What caught my eye this week.
Most people have given up on a V-shaped recovery. The concept of a U-shaped one is positively passé.
As for the Swoosh – please!
Nope, the latest red hot letter to explain the state we’re in comes with the K-shaped recovery.
As Barry Ritholz rather reluctantly explained this week:
If you were to describe the 11th letter in the English alphabet to someone who has never seen it, you would note that it is distinguished by a bold vertical line, from the midpoint of which begins two rightward traversing lines, one slanting 45 degrees upward from the horizontal, and the other 45 degrees downward.
This description of the economy fairly captures the two separate paths of the recovery.
The line heading upward symbolizes those parts of the economy that have benefited from pandemic […]
The line heading downward symbolizes, well, pretty much everyone else.
Here’s an illustration from the US Chamber of Commerce:
Does it apply to us, too?
Many Monevator readers are richer than they were in January. We’ve retained our jobs, spent less due to being locked-in, and may also have seen our US-heavy portfolios rise, especially if we’ve some bonds and gold, too.
At the same time, other Britons caught in the wrong place when the music stopped – particularly those who fell outside of the safety nets, such as directors of the wrong limited companies – have been hit hard.
Ritholz sees the K-recovery as a continuation of wider trends:
Over the past four decades, the U.S. has become a nation that has seen the benefits of economic growth, productivity and innovation accruing to fewer and fewer people.
Once a nation of ‘Haves’ and ‘Have Nots’, we are now a nation of ‘Haves’, ‘Have Nots’, and Have Much More’.
The last category has left the first two in the dust.
Here’s an example of the K-shaped recovery applied to the US workforce by The Washington Post, cited by econlife:
OK Computer (says no)
Here in the UK I’d say we’ve only seen the ghost of a K-shaped recovery so far.
Government support and the generous furlough scheme curbed – or at least delayed – the lived impact of the UK’s brutal GDP collapse.
While we have plenty of rich individuals who are doing alright, sector wise we don’t have a vast tech industry that can benefit from the upper leg of the K. At the same time, the Eat Out to Help Out scheme may have helped the K’s lower leg look kinkier for the hospitality sector.
Not wildly convincing.
Ultimately the letter K will probably prove about as useful as the letters that preceded it in predicting what will happen next.
Which, to my mind, is not very useful at all!
The ISA Allowance: What it is and how to use it [Deep dive!] – Monevator
From the archive-ator: Am I saving enough for retirement? – Monevator
Note: Some links are Google search results – in PC/desktop view you can click to read the piece without being a paid subscriber. Try privacy/incognito mode to avoid cookies. Consider subscribing if you read them a lot!1
Minimum age for UK personal pension to rise to 57 by 2028 – Guardian
US unemployment rate falls back below 10% on rehiring spree – BBC
Coffee, ketchup and Nike Air Max: it’s the Covid consumer economy – Reuters
Hedge fund billionaire Ackman says US government should fund equity pensions from birth – MarketWatch
UK house prices hit record high after easing of lockdown – Guardian
Products and services
Virgin’s new 90% mortgage deal offers hope to first-time buyers – Which
Open a SIPP with Interactive Investor before 30 September and you won’t pay any SIPP fee until April 2021, saving £60 – Interactive Investor2
Monzo to bring in some fees for cash withdrawals – Guardian
Pret to offer coffee on a monthly subscription – BBC
NS&I rate cut expected, following £8bn into premium bonds – ThisIsMoney
Sign-up to Freetrade via my link and we can both get a free share worth between £3 and £200 – Freetrade
Homes for sale (or to rent) in converted pubs [Gallery] – Guardian
Comment and opinion
Merryn S-W: Sunak must avoid the rabbit hole of huge tax rises [Search result] – FT
By any other name [On pseudo-alternative assets] – Demonetized
How much is enough? – A Wealth of Common Sense
If the 60/40 keeps working then democracy has failed – Bloomberg via MSN Money
The Texas Hedge: Don’t currency hedge your equity portfolio – Finumus
Debtors’ prison – Humble Dollar
Why do poor people stay poor? – Of Dollars and Data
Naughty corner: Active antics
Follow the earnings… – Novel Investor
…how dare you, Sir! – The Reformed Broker
Warren Buffett buys stakes in five Japanese trading firms – ThisIsMoney
Commodity investment trusts are all the rage – IT Investor
