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April 2008 - Whether to hedge or partially hedge the Yen is a question coming to the fore again recently and finding its way onto the agenda of investment committee meetings of Japanese pension funds. After several years of weakness, the yen has started to appreciate since last summer on the back of the unwinding of the carry trade triggered by the sub-prime crisis and general investor risk-aversion.

Traditionally many Japanese pension funds kept non-yen exposure unhedged to a large degree, due the unusual high cost of hedging from a base-currency with as low a short term interest rate as the yen. Until recently this made the foreign equity bucket of pension funds the most profitable investment category, but recently the situation has reversed and yen strength combined with negative returns in local terms have caused a “double whammy” for unhedged JPY-based investors.

The asset class outperformed all other standard asset classes in the fiscal year 2006 (April 2006-March 2007) with 17.85% partly thanks to strengthening foreign currencies (although the USD was roughly flat over this period, the EUR and AUD strengthened double digits). However in fiscal 2007 foreign equities have lost about 10% expressed in yen, not least due to a fall in the USD to the same degree.

The fundamental question as to whether or not to hedge has been the subject of ample empirical research with some degree of consensus that non-base currency exposure in the long term does not come with a positive expected return, whilst it does entail incremental risk.

According to this line of thought, as a non-rewarded risk factor, FX risks should be fully hedged. It is unclear however to what degree this argument holds for a base-currency as unfavourably positioned in terms of hedge costs as the Japanese yen. Indeed if currency markets are driven largely by short term interest rate differentials, a view supported by much empirical research, the systematic interest rate disadvantage of the JPY could argue for unhedged exposure, even without using the hedge cost argument. This has led many Japanese pension funds to be un-hedged when it comes to their equity exposure and often less than fully hedged on their foreign bond exposure.

Now that the risks are becoming more apparent, theoretical arguments against hedging are overtaken by the notion that the yen is at last making a comeback from what was a significant level of undervaluation. Anyone who has made a recent business trip to Japan must have been surprised by the inexpensive cost of hotels in downtown Tokyo, compared with other major cities. My Japanese colleagues tell me the most surprising thing about a trip to London these days is the subway-fare converted to JPY.

Meanwhile, the cost of hedging has declined substantially due to looser monetary policy in some of the main economies, the USA in particular. The short term interest differential between USD and JPY, having hovered well above 4% for over two years, has seen a steep decline entering 2008 to just above 2% currently, making the effort of taking away currency risks a lot cheaper. This probably drives the issue onto the agendas of investment committees: if hedge-cost will be lower in the near future, does it still make sense to keep the risk on the books whilst further depreciation of the yen would only drive the JPY further away from what the average Japanese feels is an already undervalued currency.

The counter argument would say: if the Japanese economy continues to under-perform and interest rates continue to be at or near zero, it is hard to imagine significant and substantial appreciation of the currency, apart from the occasional flight out of carry trades giving the yen a short term boost.

Meanwhile many funds are monitoring the trend in Europe towards a recognition that currency offers possibilities to enhance returns through active management. The thinking goes like this: Currency markets are not dominated by return-seeking participants. Exchange rates are mostly driven by policy actions of central banks, and actual money flows, be they from international trade, corporate hedging or just you and me traveling outside our home currency zone. So the market is efficient in a technical sense, but inefficient in an economic sense. Empirical research suggests these inefficiencies in currency markets can be exploited to generate attractive risk-adjusted returns. Moreover, they can claim a fair share in a pension fund’s risk budget, especially since these currency alpha returns might be lowly correlated with other portions of the fund’s risk budget, such as equity. One could therefore hedge part of the outright foreign exchange risk and add a degree of active currency risk, and cover the hedge costs o the former action by alpha returns from the latter program, improving the risk-return profile of the total portfolio in the bargain.

While the hedging issue remains a particularly tricky one for a pension fund in an ultra-low interest-rate country, it will be interesting to see pension funds embrace the currency alpha concepts being put forward. 

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