Record-high levels of currency volatility in the world markets over the last few years have left a growing number of Canadian institutional investors pondering the suitability of their currency investment policy. Over the last decade, investors have increasingly moved their asset mix toward foreign assets. Canadian investors first diversified their equity portfolios with investments in small cap foreign stocks and dedicated emerging market mandates.
More recently, the appetite has turned to non-public assets such as private equity, real estate and infrastructure. The case for diversification is well accepted, given the broader opportunity set that foreign markets have to offer and the limitations of the concentrated Canadian bond and equity markets. Over this period, exposure to foreign assets also brought additional risk exposure through the currency associated with those foreign investments.
Given today’s environment, it’s not surprising that investors are more concerned with effectively managing currency risk—especially tail risks—through currency hedging. Unfortunately, there is no definitive answer to the question, What is the optimal hedge ratio to minimize risk? Much depends on the portfolio’s specific composition, the investor’s objectives and an appraisal of the investor’s domestic currency valuation.
Revisiting static hedge ratio
Basic asset allocation principles drive the investment decisions established in most Canadian investment policies. Investors look at the equity risk premium and the global investment universe to gain better breadth and take advantage of the liquidity premium associated with investments in non-public markets. These asset allocation principles are based on long-term risk and return assumptions, which consider currency to have zero expected returns.
Since the Canadian market does not offer sufficient investment options to allow investors to build fully efficient portfolios, Canadian investors have grown more dependent on foreign investments, which are significantly affected by currency fluctuations. The currency exposure associated with a typical Canadian asset mix is roughly 15% to 20% in the U.S. dollar, 8% to 12% in the euro and 3% to 5% in both the Japanese yen and the British pound. For this reason, it’s critical to address the currency risk from international investments—rarely would a portfolio manager have a single holding as large as these major currencies.
The time horizon mismatch between strategic asset mix and currency cycles creates more questions than answers in addressing the currency hedging dilemma. Currency returns tend to revert to mean over time, but they also show much greater volatility over shorter time periods. Asset allocation optimizers use long-term risk and return assumptions to derive optimal asset mixes. As currency returns tend to wash out over a long investment horizon, currency hedging has little impact on the results of an efficient frontier analysis and asset/liability matching exercise. Moreover, ex-post estimates of optimal hedge ratios are poor predictors over full market cycles.
Since traditional tools do not provide proper guidance on how to treat currency as an integral part of the portfolio’s long-term asset mix, investors have turned to the academic world for insight. Many studies and theories have been published on the optimal hedge ratio policy (unhedged, fully hedged and partially hedged). However, Canadian investors have yet to find a suitable basis on which to build and manage a sustainable currency policy: a well-designed policy that will evolve over time and reflect the investor’s risk tolerance to this volatile exposure.