The different shades of active management – Valididea
“I can’t believe I’m saying this but I’m passing in Seth Klarman” – Institutional Investor
Why UK coronavirus deaths are falling even as cases rise [Free to read] – FT
Slow burn likely until vaccines available [Deep, US-centric] – Morningstar
A Covid-19 reunion: The joy of seeing parents again – Next Avenue
Kindle book bargains
How Innovation Works by Matt Ridley – £0.99 on Kindle
The Deficit Myth: Modern Monetary Theory by Stephanie Kelton – £0.99 on Kindle
How to Get Rich by Felix Dennis – £0.99 on Kindle
Bitcoin Billionaires: A True Story of Genius, Betrayal and Redemption by Ben Mezrich – £0.99 on Kindle
Off our beat
Making time – Humble Dollar
Massive mystery holes appear in Siberian tundra – CNN
The value of EQ has peaked – Summation [via Abnormal Returns]
Bitcoin miner is scoring 700% profits selling energy to grid – Bloomberg
The oysters that knew what time it was – Wired
Take ownership of your future self – Harvard Business Review
“Poker isn’t just about calibrating the strength of your beliefs. It’s also about becoming comfortable with the fact that there’s no such thing as a sure thing – ever. You will never have all the information you want, and you will have to act all the same. Leave your certainty at the door.”
– Maria Konnikova, The Biggest Bluff
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Good to see a graph that chimes with my (and many others I’m sure) viewson the economy.
Some stocks (tesla and Aple for example) are just insane at the moment – but the overall trend seems to be justified.
It’s very funny that we are all being told to go back to work to keep the retail/service economy running when the very real and overall good of killing the 9-5 worm week with the mindless commute is within grasp.
Written as someone who now gets an extra 3 hours sleep in the morning and can finish work a hour earlier and no lose any work time.
I’ve gone full circle on the FIRE stuff and the news about increasing pension age is the final straw.
I’ve come to the view that I rather live life now than trade it for an uncertain future. Now my goal is to have enough to stand on my own two feet in old age; food and shelter, the minimum for comfort, as opposed to “living the life” then.
The necessities and wants of an ever deteriorating body are easierly met.
I’m one of the lucky few who actually enjoy their job, so I guess that make things easier.
Re the increase in the minimum age at which private pensions can be accessed from 55 to 57 in 2028:
This seems to be based on John Glen’s written answer stating ‘that announcement set out the timetable for this change well in advance to enable people to make financial plans and will be legislated for in due course’.
As far as I can tell (please correct me if I’m wrong) there is still no clear indication of whether this will be a sudden jump from age 55 to age 57 in 2028 (perhaps March 2028) or whether it will be a gradual increase (say from April 2026 to March 2028).
Those reaching age 55 around this time still don’t know when they will be able to access their private pension and so can’t make plans based on a known date of access. For example someone born in February 1973 doesn’t know if they will be able to first access their private pension at age 55 or age 57.
While this affects a small demographic of mainly better off people, I can’t see the need for the lack of clarity for this group.
@weasel – easierly? That made me chuckle
Now I have to add something. I find it supremely ironic that a Conservative government (supposedly the party of the free market and laissez faire economics) is spending energy trying to make people go back to city centres against their will to be less productive (surely all that time in coffee shops and retail outlets is less time spent working? I find it baffling myself, when I went to work in an office I barely stepped outside for the entire working day, who are these people nipping out to the shops, what is this thing called a ‘lunch break’?).
I suspect the real answer lies not in concern for baristas and shop assistants, but for the landlords of the real estate.
I think the general presumption is that the private pension age will be the state pension age minus 10 years. So in your example, somebody born in February 1973 would be able to access their private pension at age 57. But I am curious whether that has been confirmed anywhere.
Another excellent Finumus article on why we shouldn’t be hedging our equity portfolio.
As usual, he gives a brilliantly clear explanation.
