Should I strategically hedge?

How much currency exposure should I be hedging as a strategic policy decision? It has always been our view, and now industry standard practice, that a total portfolio asset allocation approach is the appropriate way of deciding the strategic currency hedging policy. In making the decision it is useful to recall that our international investment consists of two components: hedged assets and currency. By viewing the entire portfolio as a portfolio of assets, both domestic and foreign but containing no currency exposure, plus the currency exposure, we can separately consider asset allocation and currency hedging.

With expectations of return, risk, and correlations plus the risk preference, we simply use mean variance optimisation to derive an optimal currency exposure, assisted with investors chosen asset mix. In this process, we can use asset information to derive an optimal currency exposure that is consistent with the investor's risk preference. Clearly the optimal hedge ratio (the amount of currency exposure removed from the portfolio relative to the initial amount) will be unique to each portfolio and will be a function of risk preference and expectations of returns, volatilities and correlations. It is inappropriate to recommend a single hedge ratio for all investors, but instead an analysis should be undertaken to identify a hedge ratio consistent with the overall objectives of the plan. Each investor should undertake such analysis to identify the hedge ratio that is consistent with these overall plan characteristics.

A criticism of the mean variance approach is that it is sensitive to input values. While results in this analysis are always client specific, we can make some general statements on currency hedging.

Statements on Currency Hedging

1. Partial hedging is optimal for a typical 60/40 portfolio plan with significant international exposure.

2. As the international exposure increases, the hedge ratio also increases as currency has a greater impact on total portfolio risk.

3. As the asset allocation moves more into fixed income than equity the investor is illustrating a lower appetite for risk and more hedging becomes optimal. Additionally, there has been a small positive correlation between domestic fixed income and currency (whereas between domestic equity and currency the correlation appears close to zero) and so currency becomes less of a diversifying investment. Therefore more hedging becomes optimal.

4. Expectations of equity returns and fixed income returns are also required inputs in the strategic hedging study. As the difference between these two expected returns increases, so equity becomes more attractive than fixed income, and the asset allocation comes to represent an increasingly risk averse investor. The hedge ratio therefore increases. The same argument holds for a decrease in the difference in volatility between equity and fixed income.

5. As the correlation between currency and any of the assets increases, so the diversifying property of currency diminishes and the hedge ratio increases. The sensitivity of the increase depends on the size of the allocation to the asset.

If liabilities are included in the investment portfolio construction process then they can be incorporated into the strategic currency study in an identical way to the incorporation of them into an asset/liability allocation study.

• If the liabilities have a high correlation with equity assets, then a high equity proportioned asset portfolio now reflects a more risk averse investor and more hedging is appropriate.
• If the liabilities have a high correlation with fixed income assets (currency has a small correlation with fixed income), then holding currency will diversify some of the liability risk and less currency hedging is optimal.
• With the crude approximation that liabilities for retirees and active members are like fixed income and equity respectively, the level of hedging in an asset/liability framework thus depends on the maturity of the fund.

The fact that the long run currency returns appear normally distributed (see above) means that mean variance analysis is entirely appropriate for the strategic hedging study. However, because of the asymmetry of option hedging strategies, such strategies cannot be evaluated in such a framework. Monte Carlo simulation is the only way to assess this approach in the short run (1 year).

Over the long term, the return distribution of an option based hedging strategy tends to a symmetric normal distribution and a mean variance framework is appropriate. This is an important point for the investor to understand: short term (e.g. annual) protection programmes do not provide long term (e.g. 5-10 years) return asymmetric protection. In fact, there is a one-to-one equivalence between each fixed hedge ratio and an option protection program with varying levels of protection. See Chart 4 below. Fully hedged, half hedged, and unhedged portfolios are equivalent to in-the-money, at-the-money and out-of-the-money option protection respectively.

In summary, investors should unbundle currency from the assets that gave rise to this exposure - address this exposure strategically as one would any separate exposure, using portfolio optimisation techniques. The strategic exposure decision is the most important decision an investor makes about assets and it is only after that decision that he must address the other two decisions

What is Currency Overlay?

