When hedging pays off
Some of investors' most valuable lessons come through painful ex-periences.
Probably the most important lesson investors in Asian emerging markets learned over the last six months is that they should consider currency hedging. Obviously, if in-vestors had hedged their equity re-turns, then the performance of their portfolios would have been dramatically improved.
The first step is the same for developed and emerging markets. One can invest in international equities on a currency hedged or unhedged basis. Since 1992, the unhedged MSCI Emerging Market Asia index has had an average annual return of 8.6% with a standard deviation of 24.4%. The hedged index has returned 8.5% with a standard deviation of 23.4%. In other words, the return and risk numbers have not been much different.
The difference between hedged and unhedged return - the impact of currencies on the total return - has been as much as 14% over a 12-month period. Based on these numbers and a more comprehensive study we did on em-erging market currency returns going back to the 1970s, it appears that currency risks embedded in emerging market equity portfolios are nearly as large as hedged equity market risks.
We estimate that the hedging costs of emerging market currencies averages approximately 0.5% per year under normal market conditions, but can increase to as much as 2% during crisis periods. These costs are much higher than the 0.1% to 0.15% per year incurred by hedging in developed currency markets. Because the hedging costs are higher in emerging currencies than developed ones, one might be more inclined normally to be unhedged in emerging markets. For these reasons, and because we be-lieve that emerging market currencies have positive expected returns (large-ly due to risk premiums), we normally recommend to our clients that they use unhedged benchmarks for emerging market currencies.
Another factor influencing the choice of a benchmark is the distribution of returns. In emerging market currencies, unlike developed market currencies, the distribution of returns is not normal; it is skewed. Since em-erging market currency crises are easier to identify, normally being unhedged and hedging when the risks are high is probably the most desirable strategy .
After the benchmark/strategic ex-posure is set, the investor faces the second step - who should manage the currency risk? In currency programmes that are used in the developed markets it is now widely recognized that currency exposures should typically be managed by currency specialists.
The best practice for international investors is to independently select international equity and currency managers. While this process is be-coming much more standard in the developed markets, it is still rare in the emerging markets. And yet it is the same practices which are even more important in emerging markets.
Ray Dalio is with Bridgewater Associates in Connecticut