Currency risk for the long term [Europe]

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TrivialYoungInvestor
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Currency risk for the long term [Europe]

Post by TrivialYoungInvestor » Sat May 11, 2019 7:17 pm

Hey everyone,
I am a young investor starting out on investing for the long term (no surprises here), and I'm a bit puzzled about currency risk.

Important to mention, I'm an European in a country using the Euro.

One way seems to purchase currency-hedged ETFs. However, I am reluctant of doing this due to its higher fees, and because I don't understand long-term currency risk yet, and I haven't found much information online so far.

How can you help me about this? Is there any book, or article, that is worthy of reading on this subject?

Schlabba
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Re: Currency risk for the long term [Europe]

Post by Schlabba » Sun May 12, 2019 3:26 am

If you buy a worldwide diversified index fund the companies you own are generating their profits in all kinds of currencies, and many of those comapnies operate across currency borders as well.

I personally wouldn’t hedge any long term investments. Maybe only if you buy a bonds fund that you intent to use as a financial buffer you could pick the hedged version.

Topic Author
TrivialYoungInvestor
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Re: Currency risk for the long term [Europe]

Post by TrivialYoungInvestor » Sun May 12, 2019 4:26 am

That was my thought for now. By holding a World portfolio I was able to reduce currency risk for the USD.

Nevertheless, I am interested in increasing my US exposure, based on how the S&P 500 performs in the long term, and on the strength of the US economy.

Thus, I’m interested to learn how to manage that risk in the long term.

andrew99999
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Re: Currency risk for the long term [Europe]

Post by andrew99999 » Sun May 12, 2019 4:43 am

You are going to pay one way or another, through

• Currency risk
• Concentration risk
• Drag on returns for cost of hedging

You can split them up to reduce the degree of cost of each, or split it only between the problems that matter to you, but just like everything else in finance, it isn't a problem with a perfect solution, it is deciding on the trade-offs that suit you.

msk
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Re: Currency risk for the long term [Europe]

Post by msk » Sun May 12, 2019 4:49 am

Stocks, RE and similar carry very little currency risk long term. IMHO not worth the bother of hedging. Bonds and cash do carry risk. Imagine you are Venezuelan and you hold Bolivar bonds. Or a Turk and hold Turkish Lira, cash or bonds. More tangentially imagine a Greek holding Greek Euro bonds and then Greece decides to bring back the Drachma. Would those bonds remain in Euro or be redenominated in Drachma? If you sense that your country has very little probability of dropping out of the Euro zone then personally I would not bother with hedging, neither for stocks nor bonds.

Schlabba
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Re: Currency risk for the long term [Europe]

Post by Schlabba » Sun May 12, 2019 4:57 am

My advise is also not to hedge.
But if it helps you sleep at night and stay the course, it might be worth getting a hedged etf. The
iShares S&P 500 EUR Hedged costs 0.20% TER, which is the same as their MSCI World.

Valuethinker
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Re: Currency risk for the long term [Europe]

Post by Valuethinker » Sun May 12, 2019 6:13 am

TrivialYoungInvestor wrote:
Sat May 11, 2019 7:17 pm
Hey everyone,
I am a young investor starting out on investing for the long term (no surprises here), and I'm a bit puzzled about currency risk.

Important to mention, I'm an European in a country using the Euro.

One way seems to purchase currency-hedged ETFs. However, I am reluctant of doing this due to its higher fees, and because I don't understand long-term currency risk yet, and I haven't found much information online so far.

How can you help me about this? Is there any book, or article, that is worthy of reading on this subject?
With your global equities which should be the majority of your portfolio at a young age just use an unhedged fund. In the assumption that in the long run the currency will even out.

On the bonds a global fund hedged back into Euros is optimal. The problem with a eurozone government bond fund is that the largest component is Italy and Italy is not free from credit risk. The higher yields on Itsluan government bonds vs the risk free German bond tells you that.

As for overweight in USA. What do you know about the prospects for the USA that the market does not know? In other words the potentially better prospects of the US market are already priced in in an efficient market.

Topic Author
TrivialYoungInvestor
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Re: Currency risk for the long term [Europe]

Post by TrivialYoungInvestor » Sun May 12, 2019 12:01 pm

Thanks everyone for the help!

It’s an interesting point that I’ll pay with some risk one way or another. I’ll keep that in mind.

Nevertheless, I would like to know more about currency risk to make a better judgement over my decision. Where can I read more about this?

