Managing Currency Risk – The Canadian Perspective
By: Gregory J. Chrispin
With the increased impact of currency risk on pension fund returns, Canadian plan sponsors need to develop currency policies which can manage this risk, says Gregory J. Chrispin, of State Street Global Advisors.
The rapid appreciation of the Canadian dollar against the U.S. currency made headlines in the financial press throughout 2003. Although the Canadian stock market picked up steam last year, the sharp rise in the Canadian currency had a significant dampening impact on global investment returns when expressed in Canadian dollars. For many plan sponsors, currency is an unfamiliar topic and one which has not received much attention in the past.
As a result of the issues surrounding currency risk in Canadian pension plans, plan sponsors need to look at ways of developing a currency policy which addresses and manages these risks.
At first sight, establishing a currency policy may not appear to be an easy task. However, with some guidance, it is not as daunting as it seems. The first step in establishing a policy is to understand the impact of currency on the plan, both in terms of return and volatility. This, combined with the plan’s risk and return objectives, will guide and help determine the appropriate degree of strategic, or passive hedging. Once a passive benchmark has been set, then the plan can decide on whether an active or tactical program is suitable and, if so chosen, what objectives the active program should be pursuing. The final part of the policy then consists of implementing the program and setting up procedures to ensure its smooth operation and easy monitoring.
Impact Of Currency Returns
The first stage of the assessment consists of understanding the impact of currency returns from a portfolio of international equities. Currency exposure is typically derived from an investment in some underlying non-domestic asset class such as fixed income or equity, which does not provide any implicit or explicit return stream. For this reason, many investors have assumed that currency exposure has no real long-term expected return associated with it. This may be true over the very long term (20 to 25 year periods) but over shorter periods, this is not the case. Analysis shows that currency returns rarely fail to wash out over periods as long as five years which implies that currency exposure can add substantially to interim volatility of international investment portfolios. Since most plans review strategic objectives in periods ranging from three to five years, this amounts to significant risk over horizons longer than most strategic time frames.
In fact, over the 30 years from 1974 to 2003, five year currency returns have exceeded 10 per cent for more than 50 per cent of the time. With respect to funding requirements and regular solvency tests, most funds cannot wait 20 years for currency returns to unwind and the volatility of the five year returns can cause problems.
Another important consideration from a Canadian perspective is that with the gradual increases of the foreign property rules,1 many plans have increased their exposure to international assets to take advantage of a wide range of opportunities in overseas markets. As a result, this increased exposure to foreign currencies has materially affected the risk and return characteristics of the overall plans.2
In this context, the ‘do nothing’ strategy, which has been the right one during the long period of depreciation of the Canadian dollar, may no longer be optimal. Whether managed passively or actively, currency risk can no longer be ignored.
For any plan with more than 15 per cent invested internationally, the impact of currency volatility is significant and likely to increase in significance. This volatility has been beneficial in the past because returns have been generally positive and have been negatively correlated with equities. However, this may not be the case in the future and the level of strategic hedging in the benchmark must be considered. An analysis of the volatility of portfolios invested in both Canadian equities and selected international portfolios has shown that combining domestic equities with unhedged international equities appears to produce lower risk portfolios. This is because of the negative correlation between currencies and foreign equities, which produces a more diversified and de facto less risky portfolio. Moreover, both hedged and unhedged foreign equities reduce the risk of a domestic-only portfolio and most of the risk reduction benefit is achieved when moving from an allocation of zero per cent to 40 per cent in international equities as can be seen in the chart Equity Portfolios: Volatility.
However, as these results are based on the analysis from just one period of data, and as the correlations are not stable, it is not advisable to base any asset allocation decision, including the level of hedging, on quantitative analysis alone. In deciding upon a suitable level of hedging in the benchmark, other factors need to be considered. If the plan holds less than 15 per cent in international assets, then an unhedged benchmark may be the most suitable. The overall contribution of currency to plan volatility will be low or modest and the diversification benefits will likely outweigh volatility effects.
For plans with international asset positions of 15 per cent and 40 per cent, a 50 per cent hedged benchmark is likely to be more appropriate. The 50 per cent hedged benchmark is gaining in popularity around the world as it offers specific benefits. It avoids the potential for large underperformance that is associated with ‘polar’ benchmarks (being fully unhedged when the Canadian dollar is strong or being fully hedged when it is weak). This minimizes the ‘regret’ that comes with holding the wrong benchmark in the wrong conditions. The 50 per cent hedged benchmark also provides some protection against falling foreign currencies and offers some participation when they are rising. Furthermore, it provides some risk reduction if one assumes that equity and currency correlations are close to zero or slightly positive. Not only have several asset consultants recommended this for most clients, but plan sponsors are also comforted by the fact that the great majority of their global peers have selected this benchmark for new currency overlay mandates over the last two to three years. For those plans which also implement an active currency overlay program, there is the advantage that the 50 per cent hedged benchmark allows the manager the opportunity to add value in periods of both base currency strength and weakness, therefore making it easier for the plan to assess the manager’s skill.
Finally, the choice specific of benchmark also has some impact on operations, as hedging programs generate realized profits and losses which need to be managed. Plans which have higher proportions of hedging will create larger cash flows. In the past, this has been an area of great concern to plans as the costs of continually investing and divesting in equities are high. There are now some simple low-cost solutions to this problem which should allow plans to select the most suitable benchmark without having to be concerned about this operational aspect.
