To hedge forex risk or not to hedge? Aye, that is the question that this family office attempts to answer.
The following commentary comes from Christian Armbruester, chief investment officer of the European firm Blu Family Office, who regularly airs views in these pages. This publication recently attended a seminar held in the firm’s offices in Richmond-on-Thames, and was struck by Armbruester’s discussion of foreign currency volatility and how deciding whether to hedge forex risk or not can be a tough call. So we asked him to elaborate on his presentation here. We are very grateful to Blu Family Office for sharing these insights. As ever, of course, the usual editorial disclaimers apply. If readers want to react, they can email firstname.lastname@example.org and email@example.com
The world is a big place with more than 200 countries and an almost equal amount of different local currencies. Any investor who is seeking global diversification in their asset allocation, would therefore have to exchange much of their money from one currency to many others. How much? That is a matter of strategy and also mechanics. After all, not everyone can simply exchange so many different currencies in a cost-effective manner. One thing is for certain: the minute we do anything we are at risk and there are also costs. Here is the journey we took as a family office, to figure out what would be the most optimal way of investing our money into the world.
The first thing we noticed is that we do not need to invest in every country. The top 50 countries make up 95 per cent of global gross domestic product and operate on 35 currencies. The marginal benefit of investing in Iraq or Zimbabwe seemed rather small versus the high cost and additional administrative burden. That made things simpler, but the more complicated question we had to answer was: how were we going to measure our success of investing? We needed a reference currency, or “base-currency”, as it is often called. Simply put, it is the currency that matters to you – where you live, where you draw income, where you pay your bills and what you are ultimately investing so that you can get more.
The next decision we had to make was, how much of our money were we going to convert. How much do we buy in the US or in Europe and what about Yen or Brazilian Real? There are wonderful investment opportunities everywhere and in so many different currencies, it really is difficult to say how much we would want of each part of the rest of the world. Some try to categorise the world by economic strength, others by the value of the local stock market, and even some look at growth. The fact is, no matter what you do, a large portion of your risk and returns from your investment activities will be determined by how much you retained in your base currency.
Let’s look at the numbers. Say 10 per cent of your money is in sterling and 90 per cent in all the other currencies, as part of your globally diversified investment strategy. And please note that sterling has even less than a 10 per cent weight in the MSCI World index. What happens if sterling goes down? Then you have made money in all the other currencies and when you convert those into the weaker pound, you have more than you had before. But what if sterling goes up? Then you would lose on 90 per cent of your portfolio. In other words, if there was such an event, such as no hard Brexit, and sterling were to re-trace some of the 20 per cent it lost against all the other currencies after the referendum, it could result in huge losses.