To Hedge or Lean In? Portfolio Managers Are Split on the Climbing Dollar.
The greenbacks’ surge is lessening the value of foreign assets in dollar terms, worrying some investors and exciting others.
When the dollar makes a big move, as it has in the past three months, currency exposure can become a pressing issue for U.S. investors with foreign holdings.
The Bloomberg Dollar Spot Index, which measures the greenback’s value against 10 major currencies, gained 4.7 percent over the three months through Oct. 27. That rally, of course, makes the foreign assets of U.S. investors worth less in dollar terms. And it spurs some investment managers with nimble mandates to hedge their currency risk.
Fund managers rely on a variety of techniques for handling currency exposure, including using futures to blunt the impact on their portfolios. Some seize on dollar increases to invest opportunistically abroad, though currency considerations are typically only one factor among many in the risk-reward equation. Flexibility is usually paramount.
“There’s not one single approach for us,” says Nelson Yu, a chief investment officer at AllianceBernstein who handles currency exposure for stocks.
At AB, equity teams select stocks with a bottom-up approach, estimating how currency exposure will affect an individual company’s earnings. But a fund’s overall currency profile is less of an issue.
In choosing stocks, “we rely on company-specific dynamics as to what will cause earnings to grow,” Yu says. “Our main strength is in picking companies, and that’s what we want to drive the portfolio, not a view on currencies.”
If an AB stock fund’s overall foreign exchange exposure isn’t aligned to the firm’s currency forecasts, it will reduce risk by hedging to match the weightings of its benchmark. But if AB has a client mandate to hedge differently or not at all, it will follow those guidelines.
Franklin Templeton treats currency exposure on the equity side similarly, generally leaving it unhedged. Like AB, Franklin Templeton incorporates currency considerations when evaluating individual stocks. “It’s a component of risk and return,” says Wylie Tollette, CIO of investment solutions.
On the fixed-income side, most of AB’s non-dollar strategies are hedged back to the dollar. “We want to start from scratch” on currency exposure, says Fahd Malik, portfolio manager for income strategies at AB.
If the firm has a strong currency view, that will overlay the bond holdings. “But if we don’t have a strong view, we steer clear,” he says.
Given the volatility of currency movements, “a systematic allocation to currencies isn’t the most effective use of capital over time,’’ Malik says. “We view currency as a risk premium. Like other sectors we invest in, currencies are part of a tool kit.”
As for Franklin Templeton, it hedges its currency exposure on developed market bond investments. That’s because currency volatility can overwhelm other return drivers for bonds, Tollette says.
At J.P. Morgan Asset Management, “our investors want us to take an active view on whether to hedge or not,” says Phil Camporeale, a portfolio manager who is involved with currency exposure for stocks and bonds. “We will or won’t hedge based on that view.”
When it comes to alternative investments, Franklin Templeton handles currency considerations on a case-by-case basis, Tollette says. It holds most of its alternative positions for three to 10 years.
“Over that period, hedges are expensive and start to eat away at potential returns,” he says. “So, our general approach is not to hedge. We include currency values when making our decision to invest.”
The dollar’s recent climb has affected Franklin Templeton’s view of the attractiveness of non-U.S. investments. The move has dampened short-term returns from foreign equities, Tollette notes.
But much of the greenback’s strength stems from its safe haven status amid military conflicts overseas, Tollette says. “Those spikes tend to abate over the medium term. And we can take advantage by redeploying capital into non-U.S. investments, including developed APAC [Asia-Pacific] stocks and bonds and diversified emerging markets holdings, except China.”
He has a positive outlook for emerging market currencies such as the Indian rupee and Brazilian real versus the dollar over the next year. If they rally, that will benefit investments in those two countries. Interest rates have ascended by even more in developing markets than in the U.S. That could push their currencies higher, reversing the recent declines and making fixed-income investments there more attractive, Malik says.
The dollar’s recent ascent against emerging market currencies provides a good entry point for investing in assets there, because they’re now cheaper in dollar terms, he says.
That advantage applies to purchases of foreign investments wherever the dollar is rising. So now could be a good time to initiate investments overseas.
But “there are many elements that drive valuation differences between the U.S. and foreign markets, and currency movements are just a small driver,” AB’s Yu says.
“Some of the drivers today are investor flows into the U.S., the [strong] growth prospects of U.S. companies relative to the rest of the world, and the dominance of the U.S. in the artificial intelligence theme,” he adds.
When the buck is appreciating, investors need to look at why that’s happening. If it’s because U.S. interest rates are rising more than foreign rates, this could offset the currency advantage for picking up foreign bonds, Malik explains. That’s because the higher rates make U.S. fixed-income assets more attractive.
The dollar’s increase against the euro might make European equity investments look cheap, but European growth will likely lag that in other regions, Tollette says. “That might be a more important driver over the next year than dollar-euro. So, we’re a little underweight the euro zone.”