The Right Hedge
Extracting value in passive currency management

By Maxime Tessier, Vice-President – Currency Management, CIBC Global Asset Management

Thanks to persistent inefficiencies in foreign exchange markets, active currency management has been, on average, more successful in adding value than active management of bonds or large-cap equities. Plan sponsors can capture these currency market inefficiencies through an unconstrained, alpha value-added solution or simply through the optimization of currency benchmarks and the dynamic management of these benchmarks.

Traditionally, currency benchmarks have been the by-product of underlying asset allocation benchmarks. Plan sponsors often take the currency exposure that stems from their asset mix and decide whether or not to hedge this exposure back into Canadian dollars, in whole or in part. This creates two potential problems. First, the optimal country mix for stocks and bonds may not be the optimal currency mix. Secondly, hedging is a one-way gamble away from foreign currencies toward the base currency. There is scant empirical evidence that Canadian-based plan sponsors who hedge their currency exposure earn better returns than those sponsors who don’t hedge. However, there is robust evidence that hedging does increase portfolio risk.

Based on research, one solution that consistently boosted portfolio returns with little or no impact on risk was to hedge selectively based on carry (the interest rate difference between foreign currencies and the domestic currency). Other short-term hedging decisions were left to a tactical currency manager.

The right mix
Another approach that minimized portfolio risk without hedging was to maintain the overall level of currency exposure while redistributing this exposure more evenly. This eliminated the large exposure concentration in U.S. dollars and euros typically caused by the use of capitalization-weighted stock and bond benchmarks, while it upheld the diversification, risk-reducing benefit of maintaining exposure to foreign currencies. As a result of this research, it was concluded that adopting a more balanced currency exposure benchmark is preferable to indiscriminate currency hedging for Canadian plan sponsors.

Dynamic management of currency benchmarks could offer attractive solutions for plan sponsors seeking to capture the excess returns inherent in the currency market. This trend has already taken hold for equities with the introduction of fundamental indexing (the use of systematic tilts based on fundamental criteria while investing in equity indices). To test this, an experiment was conducted with three such tilts for currency exposure—contrarian, mean-reverting and value. The results improved the risk/return profile of a balanced portfolio. The mean-reverting approach, for example, entailed an increase or decrease of 2% of total currency exposure, on a currency-by-currency basis. Currencies that had increased in value over the preceding five years had their weights decreased by 2% for the next five years while currencies that had dropped had their weights increased by 2%. Here again, it was found that these small, long-term adjustments could boost overall portfolio returns by roughly 40 to 50 basis points annually, with consistent positive results for most five-year intervals. More significantly, this was achieved with very little effort and at little or no increase to total portfolio risk. This research was based on historical data for fixed, five-year periods from 1980 to 2005.

As Canadian plans gain experience and confidence investing globally, they will increasingly demand more from their external managers and investment consultants with regards to currency. Equipped with the expert advice of their external currency managers, plan sponsors could implement currency benchmark optimization and dynamic benchmark management themselves, while leaving active currency management in the hands of their external managers.

To view Maxime Tessier's presentation, click here.