The four steps
Currency management is fundamental to the management of international investment portfolios. Currency risk can be a highly significant component of the return of these portfolios, particularly over ‘short’ time horizons (below five years), long enough to substantially impact plan funding. Apart from this embedded risk, there is the opportunity for currencies to be managed as an ‘asset class’ in their own right.
The lengthening, successful track records of managers have increased interest in currency management. There is currently estimated to be over $110bn (E97bn) in active external overlay programmes against a total international investment of $2trn world-wide. This can only grow given the current relative size, and given that currency returns are even more significant in today’s difficult asset markets.
We think of currency management in four steps, which are shown in the exhibit below:
One of the first steps is to determine the benchmark hedge ratio. The traditional method for addressing this problem is to conduct an ALM study, but quantifying the currency exposures in the liability stream can be problematic. Another quantitative approach is to conduct an asset-only optimisation, which is highly dependent on the inputs for volatilities and correlations between foreign exchange and the underlying assets. These relationships can be highly unstable with a requirement to optimise over multiple periods.
As a result of this difficulty, many plan sponsors instead rely on qualitative factors to determine the hedging benchmark. Each plan sponsor determines the relevant trade-off between multiple factors, such as
(a) their sensitivity to a change in value of the foreign assets in their portfolio (ie, under-funded status caused by base currency strength)
(b) their sensitivity to cash flows caused by open hedging contracts
(c) their sensitivity to peer group risk,
(d) the ‘opportunity cost’ of hedging, where the prevailing interest-rate differentials implied in hedging contracts are considered. In practice, many plan sponsors want to avoid ‘getting it wrong’ and as a result choose a 50% hedging benchmark, or the ‘benchmark of least regret’.
Fortunately, most quantitative studies identify optimal points anywhere from 40-70%, depending on time period chosen, so the 50% solution is not too far removed from the ideal.
Moving along the ‘road map’, we come to the active/passive decision, choice of style, and particularly diversification of style. A number of studies have shown that individual managers tend to produce return streams that are uncorrelated with those of other currency managers. The correlation between managers can be as low as 0.5, which is significantly low for strategies within any single asset class. The result is that the information ratio, the risk reward trade-off relative to the benchmark, can be improved through a combination of styles in multi-manager structures. Consultant research indicates that information ratios from these style combinations can be in excess of one.
The implementation stage of the ‘road map’ deals with many of the practical issues arising out of the earlier stages. A topical issue is ‘how broad a mandate should be implemented?’ With enhanced currency overlay programmes, where the currency managers might be given a very open mandate to add return to a portfolio through any combination of long/short currency positions, a plan sponsor takes advantage of the uncorrelated nature of the return stream with the rest of the investment portfolio. More and more currency managers we speak to are branching out into currency volatility trading, and emerging market FX, to further enhance returns from enhanced overlay, or ‘currency as an asset class’ mandates. However, there is a question mark over the protection afforded against adverse currency movement through this type of arrangement.
For instance, consider a US-based plan which leaves the currency risk of its EAFE assets unhedged but hires currency managers with open ‘alpha’ mandates, a 1% return target and 2% risk target. Is the plan protected against adverse currency movements in the EAFE? The currency mandate would require not 200 but 500 basis points of risk in order to offset the considerable currency risk contained in an unhedged EAFE portfolio – more risk budget to currencies than many plan sponsors are willing to provide. This suggests that a total return mandate on its own does not give the necessary hedging protection. An alternative arrangement that satisfies the risk-reduction requirement is to use a pre-determined hedge ratio, establish a passive currency mandate and implement the same alpha currency strategy. Now, the currency alpha mandates provide pure uncorrelated ‘portable’ return, whilst currency risk is effectively reduced through the passive mandate.
For the pension fund industry, currency risk management and the opportunity to generate alpha is increasingly important. Currency managers’ track records are long and favourable enough for most due diligence studies. Total return currency mandates have come of age, and deserve consideration alongside other alternative assets.
Matthew Annenberg is global head of FX analytics and risk advisory with ABN AMRO in New York