1. What should the benchmark be?
This is an important strategic issue that ought to be considered as part of every investment strategy review. The options range from 100% unhedged at the one extreme to 100% hedged at the other extreme, with various degrees of partial hedging in between. You should estimate the implications of each option for risk at the overall portfolio level rather than just at the individual asset class level, using a risk measure that is meaningful in terms of your overall investment objectives. These estimates will never be perfectly accurate, but at least they should give you an idea of what ballpark you should be looking at in setting the hedge ratio in the benchmark. (Just where that ballpark lies will vary according to how much of the portfolio is invested internationally, which of course is something that also ought to be considered as part of the strategy review process. In most cases it will point to some degree of partial hedging.)
2. What are the transaction costs of hedging?
The transaction costs arising from currency hedging include not just the bid-offer spreads that you need to incur when you roll the hedges over periodically, but also the indirect costs of dealing with the positive or negative cashflows that arise when the rollovers occur. Provided that these cash flows are efficiently managed, the overall transaction costs for hedging developed market currencies should average out at somewhere between 0.1% and 0.2% a year (on the value of the assets being hedged). Bearing this in mind you will need to strike a trade-off between risk reduction and transaction cost minimisation, which will often mean setting the benchmark hedge ratio towards the lower end of the ballpark range that you arrived at through the risk analysis mentioned above.
3. What are the cashflow implications of currency hedging?
A currency hedging programme will normally entail rolling over forward foreign exchange contracts at regular intervals. The rollovers crystallise the accumulated profit or loss, thereby creating positive or negative cash flows that need to be dealt with. In a typical programme with quarterly rollovers, the amounts of these cashflows might average out at around 2% to 3% of the value of the assets being hedged, but in extreme circumstances when exchange rates have moved dramatically they might be double this level or even or more.
At worst you might get a phone call from your currency overlay manager asking you to raise many millions in cash within a few days. It is a good idea to maintain a cash buffer with the currency overlay manager so that you don’t have to incur substantial transaction costs to raise the cash when that phone call comes. If the cash buffer gets depleted by negative cashflows you have the whole period until the next rollover date in which to find the cash to top it up, and vice versa if you get a strong positive cashflow.
(The currency overlay manager can advise you on what the level of this cash buffer should be. In most cases you should also consider equitising the cash buffer with share price index futures contracts, so that the cash does not create a drag on your long term investment returns.)
4. What currencies should be hedged?
The transaction cost estimate of 0.1% to 0.2% a year mentioned above was for developed markets. The costs of dealing in emerging markets currencies tend to be much higher – beyond 5% pa in many cases – so it doesn’t normally make sense to hedge the emerging market component of the benchmark.
5. Should the benchmark be based on the make-up of the underlying equity portfolio, or on the make-up of the benchmark for that portfolio?
In most cases the latter will make more sense – otherwise your currency exposures will effectively be driven by which equity markets the underlying manager likes best. We often see active international equity managers adding value by picking the right equity markets, but losing part of that added value on currency because the right equity markets turn out to be the wrong currency markets. However, if there is any scope for emerging markets to be overweight or underweight in the underling equity portfolio, then the emerging markets component of the currency overlay benchmark should be based on the actual exposure, so that the currency overlay manager doesn’t have to deal in emerging markets currencies just to get the exposure into line with the benchmark.
6. Active or passive currency overlay management?
Implementing a partially hedged benchmark does not necessitate active management of currency exposures. As with equity and bond management, the default option is passive unless you can find active managers that you consider to be capable of adding value. Having said that, at Mercer we feel that the case for active currency management is at least as strong as the case for active equity and bond management, if not more so. (A number of studies have found that currency overlay managers have, on average, been successful in adding value.)
7. How wide should the ranges for an active currency overlay mandate be?
All good things are best enjoyed in moderation. Even the best active currency overlay managers are bound to underperform from time to time. Setting ranges for currency exposures helps to keep these fluctuations in relative performance within a range that you can live with. Anything between plus or minus 5% and plus or minus 20% for each major currency would be reasonable in most cases (expressed as percentages of the underlying portfolio value), depending on the range of fluctuations in relative performance that you feel comfortable with.
8. Should the purpose of active currency overlay management be to add value or to reduce risk?
Most people think of currency hedging as being risky, and of active currency management as being even more risky. Most currency overlay managers have figured this out, and in their marketing pitches they try to differentiate themselves in terms of the risk reduction features of the service they have to offer. In our view this differentiation is often more illusion than reality. Currency hedging does offer scope to reduce risk, but most of the risk reduction comes from the strategic decision to set a partially hedged benchmark, rather than from active management around that benchmark. Active currency overlay management will certainly reduce your risk further if value is added at the times when you need it most, but this cannot be guaranteed.
9. How should a currency overlay manager’s performance be monitored?
You should monitor performance relative to the agreed benchmark, even for passive overlay mandates, just as you would with any other type of investment manager. However an issue specific to currency overlay is that the reporting needs to separate out the profit and loss arising from the overlay into the component that would have arisen if you had simply hedged passively, and the residual, which is the value added or subtracted through active currency management decisions.
10. How do we find the best active currency overlay managers?
Simple – ask your investment consultant for advice on this issue!
Bill Muysken is head of manager research global at William M Mercer Investment Consulting in London