A look at past performance numbers explains why. Over the last five years, the value of the Canadian dollar affected annual returns on foreign investments anywhere from -25% to +10%, as shown in the table on page 35. The currency component entailed in the ownership of these international holdings can significantly enhance or detract from overall returns, adding a source of volatility. So it’s no surprise that many pension funds have undertaken currency hedging strategies to neutralize the currency risk component of their international investments.
Problems with a passive approach
Certainly, currency management is not a new topic for institutional investors. However, given the recent rise of the Canadian dollar, a purely passive approach to currency management should be reconsidered.
A passive approach applies the same hedge ratio for each currency, irrespective of the currencies’ value. The hedge ratio is determined by the board, based on its view of future performance of the base currency (the Canadian dollar)against all foreign currencies, and is applied by the currency manager. Under a passive approach, trustees are responsible for reviewing the appropriateness of the hedging level—for example, 0% hedged, 50% hedged or 100% hedged— and readjusting accordingly.
The adoption of a passive approach in recent years has helped most pension plans achieve a more efficient risk budget in their portfolios than with an unhedged strategy. The elimination of the potential losses from a rising Canadian dollar enabled investors to remove some or all of the return volatility caused by the currency component of a foreign portfolio. While a passive hedging approach may be effective, its success may rely solely on the strength of the domestic currency or on the weakness of only a few currencies. For example, an analysis of the MSCI EAFE index, 100% hedged to the Canadian dollar over the last 15 years, demonstrates that close to 80% of the outperformance of the hedge resulted from the weakness of the Japanese yen. The index is comprised of the six major currencies(the euro, British pound, Japanese yen, Canadian dollar, Swiss franc, Swedish krona), where each currency is weighted according to its trade with the United States.
In the last five years, the weak performance of the U.S. dollar against a basket of currencies, where the euro represented more than 50% of the index and the Canadian dollar only 9%, was essentially equal to the performance of the CAD/USD exchange rate. Therefore, there is strong evidence that the contribution of the Canadian dollar’s appreciation to the total index was effectively neutral. Thus, the index’s rise is more a reflection of a general weakness of the U.S. dollar than the strength of the Canadian dollar. In order for a passive hedging program to be effective and keep the hedge ratio constant across all currencies, a strong domestic currency is required.
A strategic approach to currency hedging
With all the uncertainties of world markets and global politics, currency volatility will remain a predominant risk to pension plan assets. This risk cannot be adequately monitored by the simple application of a static hedge ratio. A pension plan’s policy toward currency hedging should be well defined, and a risk-reducing strategy should be used to actively monitor these risks. A risk-reducing currency policy will appeal to plan sponsors that want to take a medium- to long-term approach to this form of risk management.
A strategic currency overlay program, in which discretion is given to a currency manager to effectively position the currency portfolio according to a well-defined investment management process, can alleviate trustees’ concerns of an optimal hedge ratio. A tactical strategic currency overlay framework is defined in conjunction with the trustees’ risk tolerance for currency volatility and the manager’s investment management philosophy. For example, a plan with a 50% hedging policy for its international currency exposure could allow discretion to the currency manager to position the currency portfolio within a hedging range of 30% to 70%. The manager’s objective would be to limit the downside risk of a weakening currency without sacrificing the upside.
As opposed to the static hedge ratio of a passive hedging program, a tactical hedging program allows the diversification of a plan’s currency risk. Hedge ratios are established by the manager’s assessment of the risk profile of each currency pair and are applied to each respective currency exposure of the plan’s underlying assets. The tactical hedging program allows the strategy to adjust to changing market conditions and monitor explicitly the pension plan currency risk positions.
Over a longer-term investment horizon, the incremental risk associated with currency exposure is not necessarily compensated by additional return. At extreme valuation levels and major economic turning points, in which global markets are increasingly volatile, a static hedge ratio target can be particularly painful.
The Canadian marketplace is well aware of the benefit of global diversification. Tactical currency management allows plan sponsors to expand their investment opportunities with the confidence that its associated currency risk is strategically monitored.
Yann Depin is vice-president, currency management, with State Street Global Advisors – Canada. yann_depin@ssga.com
