Managing currency exposure in family office portfolios
Currency fluctuations may materially impact investment returns, making currency risk a key consideration – as well as equity market exposure and interest rate risk.
Understanding currency exposure
The impact of currency decisions depends heavily on your portfolio’s base currency. As the dominant global reserve currency, the USD plays a central role in globally diversified portfolios. For families with a USD base, FX exposure may be less material given the high weight of USD-denominated assets in a typical global multi-asset portfolio. Exposure to individual foreign currencies is also well diversified. So, the impact of FX positions at the total portfolio level may be relatively muted.
However, for families with a non-USD base currency, the situation is markedly different. Before any currency hedging, a globally diversified asset portfolio may represent a substantial ‘short’ position in its own currency, and a large ‘long’ exposure to the USD; leaving the portfolio exposed to appreciation in the value of investor’s own currency and/or to a fall in the value of the dollar, over either the short or long term.
Investors also need to be aware that different currencies have different risk characteristics. Some may be more volatile, and their value may be closely correlated with equity market risk, while others may appreciate during periods of heightened market stress. In the former case, currency hedging may add to short-term portfolio volatility but may still be worth considering to seek to protect the portfolio against long-term appreciation in the value of the base currency, or USD depreciation. A further factor is that these risk relationships are not static and may evolve, so it may not be wise to rely on FX exposure as a risk-reducing exposure.
To hedge or not to hedge?
We believe that the decision whether to hedge currency exposure is a strategic decision, not a passive one. While some argue that currency fluctuations "even out over time", this may not hold if exchange rates are initially misaligned. Currency values may deviate from fair value for extended periods, creating both short-term volatility and long-term risks, such as significant depreciation of the family’s base currency relative to the USD.
Currency positioning may serve as a risk management tool or as part of a broader strategy to enhance long-term returns. Some families may opt for active currency management through dynamic asset allocation (DAA), which may provide flexibility to navigate the complexities of FX markets.
Hedging decisions could be made within the broader portfolio context, considering correlations between asset classes and currencies. For family offices, currency exposure is a key factor that affects both risk and return, and hedging may mitigate or amplify risks depending on the base currency and asset mix.
Our high-level framework for currency positioning
| Standard Approach | Higher Governance Approach | ||
| Hedge Fixed Income and ‘Absolute Return’ investments | These assets aim for excess returns over cash, but unintended FX exposure can dominate risk. | 100% FX hedge ratio applied to all individual holdings or fund share classes where FX is not part of the investment case. | 100% FX hedge ratio applied to all individual holdings or fund share classes where FX is not part of the investment case. |
| Partial hedging of DM Equity FX exposure | Non-USD investors often leave some DM equity FX risk unhedged for downside mitigation but must manage long-term home currency short exposure. Private Markets FX may be impractical to hedge, warranting higher hedging in liquid equities. | Hedge around half of all DM FX denominated equities. | Adjust the hedge ratio based on base currency risk, portfolio equity beta, volatility vs. structural priorities, and individual currency risks. |
| Leave EM FX unhedged | EM FX exposure can be part of the investment thesis, especially in Local Currency EM Debt, where it promotes risk and returns. Hedging is costlier than for DM FX. | DM-based investors shouldn't hedge EM Equity or Local Currency EM Debt. EM-based investors should seek currency-specific advice. | DM-based investors shouldn't hedge EM Equity or Local Currency EM Debt. EM-based investors should seek currency-specific advice. |
| Valuation Based Adjustments | Strategic FX positions can be adjusted based on long-term valuations. | No valuation-based adjustments | Periodic review and adjustment of target hedge ratios to consider currency valuations and relative yields over a strategic time horizon |
| Dynamic FX positions | DAA positions may reflect FX views or unhedged asset class decisions, and should follow a robust, risk-managed framework. | Dynamic views should not be implemented where there is no wider DAA process in place | FX positions should be implemented as part of the overall DAA process and in the context of other DAA positions and opportunities |
Key takeaways for managing currency exposure
- Fund selection: Choosing between domestic currency-based, hedged, and unhedged asset classes, funds or share classes to seek to achieve the desired currency exposure.
- Currency overlay strategies: Holding a mix of domestic and unhedged foreign currency assets while implementing an overlay at the total portfolio level to seek to achieve target currency exposures.
- A hybrid approach: Combining elements of both fund selection and overlay strategies for greater flexibility.
While an overlay approach may provide more precise control over individual currency positions and facilitates integration of DAA views it may only be practical to implement this for larger portfolios or where suitable governance arrangements are in place.
Global Head of Portfolio Construction