On the subject of the impact of covid-19 being minimal even if there is an apparent rise in positive tests, and the need for policies to be based on the symptomatic impacts of covid-19, not the number of positive tests, Carl Heneghan has been brilliant in highlighting the issue.
For example in the BMJ Talk Evidence Podcast titled ‘Talk Evidence – Lockdown, a spoonful of honey, and weight loss’ there is a great bit between 1 minute and 8 minutes 20 seconds.
And he has written an interesting bit in the Spectator on 1st September titled ‘Coronavirus cases are mounting but deaths remain stable. Why?’
Ona separate point, it is worrying that the ONS data appears to be showing that the indirect affects of covid-19 are increasing. After several weeks where total all causes deaths in England and Wales have been below 5 year averages (because some of those dying from covid-19 in March and April are people who might have died in say June and July), for the past 2 weeks total deaths now exceed the 5 year average. Home deaths have been trending above normal levels for some time, this seems to be at the core of the explanation, and this has been suggested to be indirect non-covid19 deaths that wouldn’t have happened but for covid.
@white sheep, except it’s not rising in lockstep. People born in 1973 will likely have a state pension age of 68 (the intention has been flagged, but not legislated). People who are 55 now have a state pension age of 67. The current state pension age reaches 66 next month. On current timetabling, I’m not sure how long it will take to reach ‘state pension minus 10 years’ at current rates of change, perhaps never?
See tables 3 and 4 below:
Sorry poor editing with too many currents!
And I can’t even read my own link properly. Table 5 lays out the increase to 68, which apparently has been legislated for. It affects those born after 1977. So people born between 1973 and 1977 will in fact have a private pension access age 10 years below state pension age, and there is time to announce the rise to 58 in time for those born in 1977.
(I think that’s correct anyway, but no doubt others will point out any further mistakes).
No, not correct, sorry. The current legislation allows for the rise in SPA to 68 for dob after 1977, but there is an unlegislated intention to bring this forward by up to 10 years (so knocking it further out of line with the private pension age minus 10 years rule).
Anyway, I think the general point is that private pension access is not going to be aligned with SP any time very soon. And that rules can change quite frequently.
There is supposed to be an intention to provide 10 years notice of changes, but this seems only to apply to policy announcements rather than legislation, and frankly, in the current climate, surely all bets must be off concerning previous promises…
@Vanguardian – indeed. I find I am spending more now not working than I did working. Working I had the commute but the whole day was stuck in the office. Now I find myself popping out here and there, buying coffee or lunch or spending in the shops etc. Filling the days is not as cheap as people think….
In the original March 2014 consultation ‘Freedom and Choice in Pensions’ it was stated The transition to this age  will need to begin before 2028 and the government will provide further detail on this in its summary of responses to this consultation’. But in the consultation summary of responses there was then no mention of the transition.
I’m not aware of any other official comment on the transition.
Many Monevator readers are richer than they were in January…..
Mmm I’m not. Been battered
Vanguard Ftse 100 tracker took out late Feb with 10 years profits of wheeling and dealing invested and a bit of spare cash squeezed in. Thought I could sit down and relax.
One interesting thing of losing the job while having a reasonable amount in non-pension investments and savings is having to actually switch from an accumulation mindset to a possible decumulation mindset. Esp if work could take a year or longer to find. Helps to test some strategies you would have as you jump into the unknown if going for early retirement… Really test that appetite for risk.
Very much so. Some trackers I started in January…hmm. They are still between 9-16% down at close of business yesterday, in spite of pound cost averaging with continued monthly additions. I started last year so didn’t have several years of growth to provide a cushion, leaving me a smidgen down (in cash terms) at the moment. Still, I remain hopeful.
I guess I’m one of the lucky ones richer than I was in January.
But among the nice green numbers in my portfolio are some horrific red ones which will take an age to recover, if at all – I’m looking at you, VUKE, BCPT, TMPL and LWDB among other unmentionables. The latter three are still showing at minus 40%…
Of course, they’re only “losses” if I sell now so I just try to ignore them. Or if I’m feeling brave, top up a little.
Presumably there is/was a rationale to a FTSE 100 tracker though, rather than something broader?
