Last year, there were many large moves in currencies — not just in the US dollar but in the Japanese yen, the Australian dollar, and the British pound, among others. We expect that higher currency volatility will remain in place in 2023, spurred on by elevated levels of economic and asset price volatility, as well as divergence in countries’ policies, cycles, and inflation challenges. The impact of government intervention in currency markets also bears watching.

All of this suggests that currency risk within portfolios may be elevated relative to recent experience — perhaps even occasionally overwhelming the impact of fundamental views on companies. Volatility and dispersion could also create opportunities to generate alpha through active currency management. The bottom line is that it may be time for a fresh look at the impact of currency on portfolio construction.

Weighing different hedging approaches and their pros and cons

As a starting point, investors should be aware of the underlying currency exposures within their equity and fixed income allocations. Those insights will help sharpen the focus on specific currency approaches, which include:

• Structural approaches — Fully hedge all currency exposure regardless of the market outlook or leave all currency exposure fully unhedged.
• Asset-class-based approaches — Make specific currency-hedging decisions for each underlying asset class in a portfolio. 
• Optimal hedge-ratio approach — Hedge a percentage of the currency exposure to minimize portfolio volatility.
• Risk-premia harvesting — Leave all positive-carry currency exposure (e.g., those currencies from countries with higher interest rates than the home country) unhedged.
• Active management — Make currency exposure an active decision based on the outlook for the respective currency.

Of course, each approach brings with it certain trade-offs. Figure 1 illustrates the different levels of both operational and investment complexity involved in various currency-hedging strategies: 

Operational complexity — Currency hedging introduces operational complexity, not just at initiation but also to maintain hedges through currency forward rolls. This is highest for hedging processes that require constant change, including active management and premia harvesting. 

Investment complexity — Currency hedging can have a range of effects on investment complexity. Fully hedging currency effectively eliminates the impact of currency variations on portfolio returns. A fully unhedged approach exposes the portfolio to the impacts of currency movement, which can be either diversifying or volatility enhancing depending on the nature of each investor’s home currency and underlying portfolio currency exposures. Active currency management involves higher levels of complexity. Asset-class hedging can be a middle ground. For example, some investors prefer to hedge fixed income currency exposures given the larger proportional impact of currency volatility on fixed income relative to equity portfolios. 

Figure 1

Take a deeper dive on market volatility and asset allocation 

Currency markets aren’t the only area where volatility is elevated. Our 2023 Outlook offers a wide range of views from our iStrat Team on economic and market conditions and the asset allocation implications, including inflation hedging, downside mitigation, and factor-based insights for volatile, sometimes directionless markets.