The “Yield Shield”: Managing Emerging Market Currency Risks

We would like to share some recent analysis on currency effects in emerging market equities portfolios.

As investors increase allocations to emerging market equities and bonds, it is important that they consider the currency impact. Foreign exchange makes a significant contribution to the returns and risk profile of emerging markets portfolios, and in our view investors should become familiar with this impact and consider whether to actively hedge this exposure.

Our analysis shows that some long-standing assumptions on ‘Emerging Market’ currencies are no longer valid.

In particular:

  • Markets are more liquid than they were – for some EM currencies, volumes are comparable to smaller G10 currencies.
  • Currencies are less correlated with local equity markets and contribute a much larger percentage of the total risk of emerging markets than they used to.
  • The cost of hedging is no longer punitively high.

Today, the majority of the emerging market currency exposure of the MSCI Emerging Market Index (MSCI EM Index) can be hedged using fairly liquid instruments.