Yip I was confident in a good Brexit and a step change in UK prospects. Moving on…
@weenie but isn’t that diversification in action? I have also seen some stuff sunk but watched with my gob open at others rise. Shares and gold worked much harder this year than I ever did myself when I was working. I’m not quite sure I can blame all the increase on the cratering GBP a la Finimus’s warning. I am still at a loss as to how it all happened. But hey, it could give it all up to the second wave, or indeed a slow slip-slide of year on year attrition like the post-dot-com boom. I don’t think this puppy is out of the woods yet,
Telegraphs paywall is down today as a raspberry to Extinction Rebellion – in case there are any articles anyone wants to read
I bought into ishares GBP hedged global tracker IWDG in late March and have had a double whammy of gains – or rather avoided currency-based losses – as the pound has strengthened from 1.16 odd to 1.33. It’s currently my largest single holding, but I always intended to move back to unhedged global equity once a bare bones Brexit agreement was in place.
My original year end target was something like 1.35, but we are nearly there already and things could start heading in the opposite direction if the two sides don’t find a last minute fudge.
My $ denominated EM bond etf is hedged to GBP, as is a High Yield bond etf. I will probably leave them alone.
Fed policy is pointing to TIPS being a sensible low risk asset, and again the question is whether to hedge to GBP or not.
Happy with holding at least 5% in gold to cover both GBP and USD being simultaneously debased. Maybe 10% would be more effective still.
But my favoured asset class for the UK is countryside residental property with big gardens and outbuildings/annexes (with letting potential), bought as a primary residence to avoid CGT. Should be continued gains long term if Rishi Rich signs the death knell on higher rate pension tax relief, and middle class WFHers continue to move out of the cities at the current rate.
Make sure you do your homework on local broadband speeds though.
So I’ve finally had a look at my holdings. Down 7% since the end of the year. I assume this is due to the UK exposure (bonds are up!). I revised my target asset allocation a while ago to reduce exposure to UK, but hadn’t actually operationalised as I was wary of falling into the trap of selling poorly performing asset classes….but I guess at some point should bite the bullet and rebalance.
Interesting set of comments & links.
RE UK equities, they’ve been a v poor investment, particularly the FTSE 100 for 2 decades now. Mean reversion is a powerful force and the UK is particularly cheap now by CAPE.
https://www.starcapital.de/en/research/stock-market-valuation/. I am overweight through holding the vanguard life strategy as part of my equity exposure that has 25% UK weighting. It certainly feeds the otherwise temptation to meddle. So far it’s been a relatively poor decision but give the disparity in value between global indices I am happy to hold notwithstanding the poor constituents. Terry Smith would strongly disagree although even he appears to acknowledge the UK may be due a bounce back.
I’ve never understood the desire to currency hedge your portfolio. It’s notoriously hard to predict the direction of currencies and you give up on the opportunity for diversification. I’m (like most people) heavily exposed to the £ through employment, house and for completeness the state pension. International equities and bonds provides some currency diversification. Particularly as the outlook for the £ has risk, when you consider (a) there’s a risk of no agreement with the EU (b) deterioration of UK finances due to the pandemic. US $TIPS are a good option unhedged and on the face of it are cheaper than the UK equivalent. Particularly given the current $ £ exchange rate. Not that I can predict what’s going to happen but you can think what might happen.
The MSW article is interesting and highlights that whilst taxes may & probably will got up, they are not the likely answer here. i.e raising tax cannot fix this problem unless you were going to go down a route that was political suicide and even then it’s arguable you’d do enough to deal with the problem. The other alternatives are (i) default – v unlikely and unnecessary for a country that has its own currency (ii) economic growth – there seems a good chance we eventually revert to pre-crisis growth of 1 – 1.5%, which isn’t much to write home about but will help (iii) taxation – can raise a bit round the edges of wealth taxation but won’t deal with it (iv) inflation – feels increasingly likely somewhere in the future given electorates have had enough of so called austerity, we are now money printing to finance current expenditure etc etc – so like MSW global equities, gold and bonds – $TIPS seem a sensible balance.
The chance of another leg up in house prices for anywhere in striking distance of London or other cities seems significant – given you can borrow fixed for seven years at 1.5% assuming you’ve got a decent deposit.