Currency overlay refers to the specialised management of currency exposures inherent in an international asset portfolio, by a separate firm or entity from the asset manager.

Every investment in an international asset requires an equal investment in foreign currency. A currency overlay manager is dedicated exclusively to managing these 'accidental' currency exposures generated by the asset manager, separately from, but in parallel with, the underlying asset manager.

The underlying asset manager is not disturbed by the use of an overlay manager, and still manages currencies in the same manner as before. However, the overlay manager replaces the currency bets of the underlying manager with the deliberate investment position of the specialist overlay manager.

The resulting combination of managers facilitates the optimal combination - best currency decisions from the currency specialist, and best asset decisions from the asset manager.

A currency overlay programme usually reduces pre-existing unmanaged currency risk, as it hedges pre-existing exposures.

Currency Overlay - how it works

Through the application of a portfolio of forward contracts, known as the overlay portfolio, the underlying currency exposure of the assets is altered to a deliberately intended portfolio of currency exposures. This separately managed currency exposure can be expected to have a higher return than the original set of exposures, generated accidentally by the asset manager.

In Practice

• Custodian sends currency exposure to overlay manager regularly.
• Overlay manager enters forward currency contracts in client's name.
• Custodian settles contracts upon instruction of overlay manager.
• Client provides any cash needed at settlement.

What is the case for currency overlay?

Facts about currency in international investing

It is widely accepted that investment portfolios, for diversification purposes, should have an international allocation. When an investor wishes to purchase a foreign asset, he or she is required to purchase the currency of that country in order to settle the transaction. This second decision, or hidden purchase of currency in international investment, has associated with it a significant risk. Irrespective of the asset return, currency values will fluctuate to impact the market value of the investment in base currency terms.

Characteristics of currency:

• Risk
• Return
• Distributional form
• Correlation with Assets

1. Risk

Historically, 30 percent of the volatility (as measured by standard deviation) of an international equity portfolio has been associated with its inherent currency exposure. The equivalent statistic for international fixed income is 60 percent. This risk has been persistent and fairly stable since the beginning of floating exchange rates, i.e., 1973. See Charts 1 and 2.

2. Return

Unlike financial assets, the risk that this currency exposure brings is not rewarded with a long run return. Economic theory suggests that the long-term currency return (in excess of the interest rate differential) should be zero. Empirical evidence on international portfolios supports this theory.

3. Distributional Form

Individual exchange rates, like many price series, can exhibit very short term price moves that are too large to be explained by a normal distribution. However, when viewed over time periods of a month or more, and/or when viewed as a portfolio of currency, or both, evidence suggests that currency returns are indeed normally distributed. See Chart 3.

4. Correlation with assets

From 1973 to 2000 the correlation between local equity and currency is -0.01. It has been persistently low through this period. A low number is consistent with economic theory.

Conceptually, currency is a medium of exchange between two national money supplies, the demand for which depends on the relative demand for goods and assets across economies. Therefore exchange rates are driven by differences in price levels, differences in quality of traded goods and differences in expected returns on assets. These fundamental drivers are clearly different from those pertaining to the local asset markets and equity markets are driven by earnings, local risk premia and domestic economic growth.

In summary, currency exposure in international investment represents a significant risk, offers no strategic return, is uncorrelated with the underlying asset return and appears normally distributed.

A framework for addressing the currency issue

The implication of the foregoing is that the currency exposure inherent in international investment ought to be managed and not simply assumed as a hidden investment. Because of the separate nature of currency from assets one should and can prudently unbundle currency from assets and explicitly resolve for currency the main policy issues that need to be addressed for any separate asset class. (This methodology does not imply currency is a separate asset class). These issues are as follows.

Issues:

1. What is the appropriate strategic or long-run exposure to currency?

2. Should currency be managed actively around this strategic position?

3. Who should manage currency exposure and how?

It is important to emphasise that these currency policy issues, while they may appear new and alien, are in fact issues that most international investors have in fact addressed already and have made decisions about implicitly.

