Uncompensated Risks: Currency and Cross-Border Investment
Uncompensated Risks:
Currency & Cross Border Investment
I have often observed a tendency for global investors, as well as for corporates, to handwave the relevance of currency risk in their investment process: in effect, leaving the impact of currency volatility on investment returns as an afterthought.
There are some convenient, but potentially flawed, heuristics that are often relied upon to justify ignoring the impact currency movements have on investment returns.
'It all evens out over time.’ In essence a reliance on the conceit of mean reversion, those up on their game see this as the point Nicolas Nassem Taleb built his entire career dispelling. The reality is spot FX returns have tended to be highly asymmetric, especially on currency pairs that involve the USD. The reason for this is outlined in my earlier pieces on the USD and its centrality for global funding markets.
‘It’s immaterial.’ Even developed market currencies have tended to exhibit considerable variation on quarterly, biannual, and annual bases.
‘Hedging is expensive.’ This isn’t exactly true. As we will explore further in later articles in this series, there are many ways to make hedging cost effective and convenient.
Digging into the data.
The reality is, when you are buying an asset denominated in a foreign currency you are executing two trades, not just one. The first is a directional exposure to the asset you actually want. The second is a directional exposure to the currency that the asset is denominated in.
From earlier articles you may have picked up on the fact that I am a fan of AQR Capital Management and the work of its Managing Founder and Principal, Cliff Asness. In their research on public market investing, they found the following.
Currency exposure tends to meaningfully add to portfolio risk without providing commensurate compensation. Historically, unhedged developed market currency exposures have delivered negligible returns while increasing volatility by up to 15% and amplifying drawdowns by more than 30%. In effect, portfolios take on incremental risk without any associated reward – a scenario antithetical to prudent investment management.
Source: AQR Research White Paper: Risk Without Reward: The Case for Strategic FX Hedging (September 18 2015): Jacob Boudoukh, Michael Katz; Matthew P. Richardson Ashwin Thapar
While volatility itself is often derided as an inappropriate measure of risk and the realm of quant nerds, investors are highly attentive to drawdowns, to the point they can be career- ending for fund managers.
What About Alts?
Anyone who has been paying attention to markets is aware of the massive increase in capital-under-investment mandates in illiquid securities like private credit, real estate, private equity, and venture capital.
There is an argument that much of the growth in this asset class is due to its illiquid nature suppressing measures of risk like volatility, standard deviation, and drawdowns. Whether that is true or not is outside of the scope of this article, but the reality is that not even illiquid asset investors are immune to the impact of currency movements on their returns.
Private credit investors typically target annual Internal Rates of Return (IRRs) in the range of 12 to 15%. Yet the average annual peak-to-trough movements in developed market currencies like the CAD, AUD, USD, and EUR tend to routinely approach, match, or even exceed these return expectations. In other words, an unhedged cross-border private credit investment might face currency-driven volatility that rivals, or at times exceeds, its entire targeted annual return.
Worse still, as evidenced in the work of AQR and others, unlike credit spread or illiquidity risk, FX risk is not a well-compensated risk factor. There is no built-in premium for bearing currency volatility; it is an uncompensated risk that can arbitrarily erode returns.
Despite this, many investors continue to leave FX risk unaddressed. Why? While I have a few theories, lack of awareness of the impact of FX movements is one. Likely more influential, but less often discussed, are the structural barriers, operational complexities, and institutional inertia around deploying FX risk management, which may stand in the way.
The Case for Hedging
Fortunately, effective hedging strategies can, using products that have pros and cons, mitigate the majority of this downside risk, even in emerging market currencies or currencies that have a high cost of carry. As shown, effective FX hedging can drive value creation for investors who do it right.
At the end of the day, we don’t work for free, so, arguably, why would we take on risk without trying to get compensated for it?
In upcoming pieces, I will explore the structural constraints that can prevent investors from implementing effective FX risk management programs, and I will illustrate solutions I have developed to help mitigate those constraints.
Read the next article in the series: Cash Drag: The Hidden Cost of Protecting Returns
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DISCLAIMER: Opinions expressed in this article are those of the author. This article is for informational purposes only and does not constitute advice. Hedging products involve trade-offs, risks, and costs, and results may vary. Before making any decisions, consult an independent advisor not affiliated with Corpay to ensure that the solutions discussed are suitable for your business needs. A comprehensive under-standing of the complexities, benefits, and drawbacks of each hedging product is essential.
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