First Quarter 2016

CALLAN
INVESTMENTS
INSTITUTE

Considering Currency Hedging in

an Equity Portfolio

10 Charts to Help Frame a Policy

Are you considering currency management?

These 10 charts will help frame the issue
Weve recently heard a lot of institutional investors talking about their funds currency exposure. From Callans viewpoint, this is a
natural conversation given where we are in the currency cycle and the negative impact currency exposure is having on a lot of equity
portfolios. Further, this particular cycle is hitting at a time when many institutional portfolios have more non-U.S. dollar exposure than
ever, making the event particularly painful. However painful, we feel its important to remind investors to consider the context of the
issue, and to rely upon a documented currency policy to guide decisions in times like the present.
In the following 10 charts we offer such context for this discussion. These graphical representations of relevant data over time help to
frame the issues equity investors face around currency, including asset allocation, currency returns, risks, and correlations. Callan
recommends a measured approach to managing currency, including creating a documented currency policy for the investment fund to
ensure short-term decisions made during painful times are in line with long-term strategic goals of the plan.
If you dont have a documented policy on whether or not to hedge currency exposures in various asset classes, Callan
recommends you establish one. We believe its paramount to separate policy from implementation. Currency hedging can impact
the total fund or be targeted at individual asset classes. A brief look at hedging ratio options, ways to manage currency, and current
events will leave you with a better understanding of the issues at play around currency hedging, and feel more confident in following a
disciplined approach to currency management that is in line with your funds long-term goals and risk profile.
See the Appendix for issues to consider in establishing a currency policy. Contact your Callan consultant or the authors with further
questions: institute@callan.com
Knowledge. Experience. Integrity.

Currency First Quarter 2016

1. Institutional investors have more non-U.S. exposures than ever

Investments that have performed poorly due to currency hurt more than ever
Average Corporate Fund Asset Allocation

Real Estate

Average Public Fund Asset Allocation

Other Alternatives

80%

Asset
classes with
no currency
exposure

83%

Hedge Funds
U.S. Balanced
U.S. Fixed

97%

97%

Cash

U.S. Equity
Global Balanced

20%

Asset
classes with
currency
exposure

17%

3%

3%
1990

2015

1990

2015

Non-U.S. Equity
Global Equity
Non-U.S. Fixed

Over 25 years, we note a substantial increase in exposure to non-U.S. equity and fixed income investments for corporate (3% to
20%) and public funds (3% to 17%). Non-U.S. equity is typically a fund sponsors largest non-U.S. dollar-denominated exposure.
The higher the currency exposure in the plan, the more it potentially contributes to volatility.
While non-U.S. equity allocations have risen materially since 1990 (2% to 13% for corporate plans, 2% to 9% for public
plans), currency obtained through real estate and private equity have also ramped up. However, exposure is much harder to
quantify in these privately traded asset classes.
Sources: Callans Corporate and Public Fund Sponsor Databases.

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Currency First Quarter 2016

2. Negative currency returns in past 2 years = concerned investors

Cumulative Returns for 15 Years ended March 31, 2016

100.0
80.2 - Switzerland

Cumulative Returns

75.0

57.6 - Australia
28.9 - Europe
28.0 - China
21.7 - Canada
11.5 - Japan
2.0 - Taiwan
1.1 - UK

50.0
25.0
0.0
-25.0

-29.6 - India
-38.9 - Brazil
-44.6 - Mexico
-56.9 - Russia

-50.0
-75.0
2001 2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

20152016

Looking at the last 15 years, we note a large dispersion in currency returns.

From 2013 to present, currency returns have been mostly negative relative to the U.S. dollar.
Sources: Callan, MSCI. European return series is the Deutsche mark through December 1998 and the euro thereafter.

Knowledge. Experience. Integrity.

Currency First Quarter 2016

3. Historical currency movements put the current pain in perspective

U.S. Dollar Index: January 1973 April 2016
160.0000

Last price
High on 03.01.1985
Average
Low on 08.01.2011

140.0000
120.0000

89.891
143.906
94.411
69.025

100.0000
80.0000
60.0000
40.0000

20.0000
0.0000
1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015

The U.S. Dollar Index measures the value of the dollar relative to a basket of foreign currencies of significant trading partners
We observe a general downward trend (USD weakness) with periodic spikes to the positive (USD strength)
Source: Federal Reserve

Knowledge. Experience. Integrity.

