Despite earlier incarnations, a reasonable date for the euro’s actual birthday is 1st January 1999 when it became fully usable and tradable (though the physical notes and coins didn’t appear until 1st January 2002). And, for a currency that has only just entered into adulthood, it’s fair to say that it is punching above its weight – according to the Bank for International Settlements’ 2016 Triennial Survey of FX, more than 30% of all over-the-counter FX transactions involve the single currency, making it the second most important currency in the world behind the venerable US dollar.
But, global heft aside, the question for a US investor around this key birthday is: has the euro been a jolly good fellow; or, paraphrasing, how beneficial has holding the euro been? For those that have accessed euro-denominated assets – be they stocks, bonds, or real estate – and elected not to hedge out their currency exposure, what has been the impact of that decision? The euro may have (so far) proved its chops at surviving various crises, but has it, and can it, prove its chops at justifying a place in a US investor’s portfolio?
In our view, this question is best answered through an examination of the four key metrics that matter when considering the role that international currency plays in a portfolio. These metrics are:
- Return – The extent to which a long position in the currency has helped a US investor.
- Risk – The extent to which the currency has exhibited volatility, and how that has changed the risk of the portfolio.
- Correlation – Linked to risk, the way in which the currency has moved vis-à-vis the international asset, and the impact that has on overall portfolio volatility.
- Hedging Costs – The cost, or benefit, that has accrued to a US investor to hold, or remove, the euro.
Return
At the time of writing, the euro has had 1,034 weekly returns, and Figure One shows the histogram of all of them. Here is our take on the broad conclusions that an investor could draw when looking at this return data for the euro:
- The weekly returns are essentially normally distributed with a mean of 0.01% and a weekly standard deviation of 1.37% (annualized to 9.87%).
- The mean weekly return is not statistically significantly different from zero, and there have been an almost identical number of up weeks (517) as there have down (514), with a few flat (3).
Figure One: Histogram of the Euro’s Weekly Returns vs US Dollar (1/1999 – 10/2018, source Bloomberg)
Risk
So if it’s fair to say that the weekly returns to the euro have been mean zero, and therefore not particularly helped a US investor, the next obvious question is, how can that have hurt? And, the answer of course lies in return’s, often overlooked, partner – risk.
First let’s review the empirical numbers. The standard deviation of the euro’s weekly returns since inception was 1.37%, which when annualized, becomes around 9.87%. There seem fewer better candidates for that well-known market pun of “return-free risk” than the euro to date.
Correlation
The discussion of risk leads to an absolutely critical, but very subtle, point about the role that currency plays in a portfolio. Since the Correlation of the euro’s weekly returns to the Eurozone stock market (total return of MSCI Eurozone, in local terms) has been -0.01, so effectively zero, an investor might ask this very reasonable question:
“How is it possible to add an uncorrelated asset (the euro) to my Eurozone equities, and have the resulting portfolio be more risky at any point in time?”
Well, in our view, the answer comes from the implicit leverage that currency brings to a portfolio. This is shown in Figure Four where we have plotted the volatility differences between hedged and unhedged Eurozone stocks, against the rolling correlation numbers. This chart merits some consideration in our view, because, it not only shows that unhedged access has been riskier for a US investor the majority of the time (specifically 70% of rolling periods), but it also shows how important correlation is in driving that risk. Only when correlation was quite negative did the euro help to reduce the risk in the portfolio – zero was not enough!
Hedging Costs
When one sees the potential for volatility reduction that removing the euro has had since inception, the obvious question that will now occur to most investors is – how much does it cost? Since it’s to their advantage (assuming their view on the spot move of the currency is agnostic) then the expectation must be, quite reasonably, that it costs to implement the hedge. In fact, because the main driver of hedging costs are interest rate differentials, and because rates in the US have been higher than those internationally for some time, the surprising answer is that US investors have actually enjoyed a positive cost of carry to implement the hedge (economist speak for getting paid!).
Conclusions
As US investors ponder the 20th birthday present that they might gift to the euro, perhaps they should first reflect on how good of a friend the single currency has been to their portfolios. From the above analysis, it seems some “re-gifting” might be in order!