A Look at Currency Exposure for Canadian Pension Plans
Currency issues for institutional investors
It has already been over a decade since changes in foreign investment regulations have allowed Canadian pension plans to increase their proportion of assets in global investments. This increase in foreign asset exposure has led to greater exchange rate risk for international investors, resulting in a wider discrepancy between assets and liabilities for Canadian pension plans that pay benefits in Canadian dollars.
Investors have three options at their disposal with regards to their foreign investments:
- Receive the local currency return on their foreign investments plus the changes in exchanges rates;
- Hedge the currency risk/return;
- Actively manage their currency exposure.
Investors that have international portfolios need to consider the impact of changes in exchange rates on their domestic return and the contribution of currency risk to their total portfolio risk. If a decision is taken to hedge an international portfolio against the effects of changes in exchange rates, the volatility of unhedged vs. hedged returns should be considered. Depending on whether the investors would like to fully or partially hedge the portfolio, an optimal hedging ratio should be determined.
We begin by reviewing some common beliefs that investors have about managing currencies. First, it is widely believed that exchange rates revert to the mean over time, which translates into a null return over the long term. Second, investors feel that currency fluctuations cause high volatility in their portfolio over the short term. Third, short-term investors should worry more about currency risk than long-term investors. Finally, investors believe currency risk represents an additional uncertainty with unpredictable returns and should be eliminated as much as possible. In the rest of this article we will try to determine the validity of these convictions.
CAD in USD 15 year period from 2000 to 2014
Exchange rate volatility
In the 15 year period ranging between 2000 and 2014 (see Figure 1), the Canadian dollar versus the US dollar has fluctuated from $0.69 in the beginning of 2000 to $0.86 at the end of 2014, reaching a low of $0.62 in early 2002 and a high of $1.06 in late 2007 and again in early 2011. The volatility of our currency for this period, measured by the standard deviation, was high at 9.1 per cent. The dollar went through a period of appreciation against the US dollar between 2003 and 2007, where it gained as much as 9.7 per cent and then went through a period of depreciation between 2011 and 2014, where it declined in value by 3.8 per cent.
If we extend the analysis to a 35 year period ranging from 1980 to 2014 (see Figure 2), the Canadian dollar gained almost no ground, but was still quite volatile, resulting in a standard deviation of 6.9 per cent. In the second chart, a longer term overview of the Canadian dollar shows an example that currencies can revert to the mean over extended periods of time (from $0.86 in January 1980 to $0.86 in December 2014), but it also shows that international investors can expect high levels of currency fluctuations over time.
CAD in USD 35 year period from 1980 to 2014
When compared to a basket of major world currencies consisting of the US dollar, the British pound, the Euro, the Australian dollar and the Japanese Yen, the Canadian dollar exhibited similar volatility as with the US dollar.
Hedging the currency risk/return
Global portfolio returns (in domestic currency) basically consist of two components, the local market return of the foreign investment and the return from changes in exchange rates. The best scenario for an investor in foreign markets occurs when the value in foreign investments rises and the domestic currency depreciates in value. The worst scenario occurs when the value in foreign investments falls while the domestic currency appreciates in value.
Currency hedging can be used by investors to reduce or completely remove the risk of fluctuations in exchange rates on foreign investments. The hedging process adds a third component to the return calculation. The returns from hedging are generally dictated by the hedge ratio, which is defined as the return from derivative products used for hedging purposes multiplied by the proportion of foreign investments that are hedged.
Investors can very simply hedge their foreign investments by investing in a fund that is hedged against currency fluctuations or they can use an external currency overlay manager. Hedging of currency risk can be achieved by either selling currency futures or forwards, by buying currency option contracts (puts or calls) or by entering into currency swap agreements. The preferred product is forward exchange contracts due to their customization attributes. Option contracts can act as a form of insurance but the main advantage of forwards or futures is that they do not require the payment of money up front. In the situation where an investor uses several investment managers for its international strategy, the management of the aggregate currency positions can be delegated to a single currency overlay manager.
After a decision to hedge foreign currency is made, investors must determine the level of currency hedging they will adopt. They can decide to fully hedge or to partially hedge their foreign investments. Partial hedging can be achieved by using either a static hedging ratio (for example 50 per cent) or by using a dynamic hedge ratio, such as a ratio that varies from 0 per cent to 100 per cent depending on changes of exchange rates. Dynamic hedging can be based on the domestic exchange rate in relation to another currency, for example the Canadian dollar to the US dollar, or it can be established in relation to a basket of several currencies. Once a hedging ratio is determined, investors must also decide which currency, which strategy and which asset class will be hedged. Major currencies that are usually hedged by Canadian investors are the US dollar, the British pound, the Euro, the Australian dollar and the Japanese Yen. Commonly hedged investment strategies are Global, ACWI, EAFE and US equity. It can be difficult to hedge Emerging market strategies, as some currencies may be thinly traded, controlled or pegged and the use of currency cross-rates may be required.
