Currency Risk: Is it time to sit on the fence and hedge?

My last post touched on March's G20 Summit in London, where the conclusion of the meetings of the world's major economic powers was a little inconclusive to say the least. The one thing that could be taken from it as a definite is that while there were lots of platitudes and words regarding global unity and resistance to protectionism with members, all committed to trying to minimise the impact of the recession and to get growth re-started as soon as possible. The problem, I believe, will come from the fact that there was no agreement on the policy of how to do just that. Each nation will consider their own position and, in light of their existing abilities and limitations, be they fiscal or political, introduce specific local measures. It is the difference in these measures will lead to a fluctuation in confidence, demand, valuation, etc. between nations and therefore will at some point be reflected directly in currency exchange rates.

With that in mind, I'd like to touch on the risk attached to currencies for a global investor.

Let's consider the risk impact of currency by examining a couple of global benchmarks, namely MSCI Developed World and MSCI Emerging Markets. The first chart below highlights the contribution of currency risk to the total forecast risk profiles of the two indices from the perspective of a U.S. Dollar investor, the second shows that all our risk models have a similar spread between Developed and Emerging markets.

As you would expect, Emerging Markets consistently shows a much higher currency risk (50% of MSCI World is USD-based) but even that has risen to just short of 25%. This high is reflected in Developed markets too and with the above arguments in mind I see no reason that it should fall.

But what difference does currency actually make and is there anything that can be done about it? To answer these questions I looked at the previous 12-month performance (March 2008-March 2009) of the above two indices from the perspective of a U.S. Dollar investor that has no currency hedging in place and one that is 100% hedged. (Read here for more information on hedging.)

We can see that in both cases the contribution to performance on currency was very material.

What I am looking to highlight is not the benefit of hedging in to USD, (indeed had the investor been Euro-based then the hedged indices underperformed by 4.5% and 5% respectively), but that currency risk is a very real consideration for managers today. The current currency contribution to overall risk was about half 12 months ago as it is today while equity markets are just as risky, if not more so.

Tell us: If you are a global investor, what are you doing to handle your currency risk exposure?

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