a yawning trade deficit and a government that applies sanctions to its own citizens and businesses – as real money at all.

To me, there’s only ever one money. And it isn’t the British pound.

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