@seeking fire, drat, you’ve given me a reason to hold onto my UK holdings…
How to you invest in TIPs, out of interest?
Hi Vanguard Fan – On the FTSE definitely not predicting, just observing. Others have made the bear case on this forum coherently to which I also agree with. I suspect if we see some UK inflation the FTSE 250 could benefit from that tail wind nicely. In $TIPS, no magic here (see below the link). The bear case is as follows (i) why buy negative YTM (ii) untested in high inflation (iii) there won’t be high inflation (iv) why actively asset allocate in bonds if you passively asset allocate in equities – all of which could be right. But I definitely wouldn’t currency hedge them in almost any scenario.
Just wanted to say how interesting the wired article was, thanks for that one!
@SeekingFire. “I’ve never understood the desire to currency hedge your portfolio. It’s notoriously hard to predict the direction of currencies and you give up on the opportunity for diversification”
It’s easy to throw around words like “diversification” but you need to actually bother to quantify whether it generates that characteristic. For example, you realize that the return correlation between GBP/USD and US TIPS has generally been positive? When GBP/USD goes down, TIPS typically generate negative returns. There is no diversification. It’s additive risk. Over the last two decades, the return correlation has averaged around +0.25. By owning FX unhedged US TIPS, you’d have just taken more volatility for less diversification. The return correlation only went negative in the last few years (anything happen in 2016?). It hasn’t even worked on the S&P. The breakeven return correlation for it to be a diversifier was -0.27 or lower. In reality it was -0.15.
I see a strong risk of recency bias. GBP has been devaluing on and off since 2008, losing 37% against the USD. So it’s been real easy to have FX unhedged positions. Remember though that it strengthened 67% vs. the USD between 2002 and 2008. I remember because I was mainly in USD over that period and it was bloody painful. Over the past twenty years, GBP/USD has only actually dropped by 10%. FX hedging would have earned back around 12%. So pretty much a wash whether hedged or not. Being FX unhedged, however, you’d have experienced all that extra volatility.
If you have no active view on FX rates, and have no data to demonstrate diversification, how you can you justifying being anything other than FX hedged? The cognitive dissonance from retail on FX hedging is only surpassed by their cognitive dissonance on bonds. It seems that the real issue is that you don’t understand either FX or fixed income and instead reverse engineer a view that justifies what you’d like to believe.
This doesn’t undermine what Finumus said in his piece. His view was that having an open FX exposure was a tail hedge against bad things happening in your local currency. I have sympathy with that. I’ve been broadly unhedged for similar reasons. But thats not diversification. It’s not a passive investing strategy. It’s 100% active investing.
@zx, thank you for reminding me that I am a know-nothing retail investor, and should act accordingly….my understanding is that one should not hedge equities (I don’t know that there are the retail index funds to do this anyway) but maybe yes to bonds. So I am unhedged equities, hedged international bonds. As a know nothing can I go back to sleep on FX now?
Here’s a dumb question. Say I have a global index tracker for eg MSCI world. I see that the index is expressed in US$. I know that my tracker is also denominated in US$ as the underlying currency, although my holding will be expressed in GBP. So, does that mean that the actual performance in my GBP portfolio could be wildly different from both the index and the performance chart of the fund (also expressed in US$)?
Hedged ETFs available to the hoi polloi include iShares S&P 500 GBP Hedged ETF (Ticker: IGUS), IGWD and IWDG. I’m not currently invested in any of these but they are on my radar in case there is a very sharp fall in sterling during the coming winter. I’m slightly wary of ETFs in general, possibly unnecessarily so, because of complexity, counterparty risk, liquidity and the fact that they are relatively new investment vehicles with the first being launched in 1993.
I’m a bit stuck so any help to point me in the right direction is much appreciated. I’m looking for a list of UK based growth orientated ETFs that pays NO(or very little) income or dividend.
Thank @Paul. IGWD expense ratio 0.55%!!
But – surely you want to be unhedged if anticipating a currency slide in the new year? As then your international holdings will retain their value (and rise in GBP terms). I recall a 15-20% uplift in GBP terms in 2016….
