It is a common understanding that when investing in international assets, there are two sources of risk, first, the volatility that comes from the underlying asset itself (typically equities or bonds) and second, the volatility of the currency in which the international asset is denominated versus the base currency of the portfolio.
Institutional investors typically invest in international assets to access the risk premia available in overseas markets as this can provide attractive return opportunities. However, historically, many investors have chosen to hedge the currency risk associated with these overseas investments by employing a passive currency hedging within the portfolio:
This commentary will argue that employing a passive currency hedge is sub-optimal and beset with potential problems and that an active approach to managing the currency risk is superior and can materially improve the risk/return characteristics of the overall portfolio.
There are three reasons why employing a passive hedge to eliminate the currency risk in an international portfolio is a sub-optimal strategy.
- The returns from currency exposures are typically uncorrelated with those of traditional financial assets and hence, it is advantageous to retain at least a portion of the underlying currency exposure as this will enhance the risk/return characteristics of the overall portfolio. The lack of correlation is due to currency markets being of a completely different character to equity or fixed income markets; different fundamental drivers are responsible for both the level of valuation and cyclical trends.
- A passive hedging strategy only focuses on the risks associated with currency exposures and ignores the aspect of cash flows. Indeed, in periods of base currency depreciation, a passive hedging strategy will incur substantial losses which will need to be funded resulting in negative cash flows as the hedges are rolled over. Such negative cash flows will likely require the sale of portfolio assets to raise cash which can interfere materially with the asset allocation policy of the portfolio.
- A passive strategy ignores the potential to add value via generating positive returns though the active management of currency exposures over time. There is substantial empirical evidence in support of currency markets being a source of absolute returns and furthermore this return stream is typically uncorrelated with other return streams in the portfolio (for the reasons highlighted above) and therefore highly accretive to the overall risk/return characteristics of the portfolio.
Employing an active currency overlay can overcome all of these difficulties.
1. Currency Returns Are Lowly Correlated
The character of currency markets is key to the lack of correlation with traditional financial market assets. Currency markets typically move in long term cycles around competitive fair value. The competitive fair value between two currencies itself changes over time according to the relative productivity and inflation differentials between the two economies/currencies. Currencies rarely stay at competitive fair value, due to the interaction of the economic cycles existing in each economy, and typically move between periods of overvaluation and undervaluation as a result.
Accordingly, in periods of base currency undervaluation it will be preferable to employ a high hedge ratio on foreign currency exposure (anticipating a rise in the base currency towards fair value) while in periods of overvaluation it will be preferable to have a low hedge ratio (anticipating a fall in the base currency towards fair value). Hence, a passive currency hedge which is static in nature is not ideal as it does not take into account the cyclical nature of currency markets.
The purpose of an active currency overlay programme is to vary currency hedge ratios over time depending upon the macroeconomic and financial market circumstances prevailing at any time. It will enable the hedge ratio to be increased in anticipation of periods of base currency appreciation and reduced in anticipation of base currency decline. The dynamism afforded by this approach can provide substantial added value by adjusting portfolio hedge ratios (and cross hedges) in accordance with prevailing financial market and macro-economic conditions.
Chart 1: The Cyclical Nature of Currency Markets: Deviations from Fair Value can be Substantial and Persist for Long Periods
2. Negative Cash Flows Are Damaging
An example of how a passive hedging strategy can lead to substantial negative cash flows at inopportune times is the aftermath of the financial crisis of 2008. From early March to the end of November 2009, the US dollar index (DXY) declined by 17.2%1 (an annualised rate of 22.8%1). The rolling over of passive currency hedges on foreign currency exposure into the US dollar during this period would have resulted in very large realised losses. As a result, it would have required a substantial amount of portfolio assets to be sold to cover these losses and settle resulting cash flows. At the same time there was a major inflexion point in the global equity markets whereby many international equity markets rallied by over 50%1 in the period. Hence, the task of managing an asset allocation policy during tumultuous market environments in the face of funding large currency losses can be very disruptive.
An active currency overlay by contrast would have had the flexibility to be responsive to the driving forces moving the US dollar lower during this period and therefore employ a vastly different hedging policy than a static and unresponsive passive hedge. Given the potentially damaging impact of negative cash flows from an ill-timed and ill-suited passive hedge, it is advisable to engage in an active currency overlay which can mitigate negative cash flows.
1. Source: Bloomberg
3. Currency Markets Can Be A Source Of Additional Return
In the same way that equity and fixed income market exposures are adjusted over time, within asset allocation polices, in order to improve the return outlook for investment portfolios the adjustment of currency exposures over time in response to changing fundamentals can be a source of additional return.
Indeed, empirical evidence, as illustrated in Chart 2, suggests that specialist currency investment managers are able to generate pure absolute returns from currency markets. Despite currency markets being the most liquid, transparent and cheapest market to trade with the highest daily turnover in the world, unlike in equity or debt markets, most participants are not profit maximisers. For example, corporate treasurers trade currencies to manage trade flow payables and receivables while central banks often trade currencies to achieve monetary policy objectives but neither trade currencies for the explicit reason of generating a return. This creates an exploitable inefficiency for specialists, such as active currency overlay managers. This cannot be said of US equity market which is dominated by profit seekers and hence is much more efficient.
The below analysis illustrates how the addition of a low risk currency overlay programme to an international equity portfolio, with a 50% passive currency hedge, can materially improve the portfolio’s returns and risk/return profile.
Chart 2: How Active Currency Overlay Can Benefit International Investors
Millennium Currency Overlay returns are gross excess returns Based on Millennium’s longest standing overlay programme, managed for an Institutional client since 1996. To achieve actual performance, potential investors should deduct actual management/performance fees along with all account operating costs. These results do not reflect commissions, custodial and similar fees, other expenses involved in the operation and management of the client’s account.
Past Performance is not a guide to future returns and the value of investments may fall as well as rise. Millennium does not guarantee the advantages it perceives for any investment will result in enhanced performance of the programme. An investor may lose all or a substantial amount of their investment. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown.
What started out as a portfolio problem of additional volatility associated with investing in international assets can be turned into a virtue. By actively adjusting exposures to portfolio currencies, specialist currency managers can generate an additional return stream which otherwise would not exist and mitigate cash flow issues that beset passive (static) hedging programmes. Furthermore, it is typical that returns generated from taking active currency positions will be uncorrelated with the underlying asset returns in the portfolio and therefore enhance an investment portfolio’s overall risk/return characteristics.
In summary, it is our view that an active currency overlay has many advantages over a passive currency hedging strategy. There is no reason to believe that the optimum amount of currency exposure in a portfolio should be constant over time as in the case of a passive hedging approach. Indeed, it would never be considered appropriate from an asset allocation perspective that optimum exposure to equity or debt markets in an investment portfolio should be fixed and unchanging over time. Furthermore, an active currency overlay directly addresses the issue of potentially negative cash flows, which may result from the rollover of currency hedges, by taking an active approach to mitigating this impact. Lastly, and potentially most significantly, an active overlay strategy has the potential to add incremental and diversifying returns to a portfolio and enhance its aggregate risk/return characteristics. Overall therefore an active currency overlay strategy has the potential to add value in many key facets of portfolio management and hence should be considered as a core part of any integrated asset allocation policy.
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