PDF By Jay D. Franklin, CFA, FSA
Risk Manager
Index Funds Advisors, Inc.
www.ifa.com
IFA’s Currency Diversification
Introduction
Recently, there has been much pontification about the “New Normal” where US economic growth is expected to remain anemic for the next few decades, particularly in comparison to emerging countries such as China, India, and Brazil. One of the implications of the New Normal is the prolonged devaluation of the US dollar which has led some investment professionals to call into question the efficacy of investments denominated in US dollars. IFA has a different perspective on these claims.
The Source of Equity Returns
Equity investors receive an expected return for bearing risk. There is no additional expected return from economic growth, nor is there an expected return penalty for economic stagnation. Studies of GDP growth vs. equity returns of various countries show no correlation between the two.
A Historical Example
From 1955 to 2010, Great Britain experienced a long period of slower economic growth relative to the US. This is reflected in the 40% devaluation of the British Pound Sterling relative to the US dollar. However, contrary to what the proponents of the new normal would have expected, the equity returns of Great Britain exceeded the US by nearly 1% over the entire period.
IFA’s Approach to Equities
In IFA’s international and emerging markets equity holdings, currency risk is not hedged. This means that the returns received by IFA’s investors reflect both the appreciation/depreciation of the share prices in the foreign currency and the appreciation/depreciation of the foreign currency relative to the US dollar. The reason for not hedging is that hedging carries a substantial cost, and it does not significantly lower the volatility of the returns for a US investor.
IFA’s Approach to Fixed Income
Since IFA uses fixed income primarily for the purpose of reducing the volatility of equities in order to bring the overall risk level of the whole portfolio to a desired level, IFA’s fixed income investments are either denominated in or hedged to US dollars. Holding unhedged foreign currencies would greatly increase the volatility of fixed income and thus limit its ability to reduce portfolio risk. In the case of fixed income, the cost of hedging is worth the benefit of risk reduction. Currency risk does not carry an expected return.
IFA’s International Equity Allocation
The equity portion of the IFA index portfolios is nominally 35% foreign. The actual percentage is closer to 50% because a large number of the US companies derive a substantial part of their revenue from foreign sources. When the US dollar depreciates, they gain a competitive advantage in the foreign markets. The IFA portfolios are underweight in large foreign multinational companies that do a substantial amount of business in the US (e.g., Sony).
An article in the DFA Quarterly Institutional Review (4th Qtr 2009) notes that “The US equity market does not behave any different at times when the US dollar appreciates or depreciates.” Also, “US Equity and US dollar returns are not predictable to any degree by their past observations.” Both follow a random walk.
