PMC Weekly Review - February 19, 2016

A Macro View – Flexibility is the Key to Overseas Investing

The strength of the U.S. dollar over the past several years has overshadowed otherwise decent returns in the international fixed income markets. Through the end of 2015, the Barclays Global Aggregate ex-USD Index is down an average of just over -4% per year for the last three years, and down just under -1% per year over the trailing five years, on an unhedged basis. However, on a fully hedged basis, that same index is up 3.7% per year over the last three years, and up 4.3% over the last five. This in turn has led some investors to question whether their portfolio should be completely hedged (no currency exposure) going forward, while others speculate that the dollar may have reached its peak, and a wholly unhedged portfolio might be the best way to go. Only time will tell if the dollar will strengthen or weaken, and over what time frame, but there is a third option: allowing the portfolio manager the flexibility to hedge specific investments selectively.

The table on page 3 shows the average rolling three-year return (annualized) for the Barclays US Aggregate Index, along with three blended portfolios combining the US Aggregate and the Global Aggregate ex-USD Indexes, the latter on both a hedged and unhedged basis. All of the blended portfolios have a higher average three-year return than the Aggregate alone, though the unhedged portfolios have slightly lower returns and higher volatility than the hedged portfolios.

By examining only the data for fully hedged and fully unhedged portfolios, it might be logical to deduce that, over the long term, a fully hedged, blended portfolio provides the best return and the lowest volatility. However, a significant portion of the diversification benefit comes from the currency component. The correlation between the Aggregate and the hedged Global Aggregate ex-USD is 0.71 versus just 0.48 for the unhedged version. The return profiles can be very time specific as well: from 2000-2009, for example, the three unhedged blended portfolios outperformed their hedged counterparts by 30-70 basis points per year.

What happens to returns and volatility when the currency exposure is managed actively? We looked at all of the international bond funds that left at least a portion of their portfolio unhedged and had more than 10 years of returns. Only 11 funds met these criteria, but eight of those funds outperformed the unhedged benchmark, net of fees (which average about 1.0%), on both an absolute basis and a risk-adjusted basis. This lends credence to the portfolio manager’s ability to add value through currency/country exposure, and makes a compelling third option to the all-or-none discussion.

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Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.

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