Should you currency hedge your USD portfolio? (Part 1)

If you have the S&P 500 as part of your portfolio, should you hedge your USD exposure by regularly converting it to SGD? Doing this will remove the currency risk from your foreign (US) investment. But does it produce better returns?

The short answer is: No

This article compares between two portfolios:

  1. Unhedged - an investment in the S&P
  2. Hedged - an investment in the S&P, hedged monthly

The unhedged portfolio is one we all have to bear as the starting point, as the investment is in USD but we have to account for our wealth using SGD.

The hedged portfolio uses a simple method of hedging - hedge the exact amount of USD exposure based on month-end values. For example, if the month-end value is 2,200 we will simply sell 2,200 USDSGD. The result is the undhedged portfolio, plus any gains/losses from the currency hedge.

Results:

Chart 1b (below, middle) shows that the absolute dollar-value difference between the Hedged and the Unhedged portfolio is negligible. Chart 1c shows the cumulative outperformance of the Hedged vs the Unhedged portfolio, and shows no clear trend of outperformance.

Chart 1 - Absolute dollar-value comparisons

Chart 2 below compares the outperformance of the Hedged portfolio vs the Unhedged portfolio in their monthly returns, percentage terms.

Chart 2 - Monthly returns outperformance

The percentage outperformance shows no distinct bias, and its average is indeed near zero (0.02%). Together, the results from charts 1 and 2 suggest that outperformance is random and close to zero.

If the difference in the returns are negligible, what about the standard deviation of the returns? Perhaps the hedged portfolio can give us a more predictable monthly return?

Unhedged (SGD) Hedged (SGD)
Average monthly return 0.64% 0.66%
Standard deviation 4.17% 4.62%
Sharpe 0.155 0.144

Unfortunately, wWhile the hedged portfolio has marginally better monthly returns, the variance of the hedged returns are also higher, leader to a lower risk-adjusted return measure.

Thus, if we include transaction costs and effort/time spent for hedging, it is likely it will not be worthwhile to hedge.

 

Further comparisons:

Holding-period returns (HPR) might be better at representing real life, as investors typically don't hold the index for just a month. The below results are from using 12-month (1 year) and 60-month (5 years) HPRs.

1y HPR 5y HPR
Unhedged Hedged Unhedged Hedged
Average Return 8.85% 8.87% 53.54% 53.41%
Standard Deviation 17.27% 17.33% 66.70% 66.31%
Sharpe 0.51 0.51 0.80 0.81
Min Return -38.87% -41.38% -41.45% -42.99%
Max Return 62.54% 65.55% 265.44% 267.04%

By extending the holding period, the risk (standard deviation) and return measures become almost identical.

 

Finally, one more cost of hedging that we can consider is the interest rate differential between the USD and the SGD. This will be built into the currency forward rate which we must use (instead of the spot rate used in calculations above).

Historically, the USD has had higher interest rates than the SGD, and so initiating a hedge means that we needed to pay a premium for that hedge. Currently it is less than 1% p.a. but it is still a cost to be considered.

 

Thus, once we include the costs of hedging in terms of transaction costs and forward discounts sold away, the hedged portfolio will underperform the unhedged portfolio.

This further supports the case that the US portfolio does not need to be currency-hedged. 

Part 2 will look at the drivers of returns for the hedged and unhedged portfolio.

 

Data used:

  • End-of-month prices: 2018-Dec to 1981-Feb (455 months)
  • USDSGD prices from investing.com
  • S&P prices from Yahoo finance
  • LIBOR from FRED
  • SIBOR from CEIC