Another question that boggles me is, which indexes could I track? This has been easy to answer for stocks, but not for bonds.

andrew99999
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Re: Currency risk for the long term [Europe]

Post by andrew99999 » Sun May 12, 2019 7:44 pm

TrivialYoungInvestor wrote:
Sun May 12, 2019 12:01 pm
It’s an interesting point that I’ll pay with some risk one way or another. I’ll keep that in mind.

Nevertheless, I would like to know more about currency risk to make a better judgement over my decision. Where can I read more about this?
I haven't found much about it and it is rarely discussed.
I got most of my information from hearing different points of view and piecing together what makes sense and what doesn't.
The "it will even out over the long term" argument only works under specific conditions and anyone not fulfilling those conditions could be well and truly up the creek without a paddle if they are not careful.

Vanguard did write a paper but my problem with it is that they use annualised volatility as the metric, which obfuscates the real and more serious problem where it moves in the same direction for 10 or more years giving you a false sense of security.

One of the best pieces I have seen is siamond's Investing in the World series where he compares home bias vs global equities, showing that foreign investors should probably build-in some home bias due to currency risk. I suggested looking at results of data replacing home country equities with currency hedged either in full or in part, but he said it's too difficult to get data on. In any case, definitely worth a read.

Valuethinker
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Re: Currency risk for the long term [Europe]

Post by Valuethinker » Mon May 13, 2019 4:01 am

TrivialYoungInvestor wrote:
Sun May 12, 2019 12:01 pm
Thanks everyone for the help!

It’s an interesting point that I’ll pay with some risk one way or another. I’ll keep that in mind.

Nevertheless, I would like to know more about currency risk to make a better judgement over my decision. Where can I read more about this?
For a young investor, currency volatility is also an opportunity. Investors with shorter time horizons hedge against it, which means that a long term investor should be being paid by the market for taking that risk -- however how much that premium is, I don't know how one would determine.
Another question that boggles me is, which indexes could I track? This has been easy to answer for stocks, but not for bonds.
It does not matter so much vis a vis bonds.

There is a global government bond index. And there is a Barclays global investment grade credit index (i.e. includes corporate bonds). There are funds and ETFs that track either. Most of the time they will have quite similar performance, the exception will be in a bear market, when the Barclays aggregate one will perform worse.

Gilt index is not favoured for reasons I already stated vs. a global govt bond index (sterling hedged). It's a duration argument - conversely if there is deflation then long duration bonds/ funds are better.

Vanguard had a paper about the optimum level of non-home assets for investors in various countries - they looked at Canada Australia UK from memory.

andrew99999
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Re: Currency risk for the long term [Europe]

Post by andrew99999 » Mon May 13, 2019 4:25 am

Valuethinker wrote:
Mon May 13, 2019 4:01 am
For a young investor, currency volatility is also an opportunity. Investors with shorter time horizons hedge against it, which means that a long term investor should be being paid by the market for taking that risk -- however how much that premium is, I don't know how one would determine.
I don't think there is a reward for currency risk, just as there is no reward for idiosyncratic risk. As in, you don't get a higher expected return for it the way you do with a higher equities allocation.

Valuethinker
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Re: Currency risk for the long term [Europe]

Post by Valuethinker » Mon May 13, 2019 6:02 am

andrew99999 wrote:
Mon May 13, 2019 4:25 am
Valuethinker wrote:
Mon May 13, 2019 4:01 am
For a young investor, currency volatility is also an opportunity. Investors with shorter time horizons hedge against it, which means that a long term investor should be being paid by the market for taking that risk -- however how much that premium is, I don't know how one would determine.
I don't think there is a reward for currency risk, just as there is no reward for idiosyncratic risk. As in, you don't get a higher expected return for it the way you do with a higher equities allocation.
Morning coffee had not kicked in when I wrote that ;-).

I can't reconcile my notion with yours - I know yours is correct in a theoretical sense, yet mine is out there.

I stick with my opinion that for a young investor, it should not be a big bother. At least for equity investing.

If there are long run deviations to Purchasing Power Parity (and there are) then your point is important. What I can't get my head around is that a country can run a perpetual current account deficit (i.e. exchange rate overvalued) -- eventually a crash should come*. Exception being the US, because the US is the default reserve currency of the world - sending dollars offshore has a lower effect than for any other currency because people just sit on them (there's a greater risk of a dollar shortage, as there was in 2008-09 with the Fed frantically pumping liquidity into Eurodollar (offshore) markets).

