Traditionally, Canadian investors have established their currency investment policies by removing a predetermined static portion (such as 50%) of the U.S. and EAFE currency exposures. This approach reduces the risk associated with currency movement and provides a safe, least-regret position.
The 50% hedged benchmark currency policy is a good starting point to mitigate and manage currency risk, yet from an investment policy perspective, it has some serious embedded flaws. After hedging 50% of the U.S. dollar exposure, the typical Canadian pension plan will be left with 8% to 10% of U.S. dollar exposure—a residual risk that is likely still more prevalent than the actual exposure of other major currencies such as the euro (typically the second-largest currency exposure). To support this kind of policy, an investor needs to have confidence in this dominant U.S. dollar exposure.
This approach hedges the limited currency risk embedded in marginal currency exposures as well. Hedging half of a minimal currency exposure, such as the New Zealand dollar or the Swedish krona, will not achieve the desired objective of controlling risk—and, more importantly, the tail risk—more effectively. Furthermore, any additional allocation to foreign assets will increase the overall level of currency exposure and residual risk. This reality may limit investors to future investment opportunities or bias the portfolio toward domestic investments.
Adding to the difficulty of accurately defining appropriate hedge ratios, static hedges present four distinct disadvantages.
1. They reduce risk indiscriminately, reducing the upside as well as the downside, while investors are ultimately more concerned with downside risk.
2. Intended to minimize portfolio risk over the long term (10 years or more), they may be inappropriate in the short to medium term, especially in periods of high currency volatility or when currencies have deviated significantly from their long-run fair value.
3. Misjudging the most appropriate time to implement a static hedge can lead to significant currency losses, as currency prices tend to revert to fair value over a shorter time period than the period over which they deviate from fair value.
4. Managing different hedge ratios for multiple currencies can become time-