🚨 Effectiveness of Foreign Asset Investment and Currency Hedging Strategies
Today Korean Economic News | 2025.02.22
📌 Don't Bother with 'Currency Hedging' for Foreign Asset Investments
💬 Investor anxiety is growing as global REIT fund stock prices have plummeted recently. With currency hedging costs being pointed to as the main cause, controversy is spreading about whether currency hedging is absolutely necessary when investing in foreign assets.
1️⃣ Easy Understanding
While 'currency hedging' has traditionally been used to prevent exchange rate risk when investing in foreign assets, recent claims suggest that this strategy could actually reduce profitability. Let's try to understand this issue in simple terms.
When investing overseas, you need to consider the risk of exchange rate fluctuations. For example, let's assume you invested $1,000 (about 1.3 million won) in U.S. stocks. After a year, the stock value increased by 10% to $1,100, but during the same period, the dollar value decreased by 10% against the won to 1,170 won per dollar. What happens? Despite the stock rising by 10%, when converted to won, it's about 1.29 million won ($1,100 × 1,170 won), resulting in a loss of 10,000 won compared to your initial investment. 'Currency hedging' is a method to prevent this kind of exchange rate risk.
Currency hedging is similar to taking out "exchange rate insurance." It's like buying the right to exchange currency at a predetermined rate in the future. However, this insurance also comes with a cost (premium), and recently this cost has risen significantly. In particular, the cost of hedging against the U.S. dollar has increased to 3-4% annually. This means you need to earn at least 3-4% returns on your foreign investment to offset the hedging costs.
In the case of global REIT (Real Estate Investment Trust) funds, as hedging costs have risen, actual returns have significantly decreased, resulting in a sharp drop in stock prices. In contrast, products without currency hedging were relatively less affected.
Additionally, for long-term investments, exchange rate fluctuations tend to offset each other to some extent. For example, if you invest for 10 years, the overall impact may be reduced as exchange rates go up and down throughout that period. In fact, looking at data over the past 20 years, long-term investors often achieved better results without currency hedging.
In the end, the answer to the question 'Is currency hedging always necessary?' is 'it depends on the situation.' For short-term investors, currency hedging can be useful to reduce exchange rate fluctuation risk, but for long-term investors, it may not be absolutely necessary considering the high hedging costs. Also, if you diversify your investment portfolio across various currencies, you may naturally achieve a risk diversification effect.
2️⃣ Economic Terms
📕 Currency Hedging
Currency hedging is a financial strategy to minimize exchange rate risk, utilized in foreign asset investments.
- It is primarily implemented through derivatives such as forward exchange contracts, currency swaps, and options, fixing the exchange rate for a specific future point.
- Hedging costs are determined based on the interest rate difference between two currencies, and if costs increase, they can negatively impact investment returns.
📕 REITs
REITs (Real Estate Investment Trusts) are listed and traded real estate investment products.
- They pool funds from multiple investors to invest in real estate such as offices, commercial facilities, and logistics centers, and distribute rental income and asset value appreciation returns.
- They are popular as indirect real estate investment vehicles because of their high liquidity and the ability to diversify investments with small amounts.
📕 Currency Risk
Currency risk refers to the risk that the value of foreign currency assets changes according to exchange rate fluctuations.
- When holding foreign currency-denominated assets, if the value of that foreign currency decreases against the domestic currency, the value of the asset converted to the domestic currency also decreases.
- The impact of currency risk can vary depending on various factors such as investment period, currency volatility, and economic conditions.
📕 Portfolio Diversification
Portfolio diversification is an investment strategy that reduces overall risk by investing in various assets.
- Risk can be mitigated through diversification across multiple dimensions such as asset classes, regions, industries, and currencies.
- Following the principle of "don't put all your eggs in one basket," it is a core concept of modern portfolio theory.
3️⃣ Principles and Economic Outlook
💡 Causes and Effects of Rising Currency Hedging Costs
Recently, currency hedging costs have been rising sharply, which is the result of various economic factors and market conditions working together.
