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By M. Isi Eromosele
With the rise of global investing, a well-defined currency
hedging policy at the total portfolio level is more important than ever.
It is critical for investors to distinguish between the
currency translation risk that comes with investing abroad and the currency
alpha risk that results from positions taken by managers of absolute return
currency strategies or global macro mandates.
As the proportion of foreign investment in portfolios rises,
currency translation risk consumes an ever larger share of the total risk
budget. As a result, a fund’s currency hedging policy can have a far greater
impact on investment returns than the alpha generated by risk-taking managers.
Traditional approaches to currency management often do not
differentiate between these two sources of risk. There are advantages to a more
nuanced approach to global currency management.
There are ways of implementing an effective hedging policy
at the portfolio level, separate from a subsequent risk allocation process to
alpha-generating currency strategies.
Currency Translation Risk + Currency Alpha Risk
International investors hold two types of currency risk:
currency translation risk and currency alpha risk. Failure to make the
distinction between these different types of risk can result in significant
currency losses. Currency translation risk is a by-product of foreign
investment.
Investors may gain diversification benefits by holding
foreign assets, but they generally take on the currency risk without any
expectation of adding value to the portfolio.
Exchange rate movements may generate losses and gains that
may have a significant impact at the total portfolio level.
By contrast, currency alpha risk results from active bets in
absolute return currency strategies or global macro strategies that aim to profit
from differences in currency rates, interest rates and other macro arbitrage opportunities
around the world.
Managers of these types of strategies are expected to
increase the amount of currency risk in a portfolio, with the objective of
generating positive cash lows.
Allocating to these strategies should form part of the alternative
investments category of a portfolio’s risk budget, where the objective is to
gain exposure to independent return streams that are uncorrelated with existing
holdings.
The increasing acceptance of the concept of risk budgeting, the
broader acknowledgement of liability-driven investment and new accounting rules
have all prompted new thinking about how to implement currency management for
global investors.
Growing pressure on institutional investors like pension
funds to match their liabilities is prompting them to assess how hard their
risk budgets are working. By decomposing risk, it is possible to compare the
expected returns of each risk exposure. Thinking in terms of allocating to risk
exposures rather than to individual asset classes quickly shines a bright light
on the prominence of currency translation risk.
For example, it would not be unusual to see a 33 percent allocation
to foreign assets for European clients, resulting in a 33 percent exposure to
the movements of foreign currencies. This unrewarded risk can have a major
impact at the total portfolio level.
A fully hedged position works only when the base currency
rises; whereas an unhedged position works only when the base currency weakens and
a partially hedged position is only partially right all the time.
One remedial option is to use a simple approach by applying
a passive hedge. Although this may reduce currency losses, it also reduces the
opportunity to make currency gains, so there may be no expected return from
this approach.
There are better alternatives to this traditional approach
to currency hedging, which distinguish between the two types of currency risk
and design strategies appropriate for each.
New Strategies In Currency Hedging
Traditional approaches to currency hedging assume that
currency can be managed in the same way as equities and bonds. This method
attempts to apply the Capital Asset Pricing Model to currencies, using the
familiar language of alpha and beta, with little effort to justify the
underlying assumptions.
Using the term “beta” carries at least two unfortunate
connotations: that the strategic currency position offers an expected return
and that it should be implemented passively.
Furthermore, investors may be inclined to trust that the
strategic stance is in some sense correct, because it is often derived from an asset liability
study; albeit one that most likely failed to decompose currency risk from asset
risk.
The result is to match the strategic stance with a passive
hedge and then add an alpha seeking module in a combined package. This is a not
a natural combination, because the purpose of the passive hedge is clearly to
reduce currency risk, which is a policy hedging decision; whereas the purpose
of the alpha-seeking module is to increase currency risk, which amounts to
spending part of the alternative investments risk budget.
Moreover, the investment guidelines often constrain the
alpha-seeking module by linking it to the underlying exposures, limiting the
size of positions with an upper bound on benchmark relative volatility.
A major drawback to the traditional approach is that it
mixes the objectives of hedging currency translation risk and alpha-generating
currency strategies.
By assuming that currency translation risk can be managed
with a passive hedge and focusing on generating currency alpha, it fails to
address a fundamental problem that at any particular time, the strategic policy
hedge might dictate a currency position that is precisely the wrong place to be
for the portfolio.
There is a second important drawback to the traditional
approach. By tying the currency alpha component to the underlying investments, the
manager’s ability to add value is constrained by asymmetric exposure limits (i.e.,
the inability to short), over-dependence on the movements of the base currency and
an investment universe that is limited to the exposures held in the underlying
portfolio.
A more nuanced asset allocation approach deals with the two
types of currency risk separately at different levels. Foreign currency translation
risk is important for investors whose liabilities are denominated primarily in
base currency.
An incorrect currency hedging policy can result in significant
losses at the total fund level. Currency translation risk should be addressed
strategically at the total fund level, whereas the allocation to currency alpha
risk is part of subsequent decisions about how to allocate risk to alternative
investments that are uncorrelated to conventional stocks and bonds. It is
necessary to separate the two decisions and seek the best managers for each of
the two types of risk.
Having adopted a strategic stance, a currency hedging policy
must also address the question of how that stance will be implemented: passively
or actively. Active hedging is a more attractive alternative to the passive
approach, because it allows a skillful active manager to seek to control
currency translation losses by adjusting the portfolio’s currency hedges
towards the ideal stance in any currency environment, always
respecting a hedge range from 0% to 100%, with no cross-currency
trades.
This can add value over time. Investors should seek the best
manager with a demonstrable track record in actively managing currency
translation risk.
When it comes to currency alpha, investors should allow
active managers the freedom to pursue strategies based on their expectation of
market performance, by removing unnecessary constraints that might impede a manager
from translating insights into value.
Active positions should be freed from any links to the
currency exposures of the assets held in the portfolio. This allows managers to
add alpha that is unrelated to existing holdings. Since the primary objective of any alpha-seeking
manager is to add value, diversification is essential.
M. Isi Eromosele is
the President | Chief Executive Officer | Executive Creative Director of Oseme
Group - Oseme Creative | Oseme Consulting | Oseme Finance
Copyright Control ©
2012 Oseme Group
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