* hence my bearishness on Vancouver, Toronto, Sydney, Melbourne, Auckland. However the crash does not come.

xavierr
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Re: Currency risk for the long term [Europe]

Post by xavierr » Tue May 14, 2019 5:43 am

This article by Gard Capital is well written and explains why Canadians shouldn’t necessarily hedge the currency risk of their US stock. I trade FX derivatives at a broker-dealer (i.e. the instruments used for currency hedging), and I know for a fact that some of the biggest Canadian pension funds have reduced their USD currency hedges after the financial crisis, precisely for the reasons outlined in the article.

https://gardcapital.com/2018/03/04/hedg ... rspective/

From the perspective of a European investor, it is less clear whether staying naked on EUR/USD reduces the volatility of US stock holdings. That’s because EUR is also a reserve currency (less so than USD, but still). During the financial crisis EURUSD initially appreciated to 1.60 (Jul-2008) partly because the markets initially viewed the US housing crisis mostly as US problem, and partly because European asset managers and banks were repatriating funds in EUR as a consequence of a less promising global outlook (i.e. they were buying EUR – putting upward pressure). But sure enough the panic spread to Europe and shook EU arguably harder than it shook the US. EURUSD depreciated back to 1.20 (May-2010) when it became clear that the crisis was challenging the very foundation of the European Union, and when the focus turned on the vulnerability of European banks (remember when everyone was discussing whether countries such as Greece, Ireland, and Portugal would remain in the Union?).

My takeaway from the financial crisis would be to stay unhedged on at least some of my US holdings if I thought the risk of a breakdown of the EU is still on the table (i.e. the risk of at least some countries leaving the EU).

Valuethinker
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Re: Currency risk for the long term [Europe]

Post by Valuethinker » Tue May 14, 2019 5:56 am

xavierr wrote:
Tue May 14, 2019 5:43 am
This article by Gard Capital is well written and explains why Canadians shouldn’t necessarily hedge the currency risk of their US stock. I trade FX derivatives at a broker-dealer (i.e. the instruments used for currency hedging), and I know for a fact that some of the biggest Canadian pension funds have reduced their USD currency hedges after the financial crisis, precisely for the reasons outlined in the article.

https://gardcapital.com/2018/03/04/hedg ... rspective/

From the perspective of a European investor, it is less clear whether staying naked on EUR/USD reduces the volatility of US stock holdings. That’s because EUR is also a reserve currency (less so than USD, but still). During the financial crisis EURUSD initially appreciated to 1.60 (Jul-2008) partly because the markets initially viewed the US housing crisis mostly as US problem, and partly because European asset managers and banks were repatriating funds in EUR as a consequence of a less promising global outlook (i.e. they were buying EUR – putting upward pressure). But sure enough the panic spread to Europe and shook EU arguably harder than it shook the US. EURUSD depreciated back to 1.20 (May-2010) when it became clear that the crisis was challenging the very foundation of the European Union, and when the focus turned on the vulnerability of European banks (remember when everyone was discussing whether countries such as Greece, Ireland, and Portugal would remain in the Union?).

My takeaway from the financial crisis would be to stay unhedged on at least some of my US holdings if I thought the risk of a breakdown of the EU is still on the table (i.e. the risk of at least some countries leaving the EU).
Thank you. Very interesting.

andrew99999
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Re: Currency risk for the long term [Europe]

Post by andrew99999 » Wed May 15, 2019 3:40 am

So I am using MSCI world chart during the GFC
In CAD, the world index is showing a drop of about 45% peak to trough.
In USD, the world index is showing a drop of about 50% peak to trough.

Not remotely near the 24% difference as indicated in terms of the currency change in the article.

Article wrote:An unhedged Canadian investor who held a portfolio of 60% SPY/40% TLT would have gone through the financial crisis essentially flat in $CAD terms.
So it is suggesting holding long term US treasuries to dampen the market in global downturns for Canadian investors?

It seems the overwhelming reason for the difference in the articles suggested portfolio is due to holding USD bonds rather than whether to hedge or not - or am I reading it wrong?

xavierr
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Re: Currency risk for the long term [Europe]

Post by xavierr » Wed May 15, 2019 5:16 am

The numbers in the article look OK to me. It compares the returns on the S&P 500 in USD vs the returns on USDCAD during periods of market weakness (i.e. large drawdowns). In particular during the period you are referring to (Oct-2007 to Mar-2009), the S&P 500 had a total drawdown of -56.8% (~1561 to ~683), while CAD depreciated -24.5% (USDCAD went from ~0.97 to ~1.27). I.e. from the perspective of a Canadian investor, the appreciation of USD over that period would have dampened the negative returns of S&P 500 holdings once converted back to CAD.

