Last year, there were many large moves in currencies — not just in the US dollar but in the Japanese yen, the Australian dollar, and the British pound, among others. We expect that higher currency volatility will remain in place in 2023, spurred on by elevated levels of economic and asset price volatility, as well as divergence in countries’ policies, cycles, and inflation challenges. The impact of government intervention in currency markets also bears watching.
All of this suggests that currency risk within portfolios may be elevated relative to recent experience — perhaps even occasionally overwhelming the impact of fundamental views on companies. Volatility and dispersion could also create opportunities to generate alpha through active currency management. The bottom line is that it may be time for a fresh look at the impact of currency on portfolio construction.
Weighing different hedging approaches and their pros and cons
As a starting point, investors should be aware of the underlying currency exposures within their equity and fixed income allocations. Those insights will help sharpen the focus on specific currency approaches, which include:
- Structural approaches — Fully hedge all currency exposure regardless of the market outlook or leave all currency exposure fully unhedged.
- Asset-class-based approaches — Make specific currency-hedging decisions for each underlying asset class in a portfolio.
- Optimal hedge-ratio approach — Hedge a percentage of the currency exposure to minimize portfolio volatility.
- Risk-premia harvesting — Leave all positive-carry currency exposure (e.g., those currencies from countries with higher interest rates than the home country) unhedged.
- Active management — Make currency exposure an active decision based on the outlook for the respective currency.