Currencies can boost returns — but they can also decimate portfolios if their risk is not carefully managed. We discuss why, where and how to hedge currency risk – and outline our approach in taking active foreign exchange (FX) risk.
Currencies are complicated, and we believe that taking FX risk is not rewarded over the medium to long-term investment horizons of most investors. We generally see FX as a portfolio risk that needs careful assessment and management, rather than as an opportunity to generate additional returns.
Why hedge? With no clear return benefit over time, the key aim for many long-term investors is to reduce volatility. Currency moves can greatly increase the volatility of portfolio holdings. This is particularly the case for low-yielding fixed income assets, as the green bars in the Keeping a lid on volatility chart below show.
Keeping a lid on volatility
Expected index volatility with and without FX hedging
Sources: BlackRock Investment Institute and BlackRock Client Solutions, with data from Aladdin, August 2017.
Notes: The chart shows expected volatility based on current index weights and a constant-weighted 201 months of history. Volatility is broken down by contribution of the risk factors of the BlackRock Aladdin risk model. The hedged bars (the second bar for each asset class) show the impact that hedging all FX risk would have on risk levels from a U.S. dollar perspective. Global bonds are represented by Bloomberg Barclays Global Aggregate Index; EM bonds by JP Morgan GBI-EM Index; Japan by Tokyo Stock Price Index (TOPIX); the eurozone by Euro Stoxx 50; and the UK by FTSE 100.