Tin hats at the ready. If the eurozone trouble deepens, emerging market equities could once again overshoot fair value in a wave of deleveraging.
So it’s time to put a value on them hedges…
Let’s look at FX plays for now. On that note, it’s fair to say hedging long EM equities with going short high-beta G10 currencies during risk-off bouts is investment strategy du jour. Currencies like the Aussie dollar offer deep liquidity than most EM currencies could ever dream of, so it’s no wonder that emerging market investors so often tout the virtues of the AUD and the NZD to us.
But just how much bang for your buck does this strategy deliver? A fair whack in absolute terms, according to Nomura. (Click to enlarge)
To be precise, assuming an Aussie hedge generates 1.2 per cent of extra return on an annualised basis relative to the underlying performance of the MSCI Emerging Market index, according to Nomura.
Of course, if you want to neutralize beta risk you could just sell your EM positions. But as equities remain hostage to eurozone fortune, it would be pretty counter-productive to divest just as everyone else runs for the hills. So buying cheap currency hedges is likely to remain wildly popular. Presumably, the universe of potential currency hedges should expand as more EM currencies become convertible and/or offer more liquid FX markets.
Correlation risk, anyone?
Related link:
Coverage of emerging market currencies – FT Tilt (free to access)