To Hedge or Not to Hedge
The view of the FX market has changed profoundly. It is no longer seen as a by-product of international trade and capital market transactions but an asset class in itself. Fund and hedge fund managers, whose traditional strategies have been impaired by the lack of volatility in the equity markets, have been ditching traditional FX hedging strategies and launching their own currency funds. Funds are becoming increasingly sophisticated in their use of currency management in an effort to boost returns.
Mark Warms, general manager, Europe, at trading portal FXall, says: “There is no question that the number of hedge funds investing in FX for alpha has exploded. Most asset managers, on the other hand, still trade FX for transactional reasons rather than for profit. What we have seen is an increased focus on best execution. Given that foreign exchange trading is an integral part of managing an international equities or fixed income portfolio, asset managers are beginning to focus on getting the best price possible on their foreign exchange trades by using multibank execution and reporting tools. Rather than hedging exposures on an individual basis, asset managers will typically implement a currency overlay program to manage foreign exchange exposures across the portfolio as a whole.”
The Myners report suggested that all UK pension funds should consider all risks in their portfolio and how they should be managed. Currency is a risk source and increasingly it is being managed as such. These factors have led to an increasing number of banks and brokers offering fund managers currency overlay strategies, alongside the specialist fund management providers such as UK firm Record Currency Management. Peter Wakefield, managing director at Record Currency Management, says: “There is no doubt that it is a zero-sum game. However, it is all very well deciding it will all smooth out in the end, the question is how long will this take and what is your pain tolerance in the meantime?”
Under-funded pensions funds that leave the currencies unmanaged and unhedged will get pretty large swings in value contributed by currencies, which will ultimately get translated through to the balance sheet of the corporate sponsor. According to Wakefield, there is both a funding issue and a portfolio efficiency issue. If corporates and pension funds are taking this risk for no apparent gain, there is the approach that they could take this risk in another asset class that is actively managed, in order to turn it into a gain. Many pension funds have been engaging in active currency management as well as doing some of the volatility reduction.
As pension funds increase the percentage of international equities they hold, they are increasing the currency risk. This, together with issues related to under-funding, has been the biggest driver of the need for currency overlay managers. When Record Currency Management set up 23 years ago it was dealing primarily with corporates. Wakefield adds: “Corporates have natural currency exposure if they trade internationally, which they have always wanted to manage – either actively or passively. Typically the corporate position is not the same as the institutional investor – it is a hedge against currency fluctuations rather than seeking to make a return on the currency overlay.” Increasingly though, corporates have taken currency exposure management in-house, just the fund managers have created a new demand for currency overlay from increased diversification in international equities. Wakefield says: “Actively trading currencies has, until now, been the preserve of specialists, but there has been a bit of a rush recently by traditional asset managers to develop a currency capability.” Many institutional investors, he says, are setting up currency mandates in order to ensure that specialists handle the currency. “Equity managers are equity specialists, so it is typically better to ask someone else to do currency management,” he says.
While standard, forwards-based overlay programmes can generate positive returns; these returns tend to be ‘lumpy’ across the annual cycle. One method is to use an ‘overlay-on-overlay’, whereby a currency manager adds a further management strategy on top of an existing overlay contract. Even where a portfolio manager is already using currency overlay, this added layer, or the use of an options overlay to take positions in volatility, can improve the risk-return profile of existing overlay strategies, as well as improve returns. Or, more commonly, pooled vehicles are used. Here a firm sets up a fund that allocates varying amounts of cash to individual currency overlay managers to invest.
Ian Stannard, senior currency strategist at BNP Paribas, says that the cases where there would not be some sort of management of foreign exchange risk are rare. He says: “Foreign exchange has moved up the asset curve. 20 years ago it was considered a cost. 10 years ago it was considered as a risk. Today, it is an asset class. It has moved from being seen as a risk that needs to be managed to an asset from which alpha can be generated,” comments Stannard.
There are different approaches to currency overlay depending upon what the fund manager is trying to achieve and the construction of their portfolio. Stannard continues: “A fund manager may be willing to take a directional move that generates alpha to complement their portfolio or a fund manager may want to take a more active approach, in order to reduce volatility.” According to Stannard, the most active overlay strategy involves monitoring daily foreign exchange rates, rather than the underlying asset. Some companies often use several separate currency overlay programmes at once.
James Binny, executive director of ABN AMRO’s FX analytics and risk advisory, a unit set up four years ago to advise companies and fund managers on how to get the best out of their currency trading, believes profit-making has overtaken hedging. He says: “15 years ago, currency overlay was all about risk control and hedging, and you only said very quietly that money could be made from FX. In recent years, however, there has been much more demand for return generation – alpha overlay.” While the downside of taking an active position is that you can get it wrong, pension funds are already taking positions in all the other assets, and now they are recognising that currencies are another place they could be taking active risk. Currencies are being recognised as an asset class now, not just for the return generation but also for the diversification – the returns are typically uncorrelated with other asset classes. Binny explains: “Hedges generate profits and losses in the short-term, which need funding. The trouble with passive hedging is the cash flows. Traditional currency overlay is an active strategy that balances both risks – of losing money, if unhedged, and the cashflows of hedges. However, currency management can add value as well as reduce risk. It is accepted now that you can make money out of currency and it should be a useful part of the portfolio.”
According to Binny, as currency overlay has become more established it has become relatively unusual to hire a single manager, even in a single currency portfolio. Investors normally hire multiple managers for the diversification. Depending upon the fund, this could be anything from three to 10 managers. Binny continues: “But pension funds do not always have the resources to do this, which is why we were asked six months ago to package a more diversified solution. ABN AMRO now has a multi-manager product, which is like a fund of funds or a ‘manager of managers’, to get the best of breed of each style of management by employing several external currency managers.”
While the debate continues over what number of currency overlay managers work best and what proportion of a portfolio should be hedged for the best returns, it is clear that some level of FX trading is an essential part of a portfolio manager’s strategy. The idea that FX transactions will cancel themselves out over time is one that is antiquated, and few are still prepared to leave anything to chance and ignore this opportunity to trade.