Passive Versus Active
The most conservative way to deal with currency risk is passive hedging. This approach seeks to remove some or all of the return volatility caused by the currency component of a foreign portfolio while still allowing exposure to foreign stocks or bonds. By using this approach, investors can invest in non-domestic markets and avoid the potential losses due to a rising Canadian dollar currency. Currency overlay managers have been providing hedging services to manage this incidental currency exposure and have been making a stronger case in the recent past that currency should be viewed as a stand-alone asset class. The most important benefits of passive hedging include:
- a reduction of total international portfolio risk
- the ability to tight track
- management against a variety of base currencies and hedging benchmarks
- ease of integration into existing international equity and bond mandates through an overlay framework
- low transaction costs
- no additional investment at startup
Passive currency programs cover two types of service. The first type of hedging program involves hedging a fixed percentage of the foreign assets back into the base or domestic currency. The second type of passive program is often called neutralization hedging. This is a hedging program which eliminates the active currency positions which result from underlying equity managers taking active equity positions. For example, a manager may take an overweight position in U.S. equities. U.S. equities may outperform other markets, but if the U.S. dollar is weak at the same time, then the overweight dollar position will reduce the value added from the equity decision. The neutralization hedge will move the U.S. dollar exposure back to its benchmark level and, therefore, allow the portfolio to receive the full benefit of the equity decision without suffering from the adverse currency impact. Not only does this process eliminate unintended currency positions, it also reduces the active risk taken and leads to more efficient use of active risk budgets.
Once a plan has decided on the amount of strategic or passive hedging on its international assets, the next step is to consider whether or not to use an active manager.
The case for active management of currencies is strong and any plan that utilizes active equity or bond managers should seriously consider active currency management. The rationale behind any active management is that there are inefficiencies in the market which can be identified and capitalized upon. Active management can only add value if these inefficiencies exist as permanent features of the market and can be exploited without losing all of the value added by way of transaction costs.
Currency markets fulfill these conditions particularly well. Unlike bond and equity markets, not all investors who buy currencies do so with the profit motive. Many investors invest to pursue other goals. For example, central banks frequently seek to smooth volatile currency markets, while corporate treasurers need to lock in the value of overseas assets and avoid currency risk. These and other investors will continue to be participants in the future and will contribute to keeping the market liquid but inefficient. These inefficiencies can be observed through predictable behaviour such as trending and mean reversion of over/under valued currencies.
This enables skilled currency managers to identify and exploit enough of these predictable movements to be able to add value. This leads to the conclusion that favourable conditions exist which offer the opportunity for active currency management to add value. In addition, this should most definitely be entrusted to a specialist currency manager both to eliminate the currency losses from active equity managers as well as to generate a separate source of value added.
Active programs are designed to add value by tactically changing the hedges around the benchmark levels. The objective of most programs is to increase hedges in times of base currency strength and reduce hedges when the base currency is weak. This allows the plan to avoid currency losses when foreign currencies are weak, but still benefit from currency gains when foreign currencies are strong. These programs can be implemented at almost any level of active risk, depending on client preference. In the past, most programs only allowed the currency manager to reduce or increase individual hedges up to the level of underlying assets in that currency. More recently, research from overlay managers has shown that some clients have recognized that their overlay programs could generate more value for the same amount of risk if these restrictions were relaxed.
A number of studies have been published in the last three to four years which have provided strong support for the active management of currency risk in global portfolios. Furthermore, currency experts have shown there are worthwhile riskadjusted returns to be extracted from the foreign exchange markets.
Implementing An Overlay Program
The vast majority of overlay programs are implemented using forward foreign exchange contracts. The hedges would only be implemented through high quality counterparties which are leading participants in the foreign exchange market. As mentioned earlier, the major operational issue to be considered when implementing an overlay program is the management of the cash flows from the maturing hedges. If the plan does not have strategic cash reserves through which the cash flows can be channelled, other solutions must be considered. If these flows are directed into and out of the underlying equity managers’ portfolios, the costs of constantly buying and selling equities could be quite high. However, there is a much simpler solution. The currency manager is funded with a cash pool at the start of the program representing approximately six to seven per cent of the assets being overlaid. This cash can come from an equity program such as an S&P500 allocation or domestic equities. The currency manager re-equitizes the cash by buying the appropriate futures contracts and then uses the cash pool to pay and receive the profits and losses from the hedges. This is advantageous as it is a completely self-contained program which keeps the cash fully exposed to the equity markets and does not disrupt the underlying managers. Each time there is a cash flow into or out of the pool, futures contracts are bought or sold to maintain 100 per cent equitization. Full separate accounting can be provided for the equitized cash account to monitor its performance against its equity benchmark. The costs of managing this process are minimal as there is no extra management fee for the service and the transaction costs from trading in futures contracts are minimal.
Many misconceptions exist about currencies, perhaps because free-floating regimes have existed for approximately 30 years. It is important for investors to adopt the same rigour and discipline in their analysis of currency risk as they do for the management of other asset classes.
Gregory J. Chrispin is director, global structured products group, at State Street Global Advisors.
1. The Foreign Property Rule was set at 10 per cent in 1971. It was raised in stages of two percentage points per year to a maximum of 20 per cent over the period 1990- 1994 and subsequently raised to maximum of 30 per cent in two stages over the period 2000-2001.
2. The level at which international assets start to impact overall plan volatility is commonly taken to be 10 to 15 per cent.
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