The Confusion of Currencies in Investment Portfolios
Investors have grappled with the question of currency allocation this year, triggered by the sharp depreciation of the dollar against most major currencies. While a sharp currency move is understandably a source of concern, we think it is important for investors to think about the various underlying questions before considering portfolio reallocations to reflect views on particular currencies.
There are several issues that need to be addressed. First, what is a currency used for? Second, how do you measure value? Third, what is the right currency to choose as a reference when investing in a multi-currency portfolio? Fourth, what does the choice of currency imply for asset allocation?
What is money?
Money is an abstract measure of value at a point in time. Money does not have an intrinsic value because central banks are not promising to exchange money for anything else on demand. Rather, they are promising to issue a currency in a way that the economy experiences low inflation. In other words, the currency comes with a promise that it does not lose value by more than 2% (the most common inflation target) per year.
This makes money a medium of exchange and unit of account. It is unsuitable for measuring value over time. For measuring value over time, you need something else: the interest rate after accounting for inflation. This is a critical point. There is an unfortunate narrative among some investment strategists that like to show the declining purchasing power of the dollar and other currencies over time. I think this is at best unwitting and at worst wilfully dishonest. You cannot measure the worth of a currency against a benchmark it is explicitly not designed to achieve.
How do you measure a currency’s “store of value” properties?
To measure the value of a currency over time, one needs to look at the purchasing power of the currency after holding it for any period of time in a default-risk free asset. In other words, you need to look at the return of holding the currency in very short term (say, 1 month) government bills. No serious investor is sitting on physical cash earning zero return over long periods of time.
So, what currency has been better at holding its value? It is easy to be intrigued by sharp exchange rate movements or seduced by long-term exchange rate trends. I would argue that the value of a currency needs to be compared to its domestic purchasing power. By this measure, the major currencies are remarkably similar.
After accounting for inflation, the real return of holding US dollar Treasury bills since the mid-70s has been 0.5%. Holding Swiss franc short term bonds would have remarkably yielded 0.5% in real terms as well. The euro has a shorter life, but looking at the average of all major currencies over the same period it is also 0.5%. In other words, the major currencies have done well: if you held your currency in very short-term bills, your currency would not have lost value.
Rapid exchange rate movements may be disconcerting. But investors looking at long term asset allocations should take comfort in the fact that markets seem as efficient as we hope over the long term, even if they are as inefficient as we fear in the short term.
What is the right reference currency to choose?
This is not a question that lends itself to a simple answer. An investor in a developed economy should be thinking of their investment returns in their local currency, because their expenditures and tax obligations are in that currency.
The question is a lot more complicated when thinking from the perspective of investors in emerging markets. Short-term government bonds of many (if not most) emerging market currencies have not exhibited the value-retention properties of developed markets. A Turkish investor, looking at his portfolio in Turkish Lira, would have seen a return of about 18% on holdings of USD cash this year. While he may celebrate the decision of not holding Lira, there will be little to celebrate if he has to pay an income tax on that gain.
The choice of a reference currency is ultimately a personal choice, based on an investor’s liabilities: expenditures, taxes, and any other commitments they may have. For example, should an investor from the Middle East who spends a lot of time in Europe think in dollar or euro terms? The answer is not obvious: most Middle Eastern currencies track the dollar. Their commitments at home are dollar-like, but they also have large outlays in euros.
What does the choice of currency imply for asset allocation?
As noted above, the real (inflation-adjusted) return of holding short-term bonds in any of the major currencies has been about the same. But what about other assets?
Exchange rates are notoriously difficult to predict. Economic theory and historical experience would have predicted that a country imposing tariffs would experience an exchange rate appreciation, not depreciation. This is exactly the opposite of what happened this year. Why? Because other factors were at play.
Are investors well advised to hedge their currency risk? The answer depends on the asset in question. For bonds, especially short-term bonds, holding unhedged positions is a risky proposition. Exchange rate movements of 5% or more in any year, in any direction, and in any currency are common. This is sufficient to wipe out the expected return of most bonds. Hedging currency risk in fixed income portfolios is not simply an option; it is a necessary condition.
What about equities? Unlike bonds, equities are not a promise to pay back a specific amount in a particular currency. Equities are a claim on the future profits of companies. The earnings of most large companies are global (with the exception of utilities and similar companies). For global investors, currency risk plays a remarkably small role in real equity returns.
An investor in the MSCI World Index – comprising of equities in all of the advanced economy currencies – would have seen returns of 8.85% in USD and 6.73% in Swiss francs since the index was created in 1987. Adjusting for inflation, this would be 5.9% and 5.5% respectively. If a Swiss investor were to hedge their currency risk (because the Swiss franc has tended to appreciate) the inflation adjusted returns would have been 5% for the USD investor compared to 4.2% for the Swiss investor since 2000 (since the MSCI hedged index was created). Hedged Euro investors would have ended up with a meagre 3.4% real return. This is a hypothetical calculation based on exchange rate forwards and excludes fees and other transaction costs of hedging.
None of this is surprising. The Swiss franc has been successful because the central bank excelled at delivering low inflation. But low inflation also means low nominal returns. Hedging currencies is a cost that is not obviously necessary for equity investors over the long term. In terms of the growth of an investor’s purchasing power, the difference in returns among major currencies has been narrow.
Why does all of this matter?
Money is an abstract measure of value at a point in time, and hence an accounting convention. Long term investors should focus on the currency of their liabilities and the quality of their investments. Thus, income generating investments, or other low expected return investments, should be hedged. Equity investments should not.
There could be other many reasons for currency diversification other than investment returns: political and other sovereign risks are among them. When making such decisions, however, investors are well advised to set aside exchange rate expectations as a prime motivator. Exchange rates are notoriously difficult to forecast, and the track record of all commonly used forecasting models leaves much to be desired.
Sharp currency movements can be an opportunity for many financial institutions to sell new products. A friend recently sent me the profile of a gold ETF managed by a very large Swiss bank that is hedged into Swiss franc. Why hedged, I asked? What does the dollar/Swiss franc exchange rate have to do with the price of gold? “Because most people don’t understand how things work, and the bank can charge fees for hedging” was his answer. Caveat emptor.