In most cases, by default the investor has chosen to have a currency exposure equal in size to the international allocation; the investor has chosen to engage in active currency management by allowing currency exposures to change through time as the asset managers change their country weightings; and the investor has chosen to take equity manager's (and/or fixed income) country weighting decision process to be the appropriate approach for actively managing the currency portfolio.

Until an investor recognises the separate and independent nature of each of these decisions, it is unlikely they will approach the strategic currency decision in an appropriate way. We provide below, what we believe is an appropriate methodology for addressing these issues.

Issue 1 : How much currency exposure should I be hedging as a strategic policy decision?

It has always been our view, and now industry standard practice, that a total portfolio asset allocation approach is the appropriate way of deciding the strategic currency hedging policy. In making the decision it is useful to recall that our international investment consists of two components: hedged assets and currency. By viewing the entire portfolio as a portfolio of assets, both domestic and foreign but containing no currency exposure, plus the currency exposure, we can separately consider asset allocation and currency hedging.

With expectations of return, risk, and correlations plus the risk preference, we simply use mean variance optimisation to derive an optimal currency exposure, assisted with investors chosen asset mix. In this process, we can use asset information to derive an optimal currency exposure that is consistent with the investor's risk preference. Clearly the optimal hedge ratio (the amount of currency exposure removed from the portfolio relative to the initial amount) will be unique to each portfolio and will be a function of risk preference and expectations of returns, volatilities and correlations. It is inappropriate to recommend a single hedge ratio for all investors, but instead an analysis should be undertaken to identify a hedge ratio consistent with the overall objectives of the plan.

Each investor should undertake such analysis to identify the hedge ratio that is consistent with these overall plan characteristics. A criticism of the mean variance approach is that it is sensitive to input values. While results in this analysis are always client specific, we can make some general statements on currency hedging.

Statements on Currency Hedging:

1. Partial hedging is optimal for a typical 60/40 portfolio plan with significant international exposure.

2. As the international exposure increases, the hedge ratio also increases as currency has a greater impact on total portfolio risk.

3. As the asset allocation moves more into fixed income than equity the investor is illustrating a lower appetite for risk and more hedging becomes optimal. Additionally, there has been a small positive correlation between domestic fixed income and currency (whereas between domestic equity and currency the correlation appears close to zero) and so currency becomes less of a diversifying investment. Therefore more hedging becomes optimal.

4. Expectations of equity returns and fixed income returns are also required inputs in the strategic hedging study. As the difference between these two expected returns increases, so equity becomes more attractive than fixed income, and the asset allocation comes to represent an increasingly risk averse investor. The hedge ratio therefore increases. The same argument holds for a decrease in the difference in volatility between equity and fixed income.

5. As the correlation between currency and any of the assets increases, so the diversifying property of currency diminishes and the hedge ratio increases. The sensitivity of the increase depends on the size of the allocation to the asset.

If liabilities are included in the investment portfolio construction process then they can be incorporated into the strategic currency study in an identical way to the incorporation of them into an asset/liability allocation study.

• If the liabilities have a high correlation with equity assets, then a high equity proportioned asset portfolio now reflects a more risk averse investor and more hedging is appropriate.
• If the liabilities have a high correlation with fixed income assets (currency has a small correlation with fixed income), then holding currency will diversify some of the liability risk and less currency hedging is optimal.
• With the crude approximation that liabilities for retirees and active members are like fixed income and equity respectively, the level of hedging in an asset/liability framework thus depends on the maturity of the fund.

The fact that the long run currency returns appear normally distributed (see above) means that mean variance analysis is entirely appropriate for the strategic hedging study. However, because of the asymmetry of option hedging strategies, such strategies cannot be evaluated in such a framework. Monte Carlo simulation is the only way to assess this approach in the short run (1 year).

Over the long term, the return distribution of an option based hedging strategy tends to a symmetric normal distribution and a mean variance framework is appropriate. This is an important point for the investor to understand: short term (e.g. annual) protection programmes do not provide long term (e.g. 5-10 years) return asymmetric protection. In fact, there is a one-to-one equivalence between each fixed hedge ratio and an option protection program with varying levels of protection. See Chart 4 below. Fully hedged, half hedged, and unhedged portfolios are equivalent to in-the-money, at-the-money and out-of-the-money option protection respectively.

