Nutmeg provides globally diversified multi-asset portfolios across a choice of investment styles (check out “Our investment styles explained” for a guide to these). Underneath each style lies design-choices about risk level, suitability of asset universe at each risk-level in each investment style, UK bias for £-based investors and foreign currency exposure. We have written elsewhere about how Nutmeg manages UK home-bias. In this blog we’ll provide insight into how we determine benchmark currency exposure across the risk spectrum.
Chart 1 shows the estimated expected volatility of all our styles across ten risk levels; from 10% equity exposure in risk-level 1 (associated with around 2% annual volatility) to 100% equity in risk level-10 (associated with around 14% annual volatility). The chart also shows the split between UK and overseas equities, with risk-level 10 holding 80% of its equity allocation in overseas markets.
Hedge ratio of least regret
For a £-based investor, purchasing foreign equities naturally incurs currency risk. This exposure can be thought of as ‘leverage’; in the case of portfolio level 10, 80% of the portfolio is exposed to stock index returns, but 80% of the portfolio is also exposed to foreign currency changes. Together these add up to more than 100% of the portfolio’s value, illustrating there is implied leverage in holding foreign assets. Although this is ‘good leverage’ as it brings diversification effects as well as natural hedge effects¹, it must be managed within our overall suitability context².
To recognise and manage this risk, general industry practice is to hedge a certain amount of foreign equity exposure. A 0%-hedge (staying fully exposed) provides maximum portfolio diversification but also maximizes leverage to currency return volatility. A 100%-hedge (having no exposure) removes all such leverage risk but at a cost; a cost not only in terms of lost diversification benefits but at the additional cost of the hedging process.
Without any academic or industry-wide agreement on just what constitutes “the best equity hedge ratio”, many practitioners opt for 50% – often termed the ‘hedge ratio of least regret.’
Applying suitability filter rather than ‘regret’
The 50% “hedge ratio of least regret” is a mere academic middle-way, intended to allow symmetrical risk either side of a given benchmark. To be truthful, it’s a bit of an industry fudge, revealing the fact that – as in so many areas in finance – generations of researchers have not produced an agreed standard. Regardless of this, Nutmeg does not agree the symmetrical ‘least-regret philosophy’ should apply evenly across the full spectrum of portfolio risk. Lower-risk portfolios should hedge more rather than less, given that the extra leverage of lower currency hedges adds to volatility. Meanwhile, higher-risk portfolios would be more likely to take hedges off than put extra hedges on, since they have a natural need of the extra currency diversification.
Chart 2 demonstrates Nutmeg’s approach, with the orange line representing the percentage of portfolio volatility explained by overseas equity – the so-called volatility contribution. The chart axes pivot around risk-level 3 and 50% equity hedge ratio as our portfolio at this risk-level is closest to a 50% volatility contribution from overseas equities. The blue line shows the “volatility-adjusted” hedge ratio is mapped to 50% at risk-level 3. From a suitability perspective, the equity hedge ratio at risk-level 1 is kept as close to 100% as possible. But for the remaining risk-levels, hedge ratios are adjusted inversely according to relative overseas-equity volatility-contributions. So, risk-level 10 has a 30% hedge ratio because its overseas equity volatility contribution is one-and-one-half times the volatility contribution of risk-level 3 (50%/1.5=30%, rounded to one decimal place).
Complicated? Perhaps. Suitable? Without doubt.
We appreciate this blog is more technical than many of our other blogs. However, all too-often, the currency exposure methodology in multi-asset portfolios remains hidden under the investment industry’s marketing-fog. Currency is critically important to multi-asset portfolio outcomes. And like everything else about investing, Nutmeg takes the adoption of currency risk very seriously. We monitor all types of risk daily, ensuring that the fully managed Nutmeg and SRI portfolios maintain suitable exposures to a diverse range of multi-asset return factors.
Natural hedge effects occur as follows. When a currency price depreciates, its equity index price appreciates due to i) perceived improved competitiveness or ii) valuation benefits from the perspective of overseas investors. These natural hedging effects provide good diversification benefits to the wider portfolio. In addition, currency volatility tends to be much lower than equity volatility, providing additional positive diversification benefit.
Nutmeg’s fixed allocation portfolios do not contain overseas fixed income assets. But if they did, these would need to be hedged 100% to avoid the associated leverage. Currency volatility tends to be higher than fixed income volatility.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.