First, the interest rate difference between Korea and the United States is a major cause. Hedging costs are basically determined based on the interest rate difference between two currencies. Currently, Korea's base rate is 3.25%, while the U.S. base rate is at the level of 5.0-5.25%, creating an interest rate difference of about 1.75-2.0 percentage points. This interest rate difference acts as an additional cost when hedging the dollar. Simply put, when hedging a high-interest currency (dollar) with a low-interest currency (won), the difference becomes a cost in the structure.
Second, reduced liquidity and increased volatility in the foreign exchange market have also contributed to the rise in hedging costs. The volatility of the foreign exchange market has expanded due to increased global financial uncertainty, geopolitical risks, and changes in central banks' monetary policies. In this situation, market makers increase risk premiums, which leads to higher hedging costs. In particular, the pressure on hedging costs has increased further as global financial institutions have strengthened risk management, limiting liquidity supply in the foreign exchange derivatives market.
Third, global economic uncertainty and changes in currency value outlook have also had an impact. Uncertainty about the future value of major currencies has increased due to concerns about economic recession, inflationary pressure, and differences in monetary policy directions among countries' central banks. In this situation, those who assume currency risk (hedging product providers) demand higher premiums, which are reflected in hedging costs. In particular, as market expectations formed that the dollar's strength would continue, the cost of hedging against the dollar tended to rise further.
Fourth, the rise in hedging costs directly lowers the returns on hedged foreign asset investments. Especially for products like REITs with expected returns of 5-7%, hedging costs of 3-4% become a factor that significantly reduces actual returns. This is analyzed to have had a significant impact on the recent price drop of global REIT funds. As annual hedging costs account for more than half of the product's expected return, the investment attractiveness has greatly decreased.
This phenomenon of rising hedging costs is more of a structural aspect derived from the global financial environment and differences in monetary policies among countries, rather than a short-term market fluctuation. Therefore, there is a possibility that high levels of hedging costs will continue for the time being, suggesting the need for a fundamental reconsideration of currency hedging in foreign asset investment strategies.
💡 Hedged vs. Unhedged: Empirical Analysis by Investment Period
The effect of currency hedging can vary greatly depending on the investment period, asset type, market conditions, etc., and analysis of past data provides important insights into this.
First, currency hedging can be effective in reducing volatility for short-term investments. In short-term investments of less than a year, exchange rate fluctuations can have a significant impact on investment returns. According to empirical research, when currency hedging was applied to short-term investments in global stock markets, a 10-20% reduction in the standard deviation (volatility) of returns was observed. This is because the overall investment risk was reduced as the exchange rate fluctuation risk was eliminated. Therefore, currency hedging may still be a useful strategy for investors who are sensitive to volatility or investing for short-term target returns.
Second, for medium to long-term investments, the effect of currency hedging may decrease or even have adverse effects. In long-term investments of 5-10 years or more, exchange rate fluctuations tend to offset each other to some extent. Analyzing global stock investment data over the past 20 years, the difference in average annual returns between hedged and unhedged portfolios was not significant, at less than 0.5% when held for more than 10 years. In fact, considering hedging costs, unhedged portfolios often recorded higher net returns. This tendency may be even more pronounced in the current environment of high hedging costs.
Third, the utility of currency hedging appears differently depending on the asset type. For relatively low and stable return assets like bonds, currency hedging may be more important because exchange rate fluctuations account for a large proportion of total investment returns. On the other hand, for assets with high return volatility like stocks or alternative investments, the relative impact of exchange rate fluctuations on overall performance may be smaller. Especially for investments like REITs or infrastructure funds where the underlying assets are physical and long-term cash flows are expected, hedging costs can significantly reduce profitability.
Fourth, currency diversification itself can provide a natural hedging effect. Diversifying investments across assets denominated in various currencies has the effect of diversifying exchange rate risk in itself. For example, a portfolio invested in multiple currencies such as dollars, euros, yen, pounds, etc., has the effect of offsetting the impact of a particular currency's strength/weakness. According to empirical research, for globally diversified portfolios across five or more major currencies, the overall portfolio's exchange rate risk was significantly reduced even without currency hedging.
These empirical analysis results suggest that currency hedging is not the optimal strategy in all situations, and a customized approach is needed that comprehensively considers investment period, asset type, market conditions, portfolio composition, etc. Especially in the current environment of high hedging costs, there is a need to more carefully evaluate the cost-effectiveness of hedging strategies.
