The volatility challenge
Currency markets are in flux, driven by geopolitical tensions, shifting monetary policies, and unpredictable economic data. For investment managers, this volatility isn’t just noise, it’s a material risk that can erode returns. The recent slide in the USD against the EUR, fuelled by trade tensions, underscores the need for robust currency risk management as unhedged foreign exposures can amplify portfolio swings, turning diversification benefits into unintended liabilities.
Hedging strategies: Passive, active, or hybrid?
Managers have three broad choices when managing FX risk: ignore it, hedge passively, or take an active approach.
Passive hedging is a rules-based method to neutralise currency risk, typically using FX forward contracts. It’s cost-effective and reduces volatility, making it ideal for conservative portfolios. Key considerations include timing, hedge ratios, tenor, and rebalancing tolerance, all of which must align with liquidity and risk constraints.
Active currency overlay seeks alpha by exploiting market trends or macroeconomic views. While potentially rewarding, it demands both expertise and strong governance.
Hybrid approaches are gaining traction, using partial passive hedging with tactical adjustments on selected currencies or asset types. Dynamic hedge ratios, for instance, can lock in gains when a currency strengthens or limit losses when it weakens.
The right strategy depends on portfolio objectives: unhedged defensive assets may suit investors with volatile home currencies, while fixed income-heavy portfolios often warrant near-full hedging.
European versus US investors: Divergent needs
European investors contend with a fragmented currency landscape. Even within the Eurozone, non-euro assets (e.g., GBP or CHF exposures) add layers of complexity. Add to this the ECB’s historically lower rates compared to the US, and the challenge becomes clear: a stronger euro can swiftly erode returns from overseas investments, particularly in higher-yielding markets like the US.
Compounding this are structural hurdles like divergent tax regimes, regulatory patchworks, and a generally more conservative risk appetite. For European investors, hedging isn’t just about volatility control; it’s a tool to preserve capital in a low-rate world.
The US advantage
US investors benefit from the dollar’s dominance which reduces domestic currency risk, while the Federal Reserve’s higher policy rates have traditionally bolstered returns on cash and bonds. Yet for those venturing abroad, unhedged exposures can be a double-edged sword: a rising dollar may enhance purchasing power but simultaneously dent foreign asset valuations.
US investors however often exhibit a higher risk tolerance, favouring equities and emerging markets. Here, hedging decisions are less about defence and more about optimisation – weighing the cost of protection against potential upside in volatile currencies.
Alignment is key
FX hedging isn’t just about mitigating risk, it’s a strategic tool that should complement portfolio objectives. Whether passive, active, or hybrid, the approach must reflect the investor’s home currency dynamics, asset mix, and risk appetite. For European managers, prudence may dictate heavier hedging; for US managers, selective opportunism could prevail. Either way, clarity of purpose and execution excellence are non-negotiable.
In today’s complex markets, many firms are choosing to outsource their currency hedging to reduce the operational burden. Asset servicing groups handle data, trades, and settlement while mitigating credit and counterparty risk to boost the efficiency of currency hedging strategies.
Whatever the choice, in a world of relentless volatility, currency management isn’t optional, it’s essential.