In summary, investors should unbundle currency from the assets that gave rise to this exposure - address this exposure strategically as one would any separate exposure, using portfolio optimisation techniques. The strategic exposure decision is the most important decision an investor makes about assets and it is only after that decision that he must address the other two decisions

Issue 2 : Active versus passive currency management

While currency may offer a zero long-run return to an investor, it is clear that currency returns can be quite significantly positive or negative in the short run. Therefore, to the extent that active management of currency can capitalise upon this volatility and add return, then actively managed currency will have a positive return despite the strategic long-run zero return of a passive exposure. The excess return can be thought of as purely additive return just like the return for active asset management. Before we discuss the evidence relating to active currency management it is important to point out that international investors who make active country allocation decisions are indeed engaging in the active management of currency with respect to their benchmark.

For example, if a manager underweights Japan in favour of Europe, a hidden currency decision is implemented shorting yen in favour of European currency. Active currency management is not generally a new activity for investors. The issue is only of overt versus covert currency management. The case for active currency management is founded on three sets of principles.

Principles:

• Theory
• Academic
• Proprietary

1. Theory

Theoretically many of the conditions for efficiency do not exist in foreign exchange markets.

Conditions for efficiency:

• many buyers and sellers
• common information
• common objectives
• absence of barriers to entry

Equilibrium currency rates are determined on the basis of the relative economic fundamentals of the countries involved. These fundamentals are essentially the relative demands for goods and assets and expectations thereof. Over time spot rates tend toward this equilibrium, which itself is dynamic and changing in accordance with the relative fundamentals.

2. Academic

Significant evidence exists in the public and private domain that active currency management undertaken in a structured way, based on the relevant fundamentals, adds value over time.

An example of such evidence in the public domain is work done in 1985 by John Bilson indicating nominal short-term interest rate differentials provided insight and excess risk-adjusted return to currency management. More recently Jack Glen at the University of Pennsylvania provided evidence that relative inflation difference or PPP has provided insight into currency return over longer periods of time. This evidence is in sharp contrast to the popular perception of the usefulness of this factor.

3. Proprietary

Proprietary currency research undertaken by various firms over the past ten years including Lee Overlay Partners Limited, and actual experience confirms that significant opportunity exists to add return to international portfolios by actively managing the currency inherent to the portfolio. Interestingly also, but more complex to explain conceptually, is the significant body of literature in the public domain confirming statistically that technical analysis or trend following has been a profitable trading strategy (in spite of the high turnover associated with such techniques).

In summary, it is fair to say that unlike other asset classes, it appears that the burden of proof is not with the case for active management, but with the case for passive management of currency.

Issue 3 : Who should manage currency exposure - individual asset managers or specialist managers?

The key conceptual issue here is to recognise that currency management inevitably will take place in some form or other - even passive - and that because of the unique characteristics of currency, particularly compared to equity markets, there are significant benefits to using a specialist. These benefits, some quite obvious and some less so, are listed below as follows.

Benefits of Using a specialist

1. Higher long-run return to the portfolio through a specialist approach adding value.

1.5 Controlling currency risk through the use of strategically hedged benchmarks.

2. Lack of disruption to individual asset managers, who can continue to focus on allocation and asset selection with or without implied currency benefits.

3. Improved cash flow and transaction cost management associated with currency hedging. International asset managers sell international assets to fund currency hedging activities. Specialist currency managers integrate their cash flow management with the overall cash of the fund.

4. Specialist currency managers trade foreign exchange on a competitive basis with a diversified range of counterparties. International asset managers normally trade foreign exchange spot and forward with the custodian only.

5. Specialist managers generally use dedicated and specialised in-house traders to execute client orders, provide separate performance measurement and a range of other specialised reports relating to currency separate from the underlying assets that originally generated such exposures.

Currency is only a wash over the long run.