And I also assume that trying to time purchase likely futile as currency movements can be pretty swift?
Anyway, pretty much concluded to go back to sleep with my unhedged equities and hedged bonds. (Wake me up in late 2021…)
I’d consider hedging overseas equities in the middle a multi-faceted UK-centric crisis after a c. 20% fall in sterling!
Yes it was a excellent read so pleasant to have something interesting and different to read many thanks. It’s what make this site worth coming back to and such a change from all the normal opinionated drudge on the news
Over the past chaotic but admittedly short 9 months, my share portfolio, which is 50% (and rising) diversified away from the FTSE, has only outperformed the FTSE by 3%. This is hardly a cast iron case for or against currency or market diversification.
I have never really understood why naïve investors like me need to do any more than try to ensure that they are not overexposed to any single currency or market. The likely future movements of governments, economies, currencies and markets are well beyond my ken. I suspect I am not alone out there.
@Vanguard. What I find frustrating is when people exhibit high levels of certainty based on little info. To say that it’s hard to predict the direction of currencies is easy to agree with. To then argue, as SF did, that you should explicitly construct your portfolio to maximize your exposure to something you don’t understand, and furthermore, to imply that to minimize exposure is a bad idea, seems just a leap of faith.
With regard to your fund, I’m not quite sure what you mean. The index has a base currency that is USD. In that sense your performance will not be the same as the USD index since you are in GBP and taking GBP/USD exposure. If the index goes up 10% and GBP/USD falls 5% over 2020, then your return in GBP will be 15.79% (assuming no costs, distributions etc). If GBP/USD went up 5%, your return in GBP would be 4.76%. I don’t see what the complication is? As a long as you chart the performance of the UK sub-feeder, not the US master fund, then the performance will typically be quoted in GBP. Take as an example the UCITS ETF HMWO LN. It tracks the NDDUWI (MSCI World Net Index, a USD based index) in GBP terms. That’s all you need to look at.
@zx, yes, you’ve confirmed what I thought. Actually the performance charts on the Vanguard UK website are in USD where this is the base currency, so actually pretty meaningless if you’re holding GBP version.
ZX Spectrum, thanks for your comments it’s always good to get challenged. I think you are getting unnecessarily frustrated though as you misread my comment. Diversification is in the context of one’s whole portfolio so I’m not sure how you can draw the conclusion there is no diversification when you are not aware of an individual’s overall portfolio. If I was seeking the return from $TIPS only I would consider hedging of course but I’m also seeking the $ exposure in the context of overall net assets as an incomplete hedge to downside £ currency risk, which is the point I made in the comment. There is other ways to achieve that for sure. And so I continue to be comfortable with my comment that I wouldn’t look to hedge the investment in $TIPS in almost any circumstance. I doesn’t mean we, one or you as it depends upon people’s circumstances, although I would observe most people are heavily exposed to the £.
I’m aware of the historical positive correlation with US $TIPS / GBP as you say including 2$ in 2008 etc. However, US $TIPS have only been in issuance since 1997 and therefore in the same way as you critique the lack of data in assessing SWR rates, which I agree with, I also wouldn’t take too much from a couple of decades of correlation analysis or even shorter data from 2008 – others can take a different view and that’s ok. You mention 20 years – 10% currency depreciation. It’s also say dropped circa 50% since 1953. Not that either comment would be particularly relevant I feel because I am not taking a view on currency, as I said I can’t predict what will happen but can predict what might happen. And so I feel it’s quite easy to justify not being currency hedged
I’m not sure I predicted a high degree of certainty, not that one should construct a portfolio to maximise exposure to something I don’t understand. I think I said…”Not that I can predict what’s going to happen but you can think what might happen.” I feel comfortable I understand it sufficiently. You can see from my comment that I had already called out my inconsistency in actively allocating in bonds but taking a more global approach to equities and I’m always keen to challenge myself here and consider others should to. It’s good to have humility in one’s thinking as I’m sure you’d agree with?
The advice on Fx hedging seems to always assume a 100% certainty that all future liabilities will be in GBP. That’s a stretch even for the average UK pension saver who may eventually find that they want to retire abroad for the weather/lifestyle/cost of living/whatever. (Personally, even the short-term outlook is uncertain due to Brexit; and for retirement we might go anywhere.)
