Taking the valuation of currencies into account when formulating a hedging strategy for global investments can help clients more effectively manage their foreign exchange exposure, according to State Street Global Advisors head of currency management Colin Crownover.
"For example, when we think the Australian dollar is cheap at around US$0.60, perhaps it makes sense to hedge more of your foreign currency exposure because you think that's going to go down versus the Australian dollar," Crownover said.
"And vice versa, when it is sitting at US$0.93 perhaps the opposite is true and it makes sense to hedge less of the currency exposures to participate in the two to three-year horizons where there is more likely to be foreign currency appreciation versus the Aussie," he said.
A common currency hedging strategy in portfolios is to hedge half of the exposure only and leave this amount of protection in place for the long term.
Crownover said these types of strategies have associated inefficiencies and may not be appropriate in the medium term when currencies may be significantly mispriced.
"We think a valuation approach helps manage currency risk more intelligently because it decreases your risk and, more importantly, the large drawdowns that occur from unmanaged currency exposure," Crownover said.
"It does add returns because valuation is a good long-term anchor for the currency markets," he said.
Crownover said the diversification benefits of a valuation-based approach were highlighted during the global financial crisis (GFC), when the value of most asset classes fell at the same time.
"It gives you something that diversifies the portfolio when you need it the most. During the financial crisis the diversification you thought you had in your portfolio disappeared quite rapidly as the correlation of risky assets headed to one. The exact opposite was true with valuation-based strategies, where the correlation headed to the extremely negative position during the GFC," he said.
