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Hedging EM? Think Gold.

Published in Automated Trader Magazine Issue 36 Spring 2015

Attractive returns across emerging markets (EM) for most of the last decade - supported by economic growth -appealed to many investors. While the long-term view on EM is still positive, economic weakness in some EM regions and increased volatility in most EM currencies has increased the importance of sound portfolio risk-management strategies. Our analysis shows that gold can be a cost effective EM-currency hedge, helping investors reduce portfolio losses during periods of heightened risk.

Juan Carlos Artigas

Juan Carlos Artigas, Director, Investment Research, World Gold Council

EM investing: the good, the bad and the ugly

Over the past decade, EM has transitioned from being primarily a tactical play for some daring investors to a more widespread strategic component in portfolio allocation. For most of the past decade, it has been one of the best performing asset classes. EM stocks gained 13.7% per year (in US-dollar terms) between 2003 and 2012; EM bonds fared equally well, with annual returns of 11.6% over the same period.1

Compare that to (US -dollar) annual returns of 0.1%, 2.9% and 4.9% for Japanese, European and US stocks 2 , respectively, and one can understand why the EM story - rooted in economic growth, favourable demographics and, in many instances, market deregulation - has been closely followed by investors.

While EM still carries a lot of potential and are expected to account for more than half of the global GDP within the next decade3, many emerging economies have shown signs of stress. EM equities have fallen by almost 10% between 2013 and 2014 and EM bonds by 1.5% over the same period, due primarily to weakness in EM currencies.

To hedge, or not to hedge

Given the long term positive view on EM and the potential benefits to investors who hold it, a pertinent question is what strategies investors can employ to hedge EM exposure? In our view, currency risk should be on top of the list.

While many EM currencies generally appreciated over the past decade, they are still prone to violent pullbacks as we have recently seen. This type of volatility can be difficult to manage for investors who are heavily engaged in foreign-exchange (FX) markets; it is even more difficult for investors who are not.

FX hedging has been proven to lower portfolio risk4, especially for volatile currencies and those that are positively related to the business cycle. However, it comes at a cost.

For FX hedging, the largest share of costs comes from interest-rate differentials, particularly prevalent between developed and emerging markets. And they can have a material impact on performance. Chart 1 shows that an investor would have paid, on average, 5.2% per annum to hedge the currency exposure of this emerging-markets basket over the 25 years.

1 Equity returns based on the MSCI EM equity index level in US-dollar terms from December 2002 and December 2012. Bond returns based on the J.P. Morgan EM Global Bond Index (EMBIG) over the same period.
2 Equity returns based on the corresponding MSCI country/region indices in US-dollar terms from December 2002 and December 2012.
3 Ernst & Young, Tracking global trends: How six key developments are shaping the business world, 2011. McKinsey & Co., Winning the $30tn decathlon: Going for gold in emerging markets, 2012.
4 Eun, C.S. and B.G. Resnick, Exchange rate uncertainty, forward contracts, and international portfolio selection, The journal of finance, Vol. 43, 1988; and Schmittmann, J., Currency hedging for international portfolios, IMF Working Paper No. 10/151, June 2010.

Chart 1: Hedging EM currency risk can create a significant drag in returns

Approximate annualised cost of hedging currency exposure for the MSCI EM index*

*Cost is computed by multiplying a constructed proxy for the MSCI Emerging Markets Index respective country weights by the corresponding interest-rate differentials. Computations are made from a US dollar perspective. See Appendix II in Gold and currencies: hedging foreign-exchange risk,
Gold Investor, Volume 1, January 2013, for more details on the methodology. Source: Bloomberg, Global Financial Data, Thomson Reuters, World Gold Council

In our view, gold offers a potential solution to these issues. Gold has a number of characteristics that allow investors to hedge part of the currency-related risk while reducing costs, adding diversification and protecting against tail risks.

These include:

• Gold's link to emerging markets through consumer demand

• Its role as currency in the financial system

• Its negative relationship with the US dollar and other developed market currencies

• Its low correlation to most developed-market assets

• Its ability to protect against tail-risk events.

Including a gold-hedging strategy with an EM position can significantly reduce the drawdown (peak-to-trough declines) on the investment.5

As Chart 2 shows, gold-hedged EM equity exposure has dramatically decreased portfolio drawdown. Adding a 50% gold overlay to a partly-hedged emerging-market-equities position achieves a lower drawdown than a 100% exchange-rate-hedged emerging-market investment.

Similarly, the average pullback on a 50/50 gold/currency-hedged position at 9.2% was lower than both a fully currency-hedged and a fully-unhedged emerging markets' position.

