Over the years, we've observed some widely held misconceptions about currencies’ role in global equity investing.
When buying a foreign stock, investors not only get exposure to that company’s fundamentals but also to a currency. The currency exposure is there, whether it’s intended or not and regardless of whether an investor has analyzed the currency valuation or not. After all, the security has to be denominated in something.
As global equity investors, we see currencies as just another asset that could be under-, over-, or fairly valued depending on the respective country’s business cycle and underlying fundamentals—just like a global bond investor does. Over the years, we have observed some widely held misconceptions about currencies’ role in global equity investing. Let’s dispel the top five myths that we’ve come across:
Myth 1: Currency risk can be eliminated by hedging everything into the dollar.
We find it odd that putting an entire global portfolio into one currency could ever be considered a way of mitigating risk. This myopic view of currencies reminds us of the pre-Galileo perception that all heavenly bodies move around the earth. To us, the dollar is just another currency, moving relative to other currencies. In 2016 it went up. In 2017, it went back down. This year, we’re finally starting to see the dispersion in dollar valuations take place, where it’s not unilaterally strong or weak against other currencies.
Myth 2: Currency exposure is in the country where the stock trades.
That’s not true, although this is how currency exposure shows up in an attribution analysis. It goes much deeper than where the stock trades; currency exposure is ultimately that of the underlying business. For example, a domestic U.K. homebuilder is fully exposed to the pound while a global pharmaceutical company that happens to be headquartered in the U.K. is not. Conversely, a Japanese exporter has precisely the opposite currency economics as a Japanese domestic company.
Myth 3: American depository receipts (ADRs) don’t have currency risk.
An ADR is simply another form of ownership of common shares. Though they appear denominated in dollars, whatever currency exposure exists in the underlying ordinary shares is still there. Currency moves will show up as part of the stock return so exposure is less noticeable, but unless the currency was hedged out, where else could it have gone?
Myth 4: Hedging is free.
Investing in developed markets may appear that way, but hedging a currency requires the payment or collection of the interest rate differential between two countries. For emerging markets currencies, that can be a meaningful number. We think about that cost of hedging as an implicit part of the total return of investing in such countries. What appears to be stock appreciation shouldn’t count until that implicit currency yield has been earned. If an equity manager is investing in countries with inflation and doesn’t understand the cost of hedging, it’s likely the anticipated success of stock picking in these places will be overestimated.
Myth 5: Equity managers can’t add value in currencies.
That’s an easy way to justify why an equity investor doesn’t have currency capabilities. The principle goes back to what we mentioned in the introduction: global equity managers can use currencies as a source of alpha by treating them as another asset that requires fundamental analysis. Understanding currency exposure should be an explicit part of managing a global equity strategy so investors understand the risks and opportunities currencies introduce and how they influence the underlying company business.
An American Depositary Receipt (ADR) is a negotiable certificate issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas.
Alpha is a measure of portfolio performance vs. a benchmark, relative to the volatility of that benchmark. An alpha greater than zero suggests that the portfolio has outperformed during the period by means other than adding volatility.