Seeking the Holy Grail
What to do about currency in investment portfolios? Investment bankers ABN AMRO brought together a range of the currency managers and institutional investors in Washington DC last month to consider this will o’ the wisp in portfolios, that can deliver nasty losses as well as welcome alpha.
Management of currency is fundamental to portfolios, Matthew Annenberg of ABN AMRO in New York told the conference. He posed the question, if currency mean reverted from time to time, how significant is this? His answer was to look at the current dollar cycle, which mean-reverted frequently. Looking at EAFE data, the currency component returns exceeded the equity 29% of the time on quarterly data and 20% of the time on yearly, he pointed out.
Investors should make a strategic decision about what proportion of assets to be hedged. “To me this is an efficiency argument – deciding on the benchmark.” As to whether currencies should be actively or passively managed rested on whether there were inefficiencies in the currency market. If there were opportunities, the question for investors is how to take this active risk – the style to be used. Finally, it is a matter of implementation.
“How do you get a perfect hedge – a zero cost option – so that if the currencies in your portfolio go down you are perfectly protected, and if they go up, you participate 100%?” By plotting currency returns on a monthly basis, an investor will see sometimes they are better off and sometimes worse off, from a hedge. He referred to an evaluation undertaken for clients, with a ‘best fit line’ “to see to what extent it looked more like the perfect hedge and how well the R2 lines is distributed around the best fit line,” said Annenberg.
In deciding on active or passive management, Adam Farstrup of consultants CRA Rogers Casey, said the
neutral starting point was passive. “Currencies can deviate from fundamental value for extended periods of time suggesting some level of inefficiency.” Transaction costs were small at 5 –30 basis points and active management fees low at 20bps.
Looking at the evidence, he said studies suggest currency managers have generated an information ratio of 0.5 and the results of three managers, who represent some 70% of institutional portfolios, show positive alpha, though recent performance was not strong.
On the hedging issue he said neither being fully hedged nor fully unhedged has been optimal for all time. But using some forward looking assumptions, he said the “optimal hedge ratio lies between 40 and 70%”.
A European speaker, consultant Robert Meier, formerly of the Shell
Pension Fund in the Netherlands, warned that the concept of strategic hedging needs to be understood at all levels of pension funds. “Hedge payments can be large and could have a substantial impact on the liquidity of the pension fund.” It might have to liquidate some assets to make the payments. There was what he described as “an emotional risk”, as senior management does not like to pay for hedge losses.
Daniela Klingabiel of the World Bank Pension Fund in Washington looked at an study from work she and a colleague Arjan Berkelaar undertook. Ideally, she said desired currency exposure should be determined in an ALM framework, but the fund was unable to do such an analysis as no liability projections in foreign exchange terms were available.
What was the optimal foreign exchange exposure using a hedge ratio approach, she asked. “The optimal hedge ratio depends on expected returns, volatilities and correlation assumptions from currencies.” In a case study of two asset classes, they found the optimal ratio unstable and dependent on on time horizon of analysis and the base currency. “Volatilities have virtually converged reducing the attractiveness of hedging,” Klingabiel argued.
In the multi-asset class case, the findings were that the volatility of hedged and unhedged equity returns have converged. She noted that the volatility of unhedged currency returns has increased as volatility of local stock market returns increased.
Since a formal analysis of hedge ratios does not yield clear guidance, she said plan sponsors should use more qualitative factors to determine strategic hedge ratios.
Eric Busay of CalPERs, the largest US pension fund, argued the case for bringing currencies into the asset allocation process. He suggested that it is possible to determine a passive hedge based on correlation. The problem is that correlations are not stable overtime. His model was based on a utility maximisation function with a tracking error component assuming a 100% hedge. “A hedge ratio can be determined based on the correlations of currency to all asset classes, taking into consideration interest rate parity.”