International investing is a common practice across traditional asset classes and investment strategies. In recent years, the alternative market has become a new asset allocation tool with a two-fold rationale:
q risk diversification, as alternative investment strategies are de-correlated with traditional ones and often serve as a hedge; and
q a historically strong (albeit short) track record in a low real-interest rate environment.
Following the Asian crisis in 1997 and the Long-Term Capital Management debacle in 1998, investors have since analysed opportunities with alternative investments and managers to further diversify their asset allocation away from traditional assets, markets and strategies.
There is no doubt that this new asset class has emerged as a good fit into global asset allocation portfolios for non-restricted pension schemes. Large US public pension funds decided over the past 12 months to increase their alternative asset allocations.
European pension funds may be ready to quintuple their alternative investments over the next three years according to recent specialised surveys. This coincides with the review of preventive rules by national regulatory bodies for a more accommodative approach while leveraged offshore funds and money managers are under scrutiny for more investment transparency and risk control.
Most of the alternative vehicles available for large investors have been designed and marketed in US dollars because the managers are US-based and the demand has historically come from US money centres. Consequently, European, Japanese and UK-based investors willing to invest in alternatives have to buy dollars and ultimately decide whether or not to hedge their investments. The track records of dollar-denominated alternative investments, although short, have been strong enough for non-US investors to leave the investments either unhedged or fully hedged in a passive way, implicitly going bullish on the dollar or believing that its potential depreciation would be small in balance. The beauty of such diversification has been, in a sense, regardless of the currency risk.
European investors that went fully hedged on their US dollar alternative investments would have significantly undermined the performance, not to mention the detrimental cash flows from rolling the hedges. Besides, in such a bull trend for the dollar, the best passive currency management would have been to be unhedged over the period, and especially since September 1998. Will the dollar’s strength last over the next five years? Can we envisage a successful active currency hedging management in the future?
Over the long run, currency returns might be a zero sum game. As the short-term currency impact matters, one has to take a close look at the time-horizon when going into alternative investments. We suspect that investors turn over more aggressively their allocation to alternative than to traditional assets, reflecting the above-average annual return and volatility of the former and, to a lesser extent, the fortunes of managers. That, of course, is not a rule of thumb. In brief, the currency risk related to alternative investments calls on its own for a more active currency management approach.
One could object that in such a dollar bull trend, associated with high absolute returns, there is no added value in actively hedging the alternative investments. This refers to the ‘one way ticket’ effect: a currency overlay manager with an unhedged benchmark can only benefit from hedging when the foreign currency is weakening, unless you give the manager the possibility to leverage the dollar exposure – through options, for instance. Although continuous trend currency movements can last for long periods, we believe that the selection of a currency benchmark in this asset class could smartly reflect at some stage the investor’s directional view on the dollar. More interestingly, a currency benchmark other than the passive 0% hedged would certainly enhance the volatility profile of the alternative portfolio returns hence the overall risk-reward ratio on the investments. As always, the selection of the currency benchmark is not easy. Either the investor considers that passive unhedged or fully hedged benchmarks are respectful of the strategic alternative investment philosophy, or that the currency element is to be managed separately hence adopting an active management of the currency risk with the relevant strategic/tactical currency benchmark.
Adding a currency overlay programme in $/e is not shifting away from the above two-fold rationale of the alternative merits but rather adding another risk-reward layer on the investment allocation.
We have used the broad CSFB/Tremont Hedge Fund Index (US$) as a representative track record of the alternative asset classes and strategies. We have applied our currency overlay programme managed against a 50% hedged benchmark and a fully hedged benchmark for a European investor. The rationale of analysing a 50% hedged currency overlay programme is that it allows perfect symmetrical opportunity bets, eg, hedging on both sides of the benchmark. In contrast the fully hedged benchmark is the gauge for investors willing to go into alternatives without the currency risk but with cash flow issues from losing hedges.
While clearly in a $/E bull trend over that period, our active currency overlay programme has primarily added performance with risk-adjusted off-benchmark allocations. This advocates for a successful active currency overlay management primarily adding alphas in a ‘traditional’ manner. One should of course mind the hedging gains of such a programme when the dollar depreciates.
Alternative investments have emerged as a new trend in global asset allocation and risk diversification. Primarily oriented towards US investors, they have gained popularity among European and Japanese investors who merely have had the choice but to “buy the allocation in dollars”. Although the benefits have proven very rewarding in dollar terms, the currency performance issue has not yet been fully tackled by marketers. This is probably because neither have the merits of active currency management been demonstrated nor have the currency movements been adverse enough to be damaging.
Recently, guaranteed funds and structured products have been designed by European money managers with passive fully hedged currency management. As the euro has dropped by more than 20% against the dollar since its launch, such strategies have certainly rekindled the active currency management debate once more. The alternative industry should enhance its market share and client base by offering vehicles denominated in euros, pounds or yen through active currency overlay programmes. In alternative investment management, the community of currency overlay managers has to demonstrate that active currency management is not a derivative decision but rather a genuine risk-reward investment allocation to the benefit of the investors.
Hélie d’Hautefort is managing director and Renaud Mattis is portfolio manager at Overlay Asset Management in Paris