Active management at work: Hedging against potential sustained dollar weakness

Will a sustained period of USD weakness while the FTSE100 outperforms the S&P500 hurt W1M’s equity performance?

It is rare to see USD weakness together with FTSE100 outperforming the S&P500, but it can happen. As we have seen this year, currencies can be volatile and US equities can sharply underperform UK and other markets. There can be short term impacts on investment performance in one quarter which “come out in the wash” in­­­ the next. We are not trying to make short term currency or stock calls and are not driven by performance in a month or a quarter - but we do need to be able to mitigate potentially sustained currency and equity market moves should they go against our positioning.

We can, of course, change positioning when the market environment changes, but it can make sense to have an element of hedging as a type of “insurance” in the portfolios which reacts automatically. In our portfolios, we have natural hedges and strategies designed to mitigate specific risks.

• Natural hedges: US multinationals with massive global earnings may see results enhanced by USD weakness, while non US multinationals may be hurt by it
• Protection strategies: we design and use instruments to gives us an element of “insurance” - for example, if market’s get fearful, our portfolios can benefit from volatility spiking and that can help offset equities being down sharply

USD weakness: W1M portfolios have predominantly sterling exposures in their bond, real assets and absolute return components, but, unsurprisingly, our equity exposure gives us more foreign currency risk as we seek to buy the stocks we consider most attractive regardless of geography. In the rare occurrence of UK equities outperforming US equities AND the US dollar being weak, we know that this would be a headwind to performance given our allocation to US stocks.

If such an occurrence is short term, it does not present a significant problem; any impacts should “come out in the wash” in the medium and longer run. But, what if we see a sustained period of USD weakness and US equity underperformance?

W1M has put in place a hedge which aims to mitigate this specific risk. Allocating just 0.05% of our equity exposure to get this protection seems a small “price to pay” when if we see both material weakness in USD and UK equity outperformance of US equities over the course of the next year. 

• If the dollar fell by 5% and FTSE outperformed the S&P by 5%, the position would go up c.39%
• If the dollar fell by 15% and FTSE outperformed the S&P by 15%, the position would go up c.2678%

One choice is to be passive and let portfolios take the rough with the smooth, but where we can use strategies to give portfolios valuable protection without significant cost, there can be a significant benefit for investors.