One of the great benefits of managing one’s own active portfolio is the freedom to reduce the portfolio’s market exposure as local or global market conditions deteriorate. The simplest way to do so is to move to cash by selling holdings (e.g. starting with those with the highest global macro scores / lowest recession scores) and run a higher cash balance. The case for hedging currencies is however both more complex and less compelling.

Portfolio protection

Beating the index by 15% may feel good but if the market just lost 30% of its value, the resulting 15% loss of your portfolio is certain to dampen your mood regardless. Keeping a portfolio of above-average recession score will most likely mitigate the extent of your loss in case of market sell-offs, but it will not prevent it. There are basically three ways to prevent the significant losses that come from a stock market crash. There are, in increasing order of complexity:

Move to cash (preferably in a strong currency such as USD or CHF)

This is a simple but effective way of protecting one’s capital, and the only drawbacks are timing-related: higher transaction costs to exit/re-enter the market (including wider bid-ask spreads if the selling occurs in periods of poor market liquidity) and/or tax implications

Neutralise (part of) the portfolio by selling market index futures (and/or buying an ETF short index such as ProShares’ Short MSCI Emerging Markets)

Index Futures contracts exist for all sorts of equity markets (from MSCI ACWI to the FTSE 100), although the e-Mini S&P 500 contract is the most easily tradable and a decent proxy for global stock markets (ex-Emerging Markets). The attractiveness of e-Minis comes from the limited amount of capital required to buy a contract (typically less than 5% of the contract value, so that an e-Mini contract, worth $50 x S&P Index or say $100,000, can be secured for less than $5,000). Assume your portfolio of US stocks is worth $200,000, and that you want to protect its value over the coming months. You decide to sell one e-Mini S&P500 futures contract which matures 6 months from now, thereby hedging 50% of the value of your portfolio for that period. If your portfolio and the market indeed drop 20% over the following months, your short S&P futures position will show a gain of $20,000, thereby offsetting 50% of your portfolio losses of $(40,000). You may close the futures contract position at any moment by buying one e-Mini contract that will offset your initial position, or letting it run to expiry (cash settlement), or you can also roll the position into a later maturity date if you choose to extend the duration of your hedge. The flipside of this approach is of course that you equally forego (half of) the upside if the market keeps rising.


Buy insurance in the form of index put options

Whereas futures offer downside protection at the expense of upside potential, with options, you pay a fee upfront for downside protection but retain all of the upside potential if markets keep rising. Index put options give the holder the right to sell the underlying index (e.g. the S&P 500) at a set “strike” price. The strategy consists of buying put options maturing, say 4 months from now, with a strike price significantly below the prevailing index level (at least 20%). In period of market calmness (ie. S&P Index volatility, aka VIX Index, around 15), these “out of the money” options can be bought very cheaply (say 0.1% of the value of the index), but their value can rise spectacularly (sometimes 20-30x) as market volatility rises and equity indices tumble. In the example below, we assumed that every 3 months, the investor buys 34 put option contracts maturing 4-months later. So long as the market keeps rising and volatility remains low, these options, costing $680 a quarter (or 1.4% of a $200,000 equity portfolio) become worthless as their maturity approaches. But when markets drop (in the below case by 15% over the first 2 months following the options purchase) and volatility spikes, the value of the options contract rises very significantly (30x in our example), thereby generating a $20,400 gain like that achieved with futures. However, none of the upside is foregone if markets keep rising. The obvious drawback of this approach lies in its “exoticism”. It requires that assumptions be set that can end up widely off (e.g. timing and conditions of exit, payback multiple realised), and purchase costs can rapidly feel prohibitive if market players are more fearful than you are.

MSCI ACWI Returns in Various Currencies

Currency hedging

There is no doubt that the year-over-year return of a global portfolio can be significantly affected by the investor’s choice of portfolio currency. Over the past 5 years, the annualised return of a global market index ETF held in EUR ended up delivering 2% extra return relative to one held in US$. Differences can be seen even over longer periods, with up to 1.5% annualised excess return for a portfolio held in $US relative to one held in $CA over the past 15 years. However, since there is no “edge” to be found in trying to forecast exchange rates, the question is not whether hedging currency exposure will improve returns but whether it will reduce risk. This in turn hinges on how correlated the returns of the portfolio holdings are to that of their currency of listing. If, as is often the case, a foreign holding’s returns are negatively correlated to its currency, then hedging the currency exposures will tend to increase rather than reduce risk. One of the reasons for this often-observed (albeit unstable) negative correlation comes from the fact that most large publicly traded firms (like those covered by butterwire) are exposed to a diversified basket of world currencies that they already actively manage themselves, either via financial instruments or by shifting their procurement and pricing accordingly, so their share prices will tend to adjust to changes in the value of their quoted currency. For instance, selling forward the CHF/EUR exposure corresponding to a Swiss holding that generates most of its revenue and cost outside of Switzerland is counter-productive: if CHF appreciates relative to the EUR (as observed during the last euro-debt crisis), the company’s prospective earnings and therefore its share price (both reported in CHF) will drop, but the natural offset from the higher CHF will be foregone as the currency hedge will show a loss at the worst possible time (i.e. during a bear market).

Concretely, the case for taking on the cost, complexity and uncertainty associated with conceiving and maintaining an appropriate hedge is most compelling when three conditions are met:

  • the portfolio is held in a strong currency (basically the USD, CHF, and JPY, perhaps also CNY in the not so distant future, but not other currencies such as CAD or AUD or GBP or even EUR)
  • a large portion of it is denominated in foreign (volatile) currencies (basically Emerging Markets currencies, and possibly EUR depending on own views on the future of the eurozone)
  • the investor fears a currency depreciation but wants or needs to remain invested in the country/region