A crucial decision for portfolio managers who want to manage their currency risk, whether actively or passively, is the selection of their currency hedging benchmark. After all, when we are talking about managing currency risk, we are really talking about establishing whether or not there may be a need to hedge out that currency risk. Using a currency hedging benchmark is a more disciplined and rigorous way of managing currency risk than either not hedging or at the other extreme conducting all currency hedging on a discretionary and “gut feel” basis. There are four main currency hedging benchmarks used by institutional investors, which can be divided into:
100% hedged benchmark
100% unhedged benchmark
Partially hedged benchmark
Option hedged benchmark
Being 100% hedged is usually not the optimal strategy, apart from in exceptional cases. Equally, using a currency hedging benchmark of 100% unhedged would seem to defeat the purpose of managing currency risk, again apart from in exceptional cases. A further consideration is that many funds are not allowed to use options as they are viewed as a speculative financial instrument, ironically in the same way that some corporations are also not allowed to use them. This still leaves them however with the choice of three possible currency hedging benchmarks of 100% hedged, 100% unhedged or partially hedged. The primary instrument for such hedging would be the forward for passive currency management, though active currency managers would no doubt have greater flexibility, both in the currencies in which they can operate and the financial instruments they can use.
Currency hedging benchmarks of 0% or 100% are known as asymmetrical or polar benchmarks and have obvious limitations. With a polar benchmark, an active currency manager is able to take positions only in one direction. As a result, their ability to add value is also limited. For example, it is extremely difficult for a currency manager to be able to add value operating under an unhedged currency benchmark when foreign currencies are appreciating because the manager is generally unable to take on additional foreign currency exposure. The best the manager can do is to mimic the benchmark by holding the unhedged benchmark exposure and avoiding hedging. Similarly, when operating under a fully hedged benchmark, it is difficult for a manager to add value when foreign currencies are falling.
Adoption and use of benchmarks depends critically on the currency risk management style, for which the type of fund is clearly a key determinant. For instance, a pension fund manager may use a fully hedged or alternatively unhedged currency benchmark to either reduce risk on the one hand or minimize transaction costs on the other. Meanwhile, the active currency manager will seek a partially hedged benchmark, preferably 50%, to give them as much flexibility and room as possible with which to be able to add value. With such a symmetrical benchmark, active currency managers can take advantage of both bull and bear markets in their currencies. In the context of relative returns, it should therefore be of no surprise that there is good evidence to suggest that symmetrical benchmarks have consistently added more “alpha” than their asymmetrical counterparts.