- Real estate investors are increasingly exposed to currency risk as their portfolios become more internationally diversified. Some do nothing and accept the risk, some hedge it all and others are selective on currencies and exposure.
- Local-currency benchmarks assume perfect hedging, ignoring the associated frictions, while hedged indexes allow investors to align benchmarks with their hedging policy.
- Hedged indexes can help properly attribute underlying performance, and long-term spreads between hedged and local-currency indexes have exceeded 100 basis points per year.
Home bias in real estate portfolios is being gradually eroded over time as investors venture abroad. But in seeking a wider set of investment opportunities and the potential diversification global investing may bring, investors may also expose themselves to currency risk. They can respond in a variety of ways, depending on their exposure, appetite for bearing it and capabilities for managing it. Some do nothing and accept the risk, some hedge it all and others are more selective about which currencies and how much of the exposure to hedge. By using hedged indexes, investors may better align their benchmarks with their own approach, to ensure currency risk is accurately treated in allocation modeling and performance attribution.
Benchmarking International Real Estate Exposure
International investors have a range of multinational benchmarks available — at both the fund and property level — to align with the objectives of their portfolios. For those investing directly in property assets, currency risk is driven largely by the location of the assets — the currencies in which the properties are transacted and rents are received. For those investing through funds, each fund has a reporting currency to which the investor is directly exposed. The fund itself may be exposed to other currencies, whether the manager chooses to hedge the currency risk or not.
The chart below illustrates the currency exposures across two global indexes. The MSCI Global Property Index is exposed to a broader range of currencies than the MSCI Global Property Fund Index, given differences in geographic exposures and the truncation of exposure through choice of reporting currency.
Currency Exposure Differed for Property and Fund Indexes
Why Currency Risk Matters
Currencies can fluctuate considerably for a number of reasons: central-bank decisions, changes in inflation, balance of trade and cross-country capital flows, as well as investor speculation. Whatever the cause, currency movements have had a large impact on real estate investment performance. For instance, for the MSCI Global Property Fund Index, the cumulative total return in GBP from 2008 to Q2 2020 was 137%, while in both JPY and CNY the return was only 42%. Although currency movements can be a significant driver of returns in international real estate, the assessment and pricing of currency risk are often considered separately to the underlying real estate risk.
Different Currency Exposures, Different Returns
How Can Hedged Indexes Help?
Local-currency indexes are often used throughout the investment process to help form market views and strategy, feed into asset underwriting and benchmark property performance, but they completely ignore the currency impact. They can be thought of as perfectly hedged indexes, where costs and market frictions do not exist. While investors may find local-currency benchmarks useful for a range of purposes, those hedging currency risks in their own portfolios may find value in reflecting the impact associated with their hedging approach in their performance benchmark too.
As with MSCI’s hedging methodology for equity indexes, forward foreign-exchange (FX) contract prices may be used in calculating hedged indexes for private real estate. For listed equities, monthly hedge tenors are common, but for private real estate, quarterly hedging using three-month forward FX rates is more appropriate to account for the lower liquidity of the asset class. The foreign-currency notional values are then assumed to be rolled over in the hedged indexes on a quarterly basis. During the quarter, the unrealized profit/loss from the forward FX contracts is added to the performance of the unhedged private-real-estate indexes to calculate the hedged index’s performance.
Hedged vs. Local-Currency Indexes
Applying quarterly currency hedging to an index reduced return volatility significantly, to levels similar to those of local-currency indexes, during the period of our analysis. This dampening effect can be seen in comparing performance in AUD and JPY of the MSCI Global Quarterly Property Fund Index. Due to the cost or benefit of hedging on a cumulative basis, however, there might be considerable differences in the annualized return between hedged, unhedged and local-currency indexes.1
Currency Hedging Dampened Return Volatility
The table below shows that for other currencies the investment risk also declined. But there were significant differences in the average return over the analyzed period: For some currencies, hedging improved the return, while for other currencies it reduced returns. For Australian investors who hedged their exposure, a local-currency index may have been easier to outperform, while for a Japanese investor, the converse was true. Investors able to account for such dynamics in their performance attribution will have a more accurate assessment of the drivers of their portfolio returns.
|Standard Deviation||Total Return||Standard Deviation||Total Return|
|Index in AUD||9.1%||5.1%||6.2%||6.2%|
|Index in CAD||7.6%||5.8%||6.4%||4.0%|
|Index in CNY||7.3%||2.9%||6.4%||4.6%|
|Index in EUR||7.9%||5.3%||6.1%||3.1%|
|Index in GBP||6.8%||7.1%||6.3%||3.6%|
|Index in JPY||10.8%||2.8%||6.2%||2.8%|
|Index in SEK||7.8%||6.2%||6.3%||3.5%|
|Index in USD||6.9%||3.1%||6.1%||3.9%|
|Index in Local Currency||6.3%||4.2%|
Annualized returns (2008 to Q2 2020) for the MSCI Global Quarterly Property Fund Index.
Increased exposure to foreign currencies has made currency hedging more prevalent in real estate portfolios. Historically, currency hedging has reduced return volatility considerably, but had a large impact on overall portfolio and benchmark returns. In selecting an appropriate international benchmark, it is natural to review its alignment with an investor’s chosen policy for currency risk management. Reflecting the (potentially partial) hedging policy may help investors appropriately attribute performance and better inform allocation decisions.
1 The cost or benefit of hedging is approximately equal to the interest-rate differential between currencies (through the covered-interest-parity relationship). Hence, hedging lower-interest-rate currencies (compared to the investor's home currency) may result in positive cumulative returns over the long term.