The costs of FX hedging using currencies with higher rate differentials and less liquidity can exert a considerable drag on returns. In contrast, gold allocations and overlays can be implemented in rather simple and cost effective ways. For example, the cost of vaulting allocated physical gold ranges from 5-15 basis points while the cost of owning an ETF ranges from 15-50 basis points, a fraction of the cost of hedging emerging-market currencies.

The gold market is extremely liquid. With an estimated average trading volume of US$240bn per day6, it not only ranks fourth relative to major currency pairs behind the US dollar/euro, US dollar/yen and US dollar/pound sterling, but dwarfs any other non-US dollar cross currency pairs, surpassing all EM spot currency transactions combined.7

5 The 50% hedge ratio was used as it is a common approach for investors (FT, Hyman Robertson, State Street Global Advisors). While there is a good amount of literature on hedging ratios, many of them disagree to a large extent and optimal ratios can be time dependent (Black, F., (1989) Universal Hedging: Optimising Currency Risk and Reward in International Equity Portfolios, Financial Analysts Journal, July-August).
6 London Bullion Market Association, LBMA gold turnover survey for Q1 2011, The Alchemist, August 2011.
7 Statistics computed using the Bank for International Settlements (BIS) database.

Chart 2: Hedging currency risks with gold helps reduce drawdowns

Drawdown of unhedged, currency-hedged and gold-hedged EM indices*

The 50% EM FX hedged + 50% gold drawdown analysis assumes that gold is an overlayed position.
Source: Bloomberg, World Gold Council

Tail-risk hedging

Gold can also provide a useful tool in risk management if an EM-led crisis becomes systemic. Such events are often either related to or caused directly by the country's currency and debt markets. For investors with direct exposure to EM, including gold in currency-hedging strategies can improve performance during tail events.

For example, a 50/50 combination of gold and an EM currency-hedging strategy outperformed fully-hedged and fully-unhedged strategies during eight recent tail-risk events (Chart 3). In particular, the 50/50 combination hedged portfolio outperformed an unhedged strategy by an average of 30 basis points and collectively by a total 240 basis points over the eight events under consideration.

Similarly, it outperformed a fully currency-hedged strategy by an average of 14 basis points and 111 basis points collectively over the same period.

Chart 3: Portfolios including gold as part of a EM currency hedge have generally outperformed those using alternative strategies

Outperformance of portfolios with a 50% gold overlay on EM index*

*The portfolios used for comparison include a 5% cash allocation, 25% in US bonds, 10% in foreign bonds, 35% in US equities, 10% in developed market equities, 10% in EM equities and 5% in commodities. For the EM component we used three variants: 1) unhedged ; 2) currency-hedged; and 3) a 50/50 mix between currency hedging and a gold overlay. The returns for the 50/50 hedged EM asset are computed by weighing a 50% unhedged EM index with a 50% currency hedged EM index and a 50% overlay to gold. Assuming there is a 10% allocation to emerging market equities, the 50% gold overlay would result in a 5% cash borrowing to arrive at a 5% allocation to gold, creating a 105% long, -5% cash portfolio. The dates used are as follows. 1997 Asian financial crisis: June 1997 - December 1997; 1998 Russian default: July 1998 - September 1998; 2002 Argentina default: December 2001 - June 2002; September 11: August 2001 - September 2001, 2002 recession; February 2002 - July 2002, Global financial crisis: August 2008 - March 2009, Sovereign debt crisis I: April 2010 -July 2010, Sovereign debt crisis II: February 2011 - October 2011.

Source: Barclays Capital, Bloomberg, World Gold Council

Using gold as a long-term strategy

Gold's EM currency hedging characteristics represent an additional benefit to a strategic allocation. Our body of research has shown that an allocation to gold in the range of 2%-10% is optimal for investors across a band of risk appetites. Gold's foreign-exchange hedging capabilities further emphasize its versatility as a portfolio component.

Given the low cost of a gold allocation relative to EM currencies - from the transaction, monitoring and carry perspectives - its positive relationship to EM and its application as a tail-risk hedge, gold makes an attractive alternative to traditional exchange-rate hedging programs.

The results of our analysis show how gold can reduce portfolio drawdown for investors with emerging-market allocations relative to a foreign-exchange hedge. Further, gold has been shown to increase risk- adjusted returns by lowering volatility. This strategy may be particularly useful going forward based not necessarily on directional views on gold prices, but because the global economy has become more intertwined and gold has garnered a greater response in crises impacting more than one market.

This article is a summary of Hedging EM? Think Gold, Gold Investor, Volume 5, March 2014, available on