To hedge a global portfolio, investors have the option of hedging only one currency, for example the US dollar, or they can hedge several currencies individually. Given the high correlation among some currencies, not all currencies found in a strategy require a hedge. Another option available to investors is to hedge a basket of major widely traded currencies used in the underlying strategy. The weight applied to each currency must be determined when hedging a basket of currencies.
Simple hedging rules with a fixed hedge ratio are commonly adopted. As a general rule, a lower hedge ratio is preferred by investors under the following conditions:
- There is a low proportion of international assets in the total portfolio;
- There is a long investment time horizon;
- The domestic currency expected to be weak;
- There is a high perceived cost of hedging.
Certain aspects of behavioral finance can help investors not only determine their risk tolerance but also establish their optimal hedge ratio. ‘Regret risk’ can be associated with holding the wrong hedge in the wrong conditions, for example, being fully unhedged when the Canadian dollar is appreciating. To minimize ‘Regret risk’, a simple hedge ratio to adopt would be 50 per cent. As a rule, the higher the investor’s ‘Regret aversion’ the closer the ratio should be to 50 per cent.Over the years, there have been a lot of studies on hedging rules and hedge ratios. A study by Solnik & McLeavey (2013) looked at the distribution of benchmark hedge ratios for 563 institutional investors around the world that delegate the currency hedging decision to overlay managers. The study found that hedging policies vary across countries and that the 0 per cent, 50 per cent and 100 per cent hedge ratios are the most commonly used. Another study, Michenaud & Solnik (2008), cumulated worldwide currency hedging practices and found that 39 per cent of investors do not hedge, 34 per cent adopt a 50 per cent hedging strategy, 14 per cent adopt a 100 per cent hedging strategy and 13 per cent use another hedge ratio. The study also found that a 50 per cent hedging strategy appears to be gaining in popularity around the world. In a 1998 article published in the Journal of Portfolio Management, Bruno Solnik stated that partial dynamic hedging against currency risk is optimal.
A comparison of US equity and Global equity portfolios over a 15 year period (from 2000 and 2014) showed that, for a Canadian investor, fully or partially hedging those strategies increased returns over the long term but also increased the volatility of the portfolio. The comparison showed that over the long term, because the Canadian dollar is considered a risky, commodity-dependent, weak currency, and because the Canadian dollar shows signs of positive correlation with world stock markets (it is weak when global markets fall), Canadian investors can benefit by keeping the foreign exposure in their portfolio because it acts as a natural hedge. Otherwise, if investors are long the Canadian dollar by being hedged, the volatility of their portfolio returns will be increased in the long run. The situation is different from the point of view of an American investor. Since the US dollar is considered a reserve currency (a safe-haven), American investors should hedge the foreign exposure in their portfolio because it is more beneficial, from a risk versus return standpoint, be long their own currency.
A second observation from this analysis was that if investors decide to hedge their foreign investments, their hedging rules should be dynamically adjusted based on the level of exchange rates. The hedge should be maintained during periods of Canadian dollar appreciation and withdrawn when the Canadian currency depreciates in value. For example, the optimal time to be hedged was during the period from 2003 to 2007 when the Canadian dollar appreciated in value. During this period, hedging not only increased returns for a Canadian investor but also decreased volatility.
Finally, analysis showed that the benefits of hedging also vary depending on the asset class. After applying the same type of analysis for hedged and non-hedged international bond portfolios, hedging showed positive effects on portfolio returns as well as on portfolio volatility. As correlations between asset returns and currency returns differ across asset types, international bond portfolios could justify a different benchmark hedge ratio than international equity portfolios.
Active Currency Management
Actively managing currencies is a strategy gaining in popularity because the foreign exchange market is the largest and most liquid in the world and more currencies are now available for trading. Also, managers are now offering reasonably priced investment solutions that solely invest in currency instruments. Here are some currency management options that are available to investors:
- Balanced mandates: the fund manager is responsible for currency exposure by following the hedging rules specified in the SIPP.
- Currency overlays: an expert in foreign currency management is hired to manage the currency exposure by hedging part or all of the currencies in the investor’s international portfolio. An active currency overlay manager can deviate tactically from the assigned hedging benchmark specified in the SIPP.
- Managing currencies as a separate asset class: a currency manager takes speculative positions in foreign currencies.
If the correlation of currencies with other asset classes is low or negative, then the expected risk of the portfolio will be reduced by adding currencies as an asset class. Active currency management may be able to provide better return potential with lower risk than using a simple passive hedging strategy.
In summary, long-term Canadian investors should worry less about currency fluctuations as the Canadian dollar does revert to the mean over time and some foreign currency exposure can help the long-term stability of the portfolio. Since hedging foreign equity investments actually increases the level of volatility in the portfolio, Canadian investors would have less volatility in their portfolio by not hedging their international portfolio. However, if investors prefer to hedge their foreign equity investments, a dynamic approach to hedging seems to be the best strategy for Canadian investors, but it always depends on each investor’s skill and risk tolerance.
Michel Charron (CFA), is an investment analyst at PBI Actuarial Consultants Ltd. firstname.lastname@example.org.