You probably know what a Big Mac looks like…two beef patties and Big Mac sauce, topped off with pickles, crisp shredded lettuce, finely chopped onion and American cheese, all sandwiched between a sesame seed bun…but did you know the Big Mac has a lot to say about currency exchange rates?
The Economist created the Big Mac Index, which tracks the cost of McDonald's Big Macs across the world, in 1986 as a fun way of exploring rudimentary exchange rate theory. Purchasing-power parity theory suggests that exchange rates between countries should move to levels where identical goods (in this case a burger) and services cost the same. According to the theory, the costs of Big Macs across the world should be roughly equivalent, but they aren’t.
A Big Mac costs £3.39 in Britain and $5.71 in the United States, implying an exchange rate of $1.68 : £1. The difference between this and the actual exchange rate, $1.26 : £1, suggests the US dollar is around 33% overvalued.
This begs the question – if a Big Mac costs more in Switzerland than South Africa, does this tell us something about the differences between Big Macs in those two countries, or does it tell us something more useful about the relative value of the two underlying currencies? In general, it is possible to attempt to analyse the many key drivers of currency moves, and a whole industry of currency speculators and commentators has grown up around this over the decades. However, when all’s said and done, few can claim to have a long and reliable track record in predicting exchange rate moves. We believe it is difficult to have a high conviction view on the relative value of currencies. As a result, for our clients, we generally don’t advise trying to make extra returns by taking views on currency, and instead help them to focus on using currency hedging as a risk management tool.
Should I hedge my currency exposure?
Ever since the tools to hedge currency risk became readily available to UK investors, the question of whether to hedge this risk or not has been hotly debated. Some will argue for hedging very little of your currency risk as an exposure to a basket of currencies is expected to provide some diversification benefits. On the flip side, many argue for high hedge ratios in certain asset classes on the basis that they do not want to experience large changes in their portfolio valuation due to changes in exchange rates.
There is empirical analysis that suggests having some currency risk in your portfolio can help reduce the volatility of the portfolio (in £ terms) in the long-term. In practice, the difference between no hedging and full hedging is not that marked for riskier asset classes, albeit there is a sweet spot that lowers the volatility a little, when around 30% to 60% of overseas currency exposure is hedged for equities.
For less volatile asset classes, like investment grade bonds, the analysis shows a higher currency hedge ratio does reduce the overall volatility of total returns. However, liability-based investors (like DB pension schemes) are more concerned with changes in credit spreads rather than absolute returns. If I remade the chart for a liability based investor, the analysis would show a lower currency hedge ratio reduces the overall volatility of returns due to changes in credit spreads.
Volatility reduction due to currency hedging
Source: Bloomberg. Chart based on the FTSE All World Series All World Ex-UK Total Return Index for overseas equities, ICE BofA Global High Yield Index for global high yield bonds and Barclays Global Aggregate Corporate Total Return Index for global investment grade corporate bonds over the 15 years to 30 June 2020.
Downside protection in stressed markets
Looking at reducing volatility is one way to consider currency hedging. An alternative risk management approach is to consider using currency exposure to provide downside protection. That is, have an allocation to unhedged overseas currencies as a strategy to lessen the impact of a market downturn on your portfolio. For example, in Q1 2020 investing in US bonds on an unhedged basis will have led to a smoother path due to movements in the US dollar to Sterling exchange rate over the period.
Impact of currency hedging on US bond returns
Source: Bloomberg. Unhedged US bonds is the Bloomberg Barclays US Corporate Total Return Unhedged GBP and hedged US bonds is the Bloomberg Barclays US Corporate Total Return Unhedged USD. Results are based on a Sterling investor.
Generally, safe-haven currencies such as the US dollar appreciate versus Sterling in stressed market conditions, so investing on a currency unhedged basis can improve performance. If we look back through history, we can see this relationship has played out multiple times.
Impact of currency hedging in stressed markets
Source: Bloomberg. Overseas equities is the FTSE All World Series All World Ex-UK Total Return Index and global corporate bonds is the Barclays Global Aggregate Corporate Total Return Index. Periods shown for each set of bars are: Financial crisis (30/09/2008 – 31/12/2008), Eurozone crisis (15/03/2012 – 04/06/2012), Taper tantrum (22/05/2013 – 24/06/2013) and COVID-19 (01/01/2020 – 31/03/2020). Results are based on a Sterling investor. If your home currency is a safe-haven currency, the results will be very different!
However, this is not a perfect relationship, as shown during the Taper tantrum. In fact, if this link breaks down in future, leaving your overseas currency exposure unhedged can lead to a worse outcome for your portfolio.
If you want to give your portfolio greater downside protection, it is important to move away from thinking about currency hedging in terms of equities only. We believe clients should separate the strategic decision (how much currency risk do I want) from the implementation decision (where do I get this exposure).
For example, the decision to have a 20% exposure to overseas currencies at the portfolio level is separate from the decision of where in your portfolio you gain that exposure (equities, corporate bonds, government bonds, etc). This leads to a more holistic view of the impact of currency hedging on the portfolio and allows you to focus your currency hedging in the asset classes where it is most cost effective to do so.
In practice this might mean:
- You consider holding a greater proportion of equities on an unhedged basis to achieve a better overall portfolio level currency hedge ratio.
- If you have little or no overseas equity exposure, you consider other ways of getting currency exposure. For example, unhedged share classes of funds in other asset classes or a derivatives programme with a specialist manager.
There are several risks in the near term that may have a significant impact on markets, for example, a second wave of Covid-19, Brexit and the US election. Given this, we believe now is therefore a sensible time to review your portfolio to ensure it is as robust as possible to a market downturn.
Overall, we believe it is reasonable to target a currency hedge ratio at the low end, eg 40% for a riskier portfolio, as this reduces the volatility of the portfolio in the long-term and provides additional protection when you need it most in a stressed market environment. However, the “right” currency hedge ratio will be heavily dependent on your specific circumstances.
In terms of implementation, currency hedge ratios should be set a portfolio level, rather than on an asset class by asset class basis. This leads to a more holistic view of the impact of currency hedging on the portfolio and allows you to focus your currency hedging in the asset classes where it is most cost effective to do so.
So, what can a Big Mac tell you about currency hedging? In my view, not too much unfortunately! The real world is messy and in reality, the costs of Big Mac production are not identical across borders, which is one of many reasons why the world isn’t like the theory.