How to eliminate the exchange rate risk

Last year saw a great deal of turbulence on the currency markets. What can be done to hedge against this?
Investing in foreign securities inevitably means taking on certain currency risks. Such risks can generally be hedged by entering into counterbalancing transactions, such as forward exchange transactions, for example. However, this requires in-depth knowledge on the part of the investor. In addition, private investors don’t receive the same attractive conditions as professional investors. If you want to avoid currency risks altogether, your best option is an investment fund that does the hedging for you. For example, we have hedged currency risks to a large extent in the UBS Strategy Funds.

How much does it cost to eliminate the exchange rate risk in the case of funds?
Two types of costs arise when we hedge the exchange rate risk: transaction costs, i.e. the difference between the buying and selling rates in a forward transaction, and the interest rate differential. The transaction costs are of little consequence as the foreign exchange markets are both very efficient and highly liquid. The gap in interest rates between currencies can be a matter of some percent. If the euro interest rate is -0.1 percent and the Swiss franc interest rate is -0.9 percent that leaves us with a difference between the two of 0.8 percentage points, which is equivalent to the hedging costs. Therefore, the expected returns on euro investments should be correspondingly higher to compensate for this foreign currency effect. Whichever way you look at it, foreign investments improve portfolio diversification. Global investors receive better compensation for risks in the long-term – in the form of returns.

What’s the bottom line where currency hedging is concerned?
At the start of 2014, we decided to largely hedge our foreign currency risks in our Strategy Funds. A move that has since paid off, especially when compared with our peers. Let’s not forget that the National Bank scrapped the minimum exchange rate for the Swiss franc against the euro last January. While those invested solely in Swiss equities at the time may not have suffered any currency losses, they nevertheless saw a good 15 percent wiped off the value of their securities in a single day. Those holding a portfolio made up of 50% Swiss equities and 50% European equities fared considerably better – provided the currency risk was hedged – as European equities were not affected by the slump on the Swiss stock market. Both the euro and the dollar have lost ground this year, as a result of which our investors derived tangible benefits from our considerable hedging of the currency risk. It is equally clear that they would not participate in any rise in prices if the euro and the dollar were to shoot up unexpectedly.

Do you intend to keep on eliminating the currency risk completely?
We assess the markets regularly – and make adjustments if necessary. In the case of our funds, we are even able to favor certain currencies by increasing their tactical weighting slightly. However, we still consider currency hedging to be the smarter option.

Marc Both has worked in Asset Management at UBS since 2007 and is head of the team that manages the UBS Strategy Funds.