Currency First Quarter 2016

4. Currency returns can hugely affect total return for USD investors
Impact on MSCI EAFE Returns: 1971 2015
75

Currency added 28% in 1985,

boosting an already positive year

Currency detracted 16% in

2005, dampening overall
positive returns

50

Currency
Return
MSCI EAFE
(hdg)*

25
0
-25
-50
1975

Through 2015

1980

1985

1-Year

MSCI EAFE (hedged)*

1990

3-Year

1995

5-Year

2000

10-Year

2005

2010

20-Year

2015

40-Year*

5.0

12.1

7.8

3.8

5.6

8.2

Currency Return

-5.8

-7.1

-4.2

-0.8

-1.2

1.1

MSCI EAFE

-0.8

5.0

3.6

3.0

4.4

9.3

Sometimes currency effect is positive, other times not

Sometimes currency moves with equity returns, other times against
*EAFE local until 4Q1987, EAFE hedged thereafter.
Sources: Callan, MSCI.

Knowledge. Experience. Integrity.

Currency First Quarter 2016

5. Does currency hedging reduce equity volatility?

Sometimes.
Rolling 5-year Standard Deviation for 35 Years ended March 31, 2016
30.0

Standard Deviation

25.0

20.0

18.7 - MSCI EAFE Average

17.0 - MSCI EAFE (hdg)* Average

15.0

14.8 - MSCI EAFE

13.8 - MSCI EAFE (hdg)*

10.0

81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
16

5.0

Currency is not always additive to volatility (periods of low correlation to underlying equities).
In recent rolling five-year periods, currencies have added to volatility.
*EAFE local until 4Q1987, EAFE hedged thereafter.
Sources: Callan, MSCI

Knowledge. Experience. Integrity.

Currency First Quarter 2016

6. Currency correlations to non-U.S. equity vary over time

Rolling 5-year Currency Correlation Relative To MSCI EAFE Local Currency for 25 Years ended March 31, 2016
1.00
0.75

Correlation

0.50
0.25

0.2 - U.K.
0.1 - Euro*

0.00
-0.25
-0.50

-0.6 - Japan

-0.75
-1.00
91 92

93 94

95 96 97

98 99

00 01 02

03 04

05 06 07

08 09

10

11

12 13 14

15 16

Currencys contribution to EAFE (unhedged) volatility has risen in recent periods due to the higher correlation of sterling and euro to
EAFE equities (MSCI EAFE local currency).
The yen continues to provide diversification (low correlation to EAFE equities).
*European return series is the Deutsche mark through December 1998 and the euro thereafter.
Sources: Callan, MSCI.

Knowledge. Experience. Integrity.

Currency First Quarter 2016

7. Currency correlations to U.S. equity vary over time, too

Rolling 5-year Correlation Relative To S&P 500 for 35 Years ended March 31, 2016
1.0

0.81 - MSCI EAFE (hdg)*

0.81 - MSCI EAFE
0.76 - MSCI EAFE (hdg)* Average
0.73 - MSCI EAFE Average

0.8

Correlation

0.6
0.4
0.2
0.0
-0.2

81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
16

-0.4

EAFE (hedged) and EAFE (unhedged) have similar correlations to the S&P 500 Index.
Hedging does not seem to significantly change the diversification effect of non-U.S. equity.
Currency exposure (as seen through EAFE unhedged) adds marginal diversification relative to the S&P 500 Index.
*EAFE local until 4Q1987, EAFE hedged thereafter.
Sources: Callan, MSCI

Knowledge. Experience. Integrity.

Currency First Quarter 2016

8. In non-U.S. fixed income, does hedging reduce volatility?

All the time.
Rolling 5-year standard deviation for 25 Years ended March 31, 2016
17.5

Standard Deviation

15.0
12.5
10.0

10.0 - Citi Non-US WGBI Average

7.5

7.2 - Citi Non-US WGBI

5.0
3.5 - Citi Non-US WGBI (hdg) Average
3.1 - Citi Non-US WGBI (hdg)
3.0 - Barclays Aggregate

2.5
0.0
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 1516

Unlike non-U.S. equities, hedging non-U.S. fixed income materially reduces volatility.
Decisions on whether to hedge non-U.S. fixed income must consider the unique characteristics and implementation of the asset
class.
Sources: Callan, Barclays, Citi

Knowledge. Experience. Integrity.

Currency First Quarter 2016

9. Currency: To Hedge or Not To Hedge?

Rolling 5-year Returns Relative to MSCI EAFE for 35 Years ended March 31, 2016
10.0
7.5

Currency detracts

Relative Returns

5.0
3.8 - MSCI EAFE (hdg)*
2.5
0.0

-1.1 - MSCI EAFE (hdg)* Average

-2.5
-5.0

Currency is additive

-7.5
-10.0

81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
16

-12.5

Currency returns have been cyclical.

The last period of sustained dollar strength was in the late 1990s.
Where does the market go from here?
*EAFE local until 4Q1987, EAFE hedged thereafter.
Sources: Callan, MSCI

Knowledge. Experience. Integrity.