Then there are the GBP’s “risk-on” properties that Finumus pointed out, and the rather dubious track record over the past few decades.
So some kind of Fx diversification is necessary. The question is how to do it right. My approach is entirely unsophisticated with unhedged stock/bond funds and gold.
I too have a chunk of TIPS and was interested to read ZXSpectrum’s comment. Is the positive correlation with GBP/USD expected to hold up long-term? Presumably, USTs work better?
@Sparchwein. These are three good reasons not to FX hedge exposure (other than having an active view)
1. ALM. Most people consume products or services priced in foreign currency and should hold foreign assets to hedge those liabilities.
2. Risk insurance. Holding foreign currency is a hedge against domestic or global event risks. This is especially the case if the domestic currency is high beta/”risk-on”. Holding low beta “risk-off” currencies acts as a volatility suppressant during stress periods. This insurance often comes at the cost of both negative carry and higher volatility over the broader cycle.
3. Diversification. Currency and assets may be sufficiently negatively correlated so as to lower overall portfolio risk.
But think about what diversification really means. Take the simplest case of owning a domestic asset, d, a foreign asset, f, connected by an FX rate, fx. It can be shown that the condition for lowering portfolio volatility through an unhedged FX position is
w.σ(fx) + 2[(1-w).ρ(d,fx).σ(d) + w.ρ(f,fx).σ(f)] <0
where w is the % invested in the foreign position, σ(a) is the volatility of a; ρ(a,b) is the return correlation of a,b. That inequality already has three volatility parameters and two correlations and that's just two assets and one FX rate. How the hell is it obvious that you should be 100% FX unhedged?
Nonetheless, the inequality does make a few things apparent
1. A positive asset-currency correlation just increases total portfolio volatility.
2. Negative correlation is not enough. Only a sufficiently large negative correlation between assets and the currency can offset FX volatility.
3. If there is zero correlation between currency and foreign asset, the currency’s correlation with the domestic asset must be more negative in order to reduce portfolio volatility
4. If currency returns are less volatile than asset returns, the negative correlation can be closer to zero and still reduce portfolio vol. This is the situation for some equity markets.
5. If currency returns are more volatile than asset returns, the negative correlation has to be much larger to reduce portfolio vol. This is the situation for most bond markets.
My annoyance is that diversification is the most often touted reason for being FX unhedged but it's probably the most nuanced and difficult to justify.
I'd also point out that monetary dominance has caused asset correlations to rise, while financial repression has caused asset volatility to fall. Both of these are making it much more difficult for FX unhedged positions to generate the portfolio diversification they once did.
I’m impressed (but totally bewildered) by your post. As I suspect, are most Monevator readers. I suspect that was your intention, but I may be being unkind.
So should there not be an item 6) – “And the conclusion is…”?
As @ZXSpectrum48k alludes, a simple way to think about why hedge bonds and why not equities is the relative return profile of the two assets classes.
Over 10 years an equity market might return say 100-500%, with dividends. The currency pair might move by 0-50% either direction, say.
Over 10 years a government bond market might return say 40-100%, all-in. (Obviously likely less nowadays). Again the FX volatility might be say 0-50%.
Just looking at the (illustrative, off top of my head!) ranges here, you can see your expected returns from your overseas equity exposure is dominated by the potential return from the underlying asset class.
In contrast, your returns from bonds, being expected to be much lower, could be swamped by the FX movements. Hence a stronger case for hedging.
There’s lots else going on. For instance there are potentially natural hedges in place that help equities but may/do not help bonds.
E.g. A country devalues its currency and its exports become much more competitive. Perhaps its stock market rises over a few years as local companies become more competitive due to the weaker currency (but their profits/valuations are in that devalued currency, so it’s not a ‘free win’). In contrast the country’s existing bonds have no ability to be intrinsically re-valued upwards, they are just devalued (priced in your domestic currency) with the fall in the foreign currency. (Ignoring everything else!)