💡 Effective Foreign Investment Risk Management Strategies
Beyond the question of whether to hedge currency risk, various strategic approaches should be considered to effectively manage risk when investing in foreign assets.
First, a balanced approach through partial hedging strategies can be useful. Rather than extreme approaches of either hedging 100% of foreign currency exposure or not hedging at all, a partial hedging strategy that only hedges part of the portfolio can be effective. For example, by hedging only 50-70% of foreign currency assets, you can maintain protection against extreme exchange rate fluctuations while reducing hedging costs. Also, a dynamic hedging approach that flexibly adjusts the hedging ratio according to market conditions and exchange rate outlook can be considered.
Second, differentiated hedging strategies according to the investment horizon are important. As seen earlier, the utility of currency hedging can vary greatly between short-term and long-term investments. Therefore, it is desirable to establish customized hedging strategies that match the investment purpose and period. For example, applying a low hedging ratio to long-term portfolios for retirement and a high hedging ratio to short-term funds for specific goals. Also, a 'time-based hedging' strategy that gradually increases the hedging ratio as the investment period approaches can also be effective.
Third, selective hedging considering asset types and currency characteristics is effective. Rather than applying the same hedging strategy to all assets and currencies, a selective approach considering each characteristic is important. For example, a high hedging ratio can be applied to developed country bonds with low volatility and limited returns, and a low hedging ratio to emerging country stocks with large growth potential. Also, it can be considered to differentiate hedging strategies for currencies that have historically shown high correlation with the won (e.g., Asian emerging market currencies) and those that have shown low correlation (e.g., Swiss franc, U.S. dollar).
Fourth, currency diversification itself can be utilized as a risk management strategy. As mentioned earlier, diversifying investments across various currencies provides a natural hedging effect in itself. In particular, major currencies such as the U.S. dollar, euro, Japanese yen, British pound, and Swiss franc are affected by different economic cycles and monetary policies, so diversification among them can reduce overall exchange rate risk. Also, allocation to physical assets such as gold can play a natural hedging role against currency value depreciation.
These various risk management strategies are not mutually exclusive and can be combined and utilized according to the investor's situation and goals. The important thing is to adopt a balanced approach that comprehensively considers investment purpose, market conditions, cost structure, etc., beyond the dichotomous approach of 'hedged vs. unhedged'. Especially in the current environment of high hedging costs and great global economic uncertainty, flexible and selective risk management strategies are becoming more important than mechanical complete hedging.
4️⃣ In Conclusion
The necessity of currency hedging when investing in foreign assets is not absolute, and various factors such as investment period, asset type, market conditions, and investor risk appetite need to be comprehensively considered. Especially in the current environment where currency hedging costs have risen significantly, a mechanical complete hedging strategy could actually lower investment returns.
For short-term investors and those with strong risk aversion, currency hedging can still be an important risk management tool. This is because it helps reduce the possibility of losses due to sudden exchange rate fluctuations during a short investment period and securely obtain expected returns based on the won.
On the other hand, long-term investors or those with risk-bearing capacity need to consider the negative impact of hedging costs on investment returns. Especially in long-term investments of 5-10 years or more, exchange rate fluctuations tend to offset each other to some extent, and paying high hedging costs may be inefficient.
For a more sophisticated approach, it can be effective to use various strategies such as partial hedging, selective hedging, and dynamic hedging in combination. That is, rather than hedging all foreign currency assets in the same way, it is desirable to apply differentiated hedging strategies considering investment purpose, asset characteristics, and currency outlook.
Also, it's important to remember that diversifying investments across multiple currencies itself provides a natural hedging effect. A global portfolio diversified across various currencies such as the dollar, euro, yen, and pound has the effect of mitigating risk due to fluctuations in a specific currency.
In conclusion, the answer to the question 'Should you always use currency hedging when investing in foreign assets?' is 'not always.' A customized approach that fits the investor's situation and goals and the market environment is important, and especially in the current environment of high hedging costs, it is necessary to carefully evaluate the cost-effectiveness rather than a mechanical approach to complete hedging. Rather than accepting high hedging costs simply for 'safety,' investors should establish a balanced risk management strategy that matches their investment goals and time horizon.