Currency hedging better for fixed income
Fixed income investors can benefit more from currency hedging than equity investors, according to research from Dimensional.
The paper ‘To Hedge or Not to Hedge: A Framework for Currency Hedging Decisions in Global Equity & Fixed Income Portfolios’ looked at how currency hedging decisions depended on portfolio composition and investment goals.
“The return on foreign investments is determined by both the return of foreign assets and the return of currencies,” the report said.
“The results shed light on how currency hedging decisions depend on portfolio composition and investment goals.
“For a global portfolio with a high equity allocation, hedging currencies tends not to reduce return volatility by a significant amount.
“Consequently, currency hedging decisions informed by forward currency premiums can increase expected returns without substantially increasing portfolio volatility.”
However, the report found when the majority of the investments were in fixed income, currency hedging could be an effective way to reduce the volatility of the total portfolio.
“Therefore, completely hedging foreign exchange exposure may be appropriate for investors who prefer lower volatility from their global fixed income investments, while selectively hedged strategies can add value for those who are willing to accept more volatility in pursuit of higher expected returns,” the report said.
“Investors should think through these implications in order to make an informed currency hedging decision consistent with their investment preferences and goals.”
The report said there was little evidence to support the predictability of exchange rate movements using previous months’ currency returns or interest rates.
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