A tale of two indices
Are emerging markets currencies a source of pain or pleasure? Looking at MSCI EMF equity index returns, investors might be forgiven for thinking the answer is always ‘pain’. However, the ELMI+ index of currency forward contracts tells a potentially more pleasant story. Given the significant return volatility patterns evident in emerging currencies, active management appears worthy of consideration.
First, consider the fate of emerging markets equity investors as measured by the MSCI EMF index. From January 1994 through June 2003, the index fell 2.89% per annum in unhedged US$ terms, while at the same time rising 6.49% in local terms. The difference, -9.38%, is attributable to currency losses. Quite a foreign exchange price to pay, converting a local market gain into a loss for USD-based investors!
Could these investors have hedged themselves and protected those gains? Well, yes and no. Back in 1994, only about 40% of the MSCI EMF index had sufficiently liquid forward markets to be called hedge-able. Most investors were deterred from hedging by high interest rates, transaction costs and a host of regulatory barriers.
As indicated in chart 1 however, since 1997 the hedge-able portion of the index had risen to over 90%. Furthermore, over the past decade, the interest rate differential versus EAFE has declined from over 10% to less than 5%. In short, many of the barriers against taking a proactive currency stance have now fallen away.
To assess whether hedging would have been helpful over this period, we constructed a synthetic (partially) hedged MSCI EMF index. Over the observation period, the unhedged MSCI EMF equity index returned -2.89% and SSgA’s hedged MSCI EMF equity index returned -2.00%, outperforming by 0.87% annualised, see table 1. So, in spite of the interest rate differentials and other costs, it would have been better to hedge the hedge-able currency portion of emerging equities over this particular period.
Now that we’ve demonstrated that hedging emerging market equities would have made sense, let us examine some evidence that might contradict this. First, note that to implement such a currency hedge on equities, one normally employs short forward contracts (selling emerging currencies in exchange for dollars). A portfolio of long emerging currency forward contracts on the MSCI EMF index would therefore have earned -0.89% as indicated by the unhedged less the hedged index returns in table 1. The JP Morgan’s ELMI+ provides an alternate set of returns on a portfolio of long emerging currency forward contracts, but in fact it had positive results. In fact, since inception (January 1994), the ELMI has returned 7.79% per annum (see table 2). How then can the long forward ELMI+ be so dramatically positive while the long forward MSCI EMF is negative?
To answer this
question, we broke both indices down and compared the weighted contribution of each country. As evident in table 3, some countries had a noticeably greater contribution to the liquidity-tiered ELMI+ than to the capitalisation based MSCI EMF. Turkey, for example, while paying interest rates averaging in excess of 70% per annum, has been given a weight averaging over 6% of the ELMI+ versus closer to 2% in the MSCI EMF.
So what do the two indices tell us? First, EM currency forward strategies can vary greatly and have a tremendous effect, depending on the choice and weights of specific currencies. Second, this presents us with opportunities for active currency management either within MSCI EMF equity portfolios or via absolute return currency strategies. For this latter idea, the ELMI+ index or an equal-weighted approach could be suitable benchmarking tools.
Figure 1 offers a look at the distribution of monthly returns for index weighted and equal-weighted versions of the long forward MSCI EMF and ELMI+ indices. On an index-weighted basis, at least 50% of all monthly currency returns fall in the outer tails of the distributions, exceeding +/-2.5% for each index. Not surprisingly, the equal-weighted indices provide more even distributions, with closer to 25% of monthly currency returns exceeding +/-2.5% for each index. Whatever the benchmark, emerging currencies should look enticing to skillful managers who are prepared to take both long and short positions. Caveat emptor: to the victors goes the pleasure and to the vanquished the pain!
Peter T Willett is a senior currency portfolio manager; Robin Wehbé is a member of the strategy group; and David W Zielinski is currency portfolio manager. All three work at State Street Global Advisors in Boston