The original question had to do with foreign stocks holding, so I was referring to that section of the article. But indeed, the article goes further and argues that a Canadian investors should hold USD denominated bonds rather than CAD denominated bonds, for the same reason.

andrew99999
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Re: Currency risk for the long term [Europe]

Post by andrew99999 » Wed May 15, 2019 10:42 am

xavierr wrote:
Wed May 15, 2019 5:16 am
The numbers in the article look OK to me. It compares the returns on the S&P 500 in USD vs the returns on USDCAD during periods of market weakness (i.e. large drawdowns). In particular during the period you are referring to (Oct-2007 to Mar-2009), the S&P 500 had a total drawdown of -56.8% (~1561 to ~683), while CAD depreciated -24.5% (USDCAD went from ~0.97 to ~1.27). I.e. from the perspective of a Canadian investor, the appreciation of USD over that period would have dampened the negative returns of S&P 500 holdings once converted back to CAD.
But did it really do this?
I am looking now at XSP a CAD hedged S&P500 fund, exactly what is referred to, and the peak is 1953 in '07 and the trough is 804 in '09, which is a drop of 59%.
Even if the CAD dropped 24%, the max drawdown from peak to trough is actually worse, completely invalidating the point they are trying to make using their own example data.

Am I wrong?

xavierr
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Re: Currency risk for the long term [Europe]

Post by xavierr » Thu May 16, 2019 5:06 am

The CAD hedged ETF you are referring to did what it was supposed to, it tracked the S&P 500 in CAD terms and experienced the same drawdown (plus a drag, which seems rather big if your numbers are correct).

The point is that, if instead of holding XSP the CAD investor would've held SPY, he would've had a gain of ~24% on his USD holding and would've been better off. Think of XSP as holding a combination of SPY plus derivatives instruments as a currency hedge:

1) hold XSP:
- SPY returns in USD terms: -57%
- conversion of SPY to CAD: approx +24%
- loss on derivatives hedge: approx-24%
- drag: -2%
==> total return of XSP in CAD: -59%

2) hold SPY:
- SPY returns in USD terms: -57%
- conversion of SPY to CAD: approx +24%
==> first order approximation of SPY return in CAD: -33%

In reality the gain on FX is less than 24% because SPY itself decreased in value. The actual total return is (1-57%)*(1+24%)-1 = -47%, which is still better than -59%

andrew99999
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Re: Currency risk for the long term [Europe]

Post by andrew99999 » Thu May 16, 2019 7:32 am

xavierr wrote:
Thu May 16, 2019 5:06 am
The CAD hedged ETF you are referring to did what it was supposed to, it tracked the S&P 500 in CAD terms and experienced the same drawdown (plus a drag, which seems rather big if your numbers are correct).
Ah yes my mistake, that was hedged.
I agree during short sharp periods, it does look like it would be helpful, so thank you for posting it.
I wonder how hedging has affected medium term returns over say 10 year periods.
I did notice that for my home currency (AUD) it also dropped during the GFC so would have helped in a similar way, but it came back very quickly and excluding that short sharp drop and bounce back, the AUD vs USD rose enough over that decade such that not hedging would have had a major negative effect compared to having a portion hedged.

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jose
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Re: Currency risk for the long term [Europe]

Post by jose » Thu May 16, 2019 7:57 am

If you plan to live in Euros, your liabilities (future expenses) are in Euros, and your assets should be preferably exposed to the Euro.

In $/Euro terms, in spite of being the two largest currencies, the medium term fluctuations are very significant and sharp, so you should not be exposed to pure dollars. Imagine that the Euro goes back to $1.6. That would be very bad for you.

If you want to invest in US companies, being a resident of Europe, your European USA stock ETFs should not be hedged to the $, but either unhedged, or hedged to euros. So, you probably do not have a problem at all.

If you invest in large companies (USA or global), even if the fund is denominated in Euros, it is naturally hedged to the basket of currencies of the assets and future revenues of the global firms. Those assets and future revenues can be converted to dollars, but it does not matter to you. Global companies are diversified because they are multinationals.

Regarding the strength of the US economy, two cautions. One, as has been said before, it is fully priced in the stock market. That is, S&P500 has already outperformed, and it is expensive, so not a great deal. Second, the US has twin deficits, so no reason to be overly optimistic about the dollar.

Best you can do, go global fund of large multinationals, something European version of VT ETF, unhedged, and forget about it.

Jose

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