(Also I’m assuming here a non-Zimbabwean style devaluation. I wouldn’t expect stocks to rise in a revolution… 😉 )
We also, as has been said, need to differentiate between compensated and uncompensated risk. If you’re enduring more volatility for no expectation of higher returns, then all you’ve done is made your portfolio more risky. I can’t remember the data but from memory I’m don’t believe currency risk is actually (much?) compensated for even with equities.
However we also have to think about crisis protection, as I think @ZX mentioned, and also overall portfolio risk, as somebody else did.
I would also argue it depends also on what you mean by ‘risk’. Finance has a clear definition, but yours might be ‘certainty of all the Werther’s Originals I can eat in retirement’ or whatnot. This might justify hedging (I want certainty of local spending power) or not hedging (I want to know if my country turns into a banana republic I have overseas assets to repatriate to buy my retirement candy).
Personally, if I set up long-run barely-changing asset allocations (I don’t, I’m an active loon) then I would probably hedge all my overseas bond exposure and maybe half my overseas equity exposure. The latter wouldn’t be a mathematical optimised decision. It’d be humility in the face of uncertainty and complexity.
I have a 3000+ word unfinished draft on FX hedging that I began after seeing a lecture / having a conversation with Elroy Dimson (of the Yearbook fame) and it could easily be another 3,000 words. Someday I’ll finish it. It was becoming a mini thesis! 😉
Here is a really good Vanguard paper on currency hedging: https://personal.vanguard.com/pdf/ISGPCH.pdf
I switched from a 60:40 equity:bond portfolio to 90:10 earlier in the year and despite the increased currency risk still decided against any hedging. IMHO the additional costs of hedging are too high for the very marginal expected benefits, especially for private investors.
The interesting debate here goes back to different understandings of the term “diversification”. As I read @ZXSpectrum, the professional definition implies reduced volatility; and we’ve got pretty much the definitive explanation here that this is a mug’s game for the average guy. (I think the equation adds some clarity, actually.)
There is much to be said about the other (good) reasons for FX exposure.
How to think about liability-matching towards an uncertain future, possibly abroad?
As for definitions of risk, I care more about maximal drawdowns than average volatility, and I suspect that many private investors think similarly. Given the nasty habit of the pound to tank during financial crises, how much allocation to risk-off currencies makes sense?
And what about the tail risks for GBP? (Well isn’t the govt doing their very best to keep these top of mind.)
Looking forward to the MV article/thesis/book on the topic 🙂
@Sparschwein, I would recommend you read the paper I linked to as it covers a lot of ground. One thing it does not adequately cover is the cost of hedging. The cheapest currency hedged world tracker I know of from iShares has a TER of 0.30% and that does not include the “handful of basis points” for the actual hedging itself, just the fees. With my collection of trackers I am currently paying less than 0.10%, so the true cost of hedging is more than twice what I am currently paying in management fees. Over the long term I am aiming at drawing around 2% per year from our portfolio, so if I switched to hedged ETFs, I would be paying over 10% of our income away on something with scant evidence that it would be of any long term benefit.
I have similar issues with the cost of value investing, although there is at least some evidence that this might have a long term benefit.
The Vanguard paper makes a good, rather detailed case for leaving stocks unhedged. (The cost of hedging is another good point.) Vanguard do acknowledge portfolio risks beyond the usual volatility measure, and proceed with a simplistic “bond investors want low vol, therefore they should hedge”…
I have been targeting ~60% FX exposure and need some of it from bonds. It’s mostly TIPS now, which at least deliver some inflation hedge. Poor bond yields made the risk-off part a real headache.
@sparchswein, how do you calculate FX exposure for equities, when many FTSE companies are themselves highly exposed to FX for their earnings?
@Vanguardfan – good question. I don’t. It’s a crude system that I made up myself (for lack of relevant guidance), after the Brexit vote had caught me with my pants down.
To be consistent one would need to quantify FX exposures to all major currencies in all the stock index funds, and I wouldn’t know how to get such data. I have a global mix with only a few percent in FTSE trackers, so I chose to ignore this problem and assign 100% local currency to each.
My non-listed company shares are a slightly bigger chunk and I am going to dig into their reports for FX exposure. One more for the to-do list from this thread here.