Currency First Quarter 2016

10

10. Currency impacts U.S. equity returns too

S&P 500 Earnings Percent from each region
Earnings of companies in the
S&P 500 have exposure to
foreign currency.

Quarter ended March 31, 2016

80.0%

Investors can categorize stocks

by country of domicile
Or by country of economic
exposure.
This chart shows economic
exposure of the S&P 500 Index.
Whether you realize it or not, all
equity investors have exposure
to foreign currency.

64.2
60.0%

40.0%

20.0%

17.4
12.7
4.1

1.7
0.0%
Europe

Emerging Markets

North America

Pacific Rim

Frontier Markets

Source: MSCI
Knowledge. Experience. Integrity.

Currency First Quarter 2016

11

CALLAN
INVESTMENTS
INSTITUTE

Appendix

Currency Policy Issues to Consider

and Bonus Charts

Issues to Consider in Establishing a Currency Policy

The currency policy should incorporate the investors:

Time horizon
View on the role of currency in the total fund and individual asset classes
Risk posture
The currency policy should represent a long-term view
The desired currency exposure will be expressed as a hedge ratio
It can be at the total fund level, the asset class level, or both
Hedge ratios generally range between 0% (fully unhedged) or 100% (fully hedged)
The currency policy should also incorporate a statement of the method of implementation
Statement of strategic objectives: risk reducing and/or return enhancing
Active or passive
Internal or external

Knowledge. Experience. Integrity.

Currency First Quarter 2016

13

Callan Periodic Table of Investment Returns: Currency

Annual Returns
2006

2007

2008

2009

2010

2011

2012

2013

2014

UK

Brazil

Japan

Brazil

Japan

Japan

Mexico

Europe

India

2015
Japan

14.00%

19.94%

23.24%

33.78%

14.78%

5.41%

7.46%

4.52%

-2.01%

-0.33%

Europe

Canada

China

Australia

Australia

China

Russia

Switzerland

China

Switzerland

11.79%

17.91%

7.05%

28.99%

13.98%

4.70%

5.16%

2.92%

-2.42%

-0.73%

Brazil

India

Switzerland

Canada

Switzerland

Australia

UK

China

Taiwan

Taiwan

9.39%

12.29%

6.37%

17.76%

10.91%

0.01%

4.59%

2.91%

-5.69%

-3.79%

Russia

Australia

Taiwan

UK

Taiwan

Switzerland

Taiwan

UK

UK

China

9.18%

11.40%

-1.17%

12.32%

9.70%

-0.32%

4.27%

1.89%

-5.86%

-4.46%

Switzerland

Europe

Europe

Mexico

Mexico

UK

Canada

Mexico

Canada

India

7.97%

10.87%

-4.92%

6.07%

5.85%

-0.74%

2.26%

-0.85%

-8.27%

-4.59%

Australia

Switzerland

India

India

Canada

Canada

Switzerland

Taiwan

Australia

UK

7.45%

7.82%

-19.10%

4.70%

5.50%

-2.42%

2.16%

-2.57%

-8.53%

-5.47%

China

Russia

Russia

Europe

Brazil

Europe

Europe

Canada

Switzerland

Europe

3.40%

7.28%

-19.64%

3.22%

5.01%

-3.24%

1.56%

-6.29%

-10.50%

-10.23%

India

China

Canada

Switzerland

India

Taiwan

Australia

Russia

Mexico

Australia

1.69%

6.86%

-20.05%

2.96%

4.07%

-3.71%

1.27%

-7.04%

-11.14%

-11.10%

Taiwan

Japan

Australia

Taiwan

China

Russia

China

India

Brazil

Mexico

0.79%

6.66%

-20.60%

2.60%

3.60%

-4.97%

1.02%

-11.42%

-11.25%

-14.66%

Canada

UK

Mexico

Russia

Russia

Brazil

India

Brazil

Europe

Canada

0.38%

1.71%

-21.19%

0.73%

-0.70%

-11.00%

-3.08%

-13.21%

-12.18%

-16.62%

Japan

Taiwan

Brazil

China

UK

Mexico

Brazil

Australia

Japan

Russia

-0.94%

0.46%

-23.67%

-0.06%

-3.05%

-11.62%

-8.90%

-13.83%

-12.34%

-17.85%

Mexico

Mexico

UK

Japan

Europe

India

Japan

Japan

Russia

Brazil

-1.75%

-0.80%

-27.77%

-2.63%

-6.50%

-15.80%

-11.02%

-17.73%

-45.23%

-32.81%

Sources: Callan, MSCI

Knowledge. Experience. Integrity.