In the interim there can be sizeable misalignments of currency pairs. However, notwithstanding these fluctuations, although the long run return to currency is zero, the risk which currency introduces into a portfolio is sizeable. Therefore it makes sense to focus on currency due to the impact it can have on the volatility of your portfolio. An international portfolio already has currency exposure, which is managed implicitly by the asset manager. Currency is an unavoidable risk. Currency overlay is merely the explicit management of this risk.

True, the long-run return to passively hedged currency is expected to be zero, but currency returns are also very volatile. By actively participating in currency appreciations and avoiding the depreciations this volatility can be converted into additional return. This is how currency overlay adds value.

Currency exposure from an unleveraged overlay program never exceeds the unmanaged exposures, and never goes below zero. It cannot be speculation if it is reducing an existing portfolio risk.

Individual assets may be naturally hedged, but the portfolio of assets denominated in each currency is not.

A natural hedge means that there is a big negative correlation between the asset and the currency, this has rarely been observed. Also, correlations are volatile and natural hedges often fail. It is a risk to consider the portfolio hedged.

The answer here is one of who is the most appropriate. Ask the equity manager the following three questions:

• What is your currency benchmark?
• What is the currency investment process?
• What has been the currency performance?

Also, ask an equity manager the following two questions:

• How much can currency impact on the portfolio?
• Who is responsible for these impacts?

Contrary to popular opinion, overlay programs are relatively simple to establish and maintain.

The majority of funds choose to have their master custodian collate the data from each of their individual asset managers, and then forward the cumulative data to the overlay manager. These data can be forwarded as frequently as the custodian is confident that the data are correct, but it is recommended that the reporting frequency be no less than monthly.

Any strategy positions are implemented through the use of currency forward contracts. At the inception of the account a 'rollover date' is chosen for the account, which is typically 3 months in the future. All currency trades on the account will settle on that date, which means that only one cash flow takes place on the account.

While not absolutely necessary, many clients set aside cash pool of typically 5% of the value of the net value of the outstanding forward contracts to deal with any cash flows that may arise.

Until the cash flow is realised, the cash pool is equitised with futures, ensuring that the funds earn an appropriate return. The level of cash within the account fluctuates with the cash flow of the overlay account. If the level of cash within the corridor account falls below 3% of the portfolio, it must be replenished to the 5% level. Conversely, if the cash level rises above 8%, the client can withdraw funds down to the 5% level.

Alternatively, clients can also leave standing instructions for the custodian to sweep cash in and out of a STIF account (a cash-type account used to settle transactions) to fund currency gains and losses. Instructions are confirmed 3 days in advance between manager and custodian.

Currency markets were probably the least affected of all financial markets by the advent of the Euro due to the manner in which all of the legacy currencies shadowed the Deutschmark for many years prior to the Euro's introduction. As the correlation between movements in these currencies against the dollar was so high, the currency market effectively considered them to be proxies for the Deutschmark.

The opportunities to add value in currency markets have not diminished as the Euro has appeared. Although 11 currencies have disappeared to be replaced with only one, for many years the currencies moved so closely together that this was effectively the case already. Consequently there are still as many opportunities for currency managers to add value in the current environment as there were in the past.

Eventually they will!

The advisability of running an overlay program depends to a large extent on the size of the international portion of the fund. As a rule of thumb, we would advocate that funds consider an overlay program if the size of their international exposure is over US$100 million or equivalent, or accounts for over 10% of their total portfolio. Smaller funds tend to find that the required investment of time and expertise in running an overlay program does not reap sufficient rewards to justify the investment, however each fund should evaluate this from their own perspective.

Although there are no official figures available, it is estimated that there is currently US$100 billion overlaid in the United States alone.

Investment consultants are generally supportive of currency overlay.

In June 2000, Frank Russell Co. issued a paper entitled "Capturing Alpha Through Active Currency Overlay", which shows that most pension funds with active currency overlay have added value through the hedging strategies.

Watson Wyatt Investment Consulting also published a study earlier in 2000 showing that currency managers can add alpha to a portfolio.