It is a common understanding that when investing in international assets, there are two sources of risk: the volatility that comes from the underlying asset itself and the volatility of the currency in which the international asset is denominated vs. the base currency of the portfolio.
Institutional investors typically invest in international assets to access the risk premiums available in overseas markets as this can provide attractive return opportunities. Historically, many investors have chosen to hedge the currency risk associated with these overseas investments by employing a passive currency hedge within the portfolio.
I believe that employing a passive currency hedge is suboptimal and beset with potential problems, and that an active approach to managing the currency risk can materially improve the risk/return characteristics of the overall portfolio.
There are three reasons a passive currency hedge to eliminate currency risk in an international portfolio is a suboptimal strategy.
- The returns from currency exposures are typically uncorrelated with those of traditional financial assets. Hence, it is advantageous to retain at least a portion of the underlying currency exposure as this will enhance the risk/return characteristics of the overall portfolio. The lack of correlation is due to currency markets being of a completely different character to equity or fixed-income markets; different fundamental drivers are responsible for both the level of valuation and cyclical trends.
- A passive hedging strategy only focuses on the risks associated with currency exposures and ignores the aspect of cash flows. Indeed, in periods of base currency depreciation, a passive hedging strategy will incur substantial losses that will need to be funded, resulting in negative cash flows as the hedges are rolled over. Such negative cash flows likely will require the sale of portfolio assets to raise cash, which can interfere materially with the asset allocation policy of the portfolio.
- A passive strategy ignores the potential to add value via generating positive returns through the active management of currency exposures over time. There is substantial empirical evidence in support of currency markets being a source of absolute returns. Furthermore, this return stream is typically uncorrelated with other return streams in the portfolio (for the reasons highlighted above) and therefore highly accretive to the overall risk/return characteristics of the portfolio.
Employing an active currency overlay can overcome these difficulties.
Currency returns are lowly correlated
The character of currency markets is key to the lack of correlation with traditional financial market assets. Currency markets typically move in long-term cycles around competitive fair value. The competitive fair value between two currencies itself changes over time, according to the relative productivity and inflation differentials between the two economies/currencies. Currencies rarely stay at competitive fair value, due to the interaction of the economic cycles existing in each economy, and typically move between periods of overvaluation and undervaluation as a result.
Accordingly, in periods of base currency undervaluation it will be preferable to employ a high hedge ratio on foreign currency exposure (anticipating a rise in the base currency toward fair value) while in periods of overvaluation it will be preferable to have a low hedge ratio (anticipating a fall in the base currency toward fair value). A passive currency hedge, which is static in nature, does not take into account the cyclical nature of currency markets.
The purpose of an active currency overlay program is to vary currency hedge ratios over time depending upon the macroeconomic and financial market circumstances prevailing at any time. It will enable the hedge ratio to be increased in anticipation of periods of base currency appreciation and reduced in anticipation of base currency decline. The dynamism afforded by this approach can provide substantial added value by adjusting portfolio hedge ratios (and cross hedges) in accordance with prevailing financial market and macro-economic conditions.
Negative cash flows are damaging
An example of how a passive hedging strategy can lead to substantial negative cash flows at inopportune times is the aftermath of the financial crisis of 2008. From early March to the end of November 2009, the U.S. dollar index declined 17.2% (an annualized rate of 22.8%). The rolling over of passive currency hedges on foreign currency exposure into the U.S. dollar during this period would have resulted in very large realized losses. As a result, it would have required a substantial amount of portfolio assets to be sold to cover these losses and settle resulting cash flows. At the same time there was a major inflection point in the global equity markets whereby many international equity markets rallied by more than 50% in the period. The task of managing an asset allocation policy during tumultuous market environments in the face of funding large currency losses can be very disruptive.
An active currency overlay by contrast would have had the flexibility to be responsive to the driving forces moving the U.S. dollar lower during this period, and therefore employ a vastly different hedging policy than a static passive hedge. Given the potentially damaging impact of negative cash flows from an ill-timed and ill-suited passive hedge, it is advisable to engage in an active currency overlay that can mitigate negative cash flows
Currency markets as a source of additional return
In the same way that equity and fixed-income market exposures are adjusted over time within asset allocation polices in order to improve the return outlook for investment portfolios, the adjustment of currency exposures over time in response to changing fundamentals can be a source of additional return.
Indeed, empirical evidence suggests specialist currency investment managers are able to generate pure absolute returns from currency markets. Despite currency markets being the most liquid, transparent and cheapest to trade with the highest daily turnover in the world, unlike in equity or debt markets, most participants are not profit maximizers. For example, corporate treasurers trade currencies to manage trade flow payables and receivables, while central banks often trade currencies to achieve monetary policy objectives, but neither trades currencies for the explicit reason of generating a return. This creates an exploitable inefficiency for specialists. This cannot be said of the U.S. equity market, which is dominated by profit seekers and hence is much more efficient.
The below analysis illustrates how the addition of a low risk currency overlay program to an international equity portfolio, with a 50% passive currency hedge, can materially improve the portfolio's returns and risk/return profile.
What started out as a portfolio problem of additional volatility associated with investing in international assets can be turned into a virtue. By actively adjusting exposures to portfolio currencies, specialist currency managers can generate an additional return stream that otherwise would not exist and mitigate cash flow issues that beset passive (static) hedging programs. Furthermore, it is typical that returns generated from taking active currency positions will be uncorrelated with the underlying asset returns in the portfolio and therefore enhance an investment portfolio's overall risk/return characteristics.
In summary, an active currency overlay has many advantages over a passive currency hedging strategy. There is no reason to believe the optimum amount of currency exposure in a portfolio should be constant over time, as in the case of a passive hedging approach. Indeed, it would never be considered appropriate from an asset allocation perspective that optimum exposure to equity or debt markets in an investment portfolio should be fixed and unchanging over time.
Furthermore, an active currency overlay directly addresses the issue of potentially negative cash flows, which might result from the rollover of currency hedges, by taking an active approach to mitigating this impact. Lastly, and potentially most significantly, an active overlay strategy has the potential to add incremental and diversifying returns to a portfolio and enhance its aggregate risk/return characteristics. An active currency overlay strategy has the potential to add value in many key facets of portfolio management and should be considered as a core part of any integrated asset allocation policy.
Mark Astley is CEO of Millennium Global Investments, London.