Study questions benefits of full FX hedging
EUROPE - A 100% hedge should never be applied for a long-term investment in different currencies, according to research by Dutch consultancy Compendeon.
According to a survey by Compendeon’s investment chief Erik van Dijk and senior investment manager Harry Geels, full hedging in this case will lead to unnecessary costs and will undo the factor of benevolent volatility.
"The emotion of regret, for not having chosen 'the alternative', plays an important role in hedging decisions,” said Van Dijk and Geels. "It can lead to irrational behaviour, e.g. naive rules, like the hedging of 50%.”
Referring to a study by Kenneth Fisher and Meir Statman, the researchers argue that in the volatile period between 1998 and 2002, the returns of a totally hedged and a non-hedged international portfolio were almost the same: 9.8% and 9.7% respectively.
"Fisher and Statman explained this by ponting out that the correlation between the different countries' portfolios decreased in a non-hedged portfolio.”
According to Van Dijk and Geels, a Fischer Black study on 'Equilibrium exchange rate hedging', showed a universal hedge ratio for all investors of 70%.
"Profit made on one currency is the loss on the other currency,” the researchers added. "Currencies have the tendency to return to a long-term average. Large western currencies move neutrally towards each other in the long term.
"The hedge ratio doesn't need to be high with a long investment horizon and a varied portfolio.”
In their opinion, a model, based on technical analysis, or on multi-factor regression with momentum, overreaction, interest and inflation as variables, allows for more accurate hedging. "This will probably lead to considerable less hedging costs and less risk of the emotion regret".
As additional securities for the prediction of returns, the researchers recommend taking the average of historic returns, and the average volatility within the previous 3 and 10 years. Their model shows a recommended hedging of 25%-45% for a portfolio of developed countries and 50%-70% hedging for emerging markets.
Van Dijk and Geels based their work partly on a recent survey of institutional investors by Mellon and Russell, who found that 39% didn't hedge currency exposure and 34% applied a hedging of 50%. A full hedging was being applied by 14% of the investors, whilst the remaining 13% had different policies.