Currency can be something of a headache for investors in emerging market assets. It can dominate the variability of returns, but it can also be very costly to hedge out.
While the transactional costs of hedging are now negligible for developed markets, they remain high for emerging markets due to thinner liquidity and the difficulty in obtaining an arbitrage-free price.
In addition, the ‘carry cost’ of the hedge is also significant due to the large interest rate differential. This is because the forward rate at which the hedge is priced is based purely on the gap between interest rates in the emerging markets, where they tend to be structurally higher, and the developed markets, where they are near zero.
Rathbones’ behavioural equilibrium exchange rate framework, which looks at the long-term economic drivers of currencies, suggests that sterling is conspicuously undervalued against most Asian currencies – the Singapore dollar being a rare exception.
Investors therefore need to think carefully about their exposures and the implications of investing in emerging market debt (EMD).
By 2015, the investable universe of EMD had reached more than $17trn (£13.3trn), of which local currency debt accounted for 87 per cent. The foreign currency-denominated market – large US dollar, or what is often euphemistically referred to as hard currency EMD – is much smaller, at a mere $2.2trn.
Whether to invest in local or hard currency debt is a perennial dilemma for most asset allocators. So what are the return drivers to which sterling-based investors in EMD are buying exposure?
The JPMorgan GBI-EM Global Diversified index is composed of the local currency and sovereign universe accessible directly by international investors. Since its inception in 2003 the benchmark has increased around 250 per cent in sterling terms, transaction costs excluded.
In other words, if a sterling investor were to have tracked the index for the past 14 years, they would have generated an annualised return of 9.4 per cent. Roughly 80 per cent of this return would have come from coupon income, 16 per cent from price (the change in yields), but only 4 per cent from currency moves.
However, this fact masks a very important point. While exchange rates may not have contributed very much to the cumulative total return over the sample period, currency is the overriding source of the variability.
Another option for investors would be to hedge the foreign exchange exposure. Compared with the 250 per cent total return received by a sterling investor fully exposed to emerging market exchange rates, an investor in the currency-hedged share class would have earned just 104 per cent, nowhere near the total gain made by the index in its original local currencies.
The difference in returns mainly reflects the sizeable cost to hedge emerging market currencies, with only a marginal opportunity cost of not having the currency exposure to the region.
Hedging costs are so large that the decision to hedge is arguably a de facto big directional bet on emerging market currencies. Risk-adjusted returns would not have been improved by hedging, such was the extent to which lower volatility comes at the expense of return.
