Asset managers who are focused on absolute returns when managing their currency risk tend to use strategies that are characterized by risk reduction, adopting a passive currency management approach in order to achieve this. By contrast, funds that are focused on relative returns tend to manage currency risk more actively. Their aim is after all to outperform an unhedged position, or in some cases the hedged benchmark, in other words to “add alpha”. In this, there is no “right” and “wrong”. It depends completely on the risk management style of the fund and what risk approach it takes towards both the underlying assets and also the embedded currency risk.
Posts Tagged ‘Money’
RELATIVE RETURNS — ADDING ALPHA
July 4th, 2011SELECTING THE CURRENCY HEDGING BENCHMARK
July 3rd, 2011A 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.
Risk Reduction
July 2nd, 2011The emphasis on risk reduction within a passive currency management style deals with the basic idea that the portfolio’s return in the base currency is equal to:
The return of foreign assets invested in + the return of the foreign currency
This is a simple, but hopefully effective way of expressing the view that there are two separate and distinct risks present within the decision to invest outside of the base currency. The motive of risk reduction is therefore to hedge to whatever extent decided upon the return of the foreign currency. From this basic premise, we can extrapolate the following:
Return (unhedged) = Return (asset) + Return (currency)
and
Return (hedged) = Return (asset) + Return (hedge currency)
The overall aim remains the same, and that is to reduce the overall risk of the portfolio, maximizing the total or absolute return in the process. In other words, it is to boost the portfolio’s Sharpe ratio, which is usually defined as the (annual) excess return as a proportion of the (annual) standard deviation or risk involved.
It should be noted from this formula however that some investors balk at the idea of hedging on the simplistic view that the hedge cost automatically reduces not just the hedged return of the asset but the asset’s total return in base currency terms. This is not necessarily the case. Actually, the converse can be argued, namely that the hedge reduces or eliminates any possible currency loss. Whether or not the investor hedges, there is the foreign currency return to be considered. That may add or detract from the asset return in foreign currency terms, and therefore may in turn boost or reduce the asset return in domestic currency terms. The hedging cost component will clearly depend on a number of variables, including the currency hedging benchmark and the financial instruments that can be used, but has clear parameters. The potential unhedged currency loss is theoretically limitless.