Currency First Quarter 2016

14

Non-U.S. Currency Correlation Table

Periods ended March 31, 2016
Correlation for 5 Years ended March 31, 2016
Correlation for 10 Years ended March 31, 2016
Australia

1.00

0.86

0.75

0.15

0.65

0.54

0.12

0.66

0.60

0.54

0.66

0.65

Brazil

0.85

1.00

0.79

0.25

0.60

0.51

-0.01

0.70

0.63

0.45

0.61

0.62

Canada

0.75

0.82

1.00

0.17

0.52

0.43

-0.03

0.64

0.63

0.32

0.51

0.62

China

-0.07

0.11

0.29

1.00

0.28

-0.01

0.15

0.19

0.39

0.39

0.46

0.11

Europe (EEC)

0.45

0.63

0.68

0.04

1.00

0.38

0.24

0.37

0.53

0.78

0.53

0.57

India

0.36

0.41

0.22

-0.20

0.24

1.00

0.00

0.61

0.44

0.39

0.41

0.35

Japan

0.31

0.07

0.23

-0.15

0.05

-0.08

1.00

-0.34

0.13

0.49

0.26

-0.19

Mexico

0.65

0.68

0.60

0.11

0.47

0.69

-0.17

1.00

0.70

0.27

0.55

0.59

Russia

0.54

0.55

0.60

0.39

0.48

0.34

0.21

0.69

1.00

0.56

0.67

0.53

Switzerland

0.48

0.58

0.53

0.19

0.67

0.41

0.11

0.55

0.69

1.00

0.77

0.35

Taiwan

0.61

0.67

0.71

0.37

0.44

0.33

0.06

0.67

0.78

0.76

1.00

0.44

UK

0.37

0.43

0.56

0.17

0.69

0.13

0.11

0.32

0.50

0.60

0.57

1.00

Australia

Brazil

Canada

China

Europe
(EEC)

India

Japan

Mexico

Sources: Callan, MSCI

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Russia Switzerland Taiwan

UK

Currency First Quarter 2016

15

About the Authors

Janet Becker-Wold, CFA, is a Senior Vice President and the Manager of Callan's Denver Fund
Sponsor Consulting office. Janet joined the investment management business in 1991. Her experience
at Callan includes all facets of investment consulting including investment policy analysis, asset and
liability studies, as well as manager search and structure. She has a particular expertise in international
investing and currency management. Her clients include corporate, public, and non-U.S. based funds.
Janet is a member of Callan's Management, Manager Search, and Defined Contribution Committees,
and is a shareholder of the firm.
Janet received an MBA in Finance from the University of Colorado and a BS in Biology from the
University of Texas. She earned the right to use the Chartered Financial Analyst designation.

Andy T. Iseri, CFA, is a Senior Vice President and a non-U.S. investment consultant in Callan's Global
Manager Research group. He is responsible for research and analysis in the non-U.S. and global asset
class including developed and emerging equities, issues surrounding currency management, as well as
matters related to ESG investing. He oversees manager searches, conducts on-site visits, and attends
finalist interviews. Andy is a shareholder of the firm.
Andy earned a BS in Business Administration - International Business at California State University,
Sacramento. He belongs to CFA Institute, CFA Society of Sacramento, and earned the right to use the
Chartered Financial Analyst designation.

Knowledge. Experience. Integrity.

Currency First Quarter 2016

16

Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which
Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be
construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should
consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or
entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance
is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not
statements of fact.
The Callan Investments Institute (the Institute) is, and will be, the sole owner and copyright holder of all material prepared or developed by the
Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites
any part of any material prepared or developed by the Institute, without the Institutes permission. Institute clients only have the right to utilize such
material internally in their business.
2016 Callan

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Currency First Quarter 2016

17

About Callan
Callan was founded as an employee-owned investment consulting firm in 1973. Ever since, we have empowered institutional clients with creative,
customized investment solutions that are uniquely backed by proprietary research, exclusive data, ongoing education, and decision support. Today,
Callan advises on $2 trillion in total assets, which makes us among the largest independently owned investment consulting firms in the U.S. We use a
client-focused consulting model to serve public and private pension plan sponsors, endowments, foundations, operating funds, smaller investment
consulting firms, investment managers, and financial intermediaries. For more information, please visit www.callan.com.
About the Callan Investments Institute
The Callan Investments Institute, established in 1980, is a source of continuing education for those in the institutional investment community. The
Institute conducts conferences and workshops, and provides published research, surveys, and newsletters. The Institute strives to present the most
timely and relevant research and education available so our clients and our associates stay abreast of important trends in the investments industry.
If you have any questions or comments, please email institute@callan.com.

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