Currency Risk: the Verdict on Currency Overlay

Currency Risk: The Verdict on Currency Overlay
by Eric Innes

If one believed that an asset was inherently incapable of generating a return in the long run, would you allocate risk capital to it on a permanent basis? The answer seems obviously "no," but many pension funds still do. Many of the world's pension funds are skeptical and still do not hedge the currency exposures inherent in their foreign investment portfolios. The most common reason seems to be the view that currency gains and losses will net off in the long run. If this were the case, should a foreign portfolio hold currency risk if a return on that risk was not expected? We don't believe so. So, should currency exposures be hedged?

Our analysis considers this question and compares the risk and returns of an unhedged benchmark with hedge ratios in 10% increments up to a 100% hedged position.

The graph shows that in every case, hedging reduces the portfolio's risk. For instance, for a European pension fund, a fully hedged portfolio would have reduced the volatility of total returns significantly to 12.2% compared with an unhedged stance of 15.7%. The analysis clearly demonstrates the implication of not hedging currency; it produces higher risk for the portfolio. Therefore, the default stance to reduce or avoid currency risk should be a hedged position.

The analysis also shows that the relationship between risk and return varies depending on the base currency. A pension fund based in Euroland with a 100% hedged portfolio would have underperformed an unhedged portfolio by an annualized 3.5%. However, in the UK a 100% portfolio would have increased returns by 1.8% annually compared to an unhedged stance. For a £1 billion UK scheme with 40% invested in an unhedged MSCI World portfolio, the loss for an unhedged portfolio would have been close to £60 million over this period! This is a real loss, but is disguised by the larger equity gains from the foreign portfolio.

It is also important to note that the slope and nature of these curves will change dynamically over different historical time periods and will inevitably look different in the future. Consequently, while a 100% hedge ratio for the UK would have been optimal since 1992, it is likely to be different in the next eight years.

These arguments in favour of managing currency exposures are not new. So why is there more interest in currency hedging now? As pension funds have become more sophisticated, they have started to look at the relationship between risk and return more carefully. In the past, many pension funds have traditionally used balanced management mandates that included the ability to hedge currencies. However, currency hedging tended to be considered of secondary importance to the overall equity and bond mandate. As pension funds have demanded clearer performance attribution and the scale of currency risk and return has become more evident, doubts have been raised to whether a 'balanced' manager has sufficient expertise and focus to perform this additional specialized role. This, together with the trend towards equity indexation, where the underlying assets are managed separately to the currency, has led to an increasing demand for currency overlay services.

Pension funds have also embraced the idea of specialization. Hiring a currency specialist is the same decision as hiring specialist equity and bond managers--pension funds want the best expertise for each asset class. This specialist expertise extends to various aspects of the currency hedging decision, such as which hedge ratio to use and the cash flow implications for the fund's liquidity position.

Overlay managers assist in analyzing optimal hedge ratios. The lowest risk is not always derived from a 100% hedged position. Indeed, the optimal hedge ratio from a risk perspective for a U.S. investor is about 60%. As the optimal hedge ratio will also vary from a return perspective, we can combine the two to assess the optimal hedge ratio based on maximizing the Sharpe Ratio for each country's investor. This will change over time and therefore argues for the hedge ratio to be actively managed.

The validity of currency overlay management is not limited to purely passive hedging. The rise in the use of currency overlay has also been generated by the increasing use of active currency management. Evidence is growing that currency managers can generate added value similar to what one would expect from a specialist equity manager. Given that these returns tend to be uncorrelated with returns to other asset classes, this activity is a useful additional source of alpha.

So what is the verdict for currency overlay management? The evidence is that passive hedging can reduce risk with no long-term effect on expected return. The risk allocation saved by hedging can then be used in an active currency program with positive expected alpha. We believe the jury will approve currency overlay management.

Eric Innes is Chairman and Chief Investment Officer of YMG Capital Management in Toronto.

Contex Group