Once a source of rich returns for yield-hungry investors, emerging markets are hammering home a long-ignored truism: banking on currency strength to enhance returns on stocks and bonds is not a one-way ticket to profits.
Currencies such as the rupiah and lira have slumped 10-20 percent this year as a seismic shift in global capital flows rattles even relatively robust markets, exacerbating international investors' losses on the underlying assets.
And as a long-term dollar uptrend gains momentum, fund managers are being forced to rethink their decade-long view of emerging currencies as an obviously strong bet.
That means having to start actively managing exchange rate risk - and the cost of hedging may well make the underlying investment look far less attractive.
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So far this year, a strategy based on holding the lira, zloty, real, Mexican peso and rouble versus the euro, dollar and Swiss franc is losing 2.3 percent, Citi calculations show.
Returns on the same trade in 2012 were almost 9 percent while full-year returns have been negative only three times in the index's 12-year history, in 2002, 2011 and 2008.
"The volatility has been horrific on emerging currencies," Marino Valensise, CIO of Barings Asset Management told the Reuters Investment Outlook summit this week.
"We are perplexed by high volatility even on currencies such as Mexican peso which was brought down...for no reason."
In the past, fear of missing out on currency appreciation made investors reluctant to offset exchange rate exposure. But analysts say investors are now more open to discussing hedging.
Valensise remains reluctant to hedge but acknowledges the risk, especially for emerging debt, where currency appreciation contributed up to half the annual return in some recent years.
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Currency volatility "is going to be an issue for investors in EM bond markets because the currency side is so big relative to the bond return," he said.
So a dollar-based investor who earned 8 percent yields on Indian bonds would still have plunged into loss due to the rupee's 12 percent year-to-date fall versus the greenback.
In many ways the currency weakness is hardly surprising. Growth in developing countries is slowing, exports are falling and once-famed current account surpluses are dwindling.
And as the tide of global liquidity ebbs, over $30 billion has flowed out of emerging bonds alone in the past six months, according to data from fund tracker EPFR Global.
"Everything out there is conspiring to weaken emerging currencies," said Luis Costa, head of CEEMEA FX and debt strategy at Citi. "There's been a big change in mindset ... Until this year FX was a source of alpha (enhanced returns) but now, if you hold local debt, the currency is the problem."
Derivatives markets indicate little respite.
One-month implied volatilities, a gauge of how choppy a currency is likely to be, are picking up again in currencies such as the Indonesian rupiah, Indian rupee and Turkish lira after easing in October.
Risk reversals, which compare demand for options on a currency rising or falling, show similar bias.
And in a vicious circle, hedging itself puts exchange rates under more pressure.
Real money flows in forward transactions suggest a sharp increase in hedging this year, according to Citi.
Flows passing through Citi trading platforms indicate that the zloty is the most hedged of the big emerging currencies, possibly reflecting its status as a proxy for eastern European risk, followed by Mexican peso and Turkish lira.
Some of this is also down to multinational companies whose earnings are being eroded by emerging currency swings. Again, Citi has observed a 35 percent year-to-date rise in corporate FX hedging volumes.
So far at least there are signs that big investors would rather hedge than exit bond positions altogether.
"We'll take currency exposure where we think there's upside potential. But equally we have the flexibility to own the bond without owning the currency, or
even being short the currency," Goldman Sachs Asset Management's EMEA CEO Andrew Wilson said.
The drawbacks? First, stop-start moves in U.S. yields mean that constantly positioning for a fall in emerging currencies can be costly. But more importantly, interest rate differentials between emerging and developed countries can make it ruinously expensive.
For instance, Indian rupee forwards price in a roughly 10 percent depreciation over the next year. That means an investor aiming to hedge $1 million in rupee exposure for 12 months must be prepared to pay away a tenth of this, or $100,000.
And as risks rise, so do hedging costs: the one-year cost of hedging the rupee has almost doubled since early 2013.
"If you hedge, you often give up 80 percent of the income," said Jeremy Brewin, head of emerging debt at ING Investment Management. "In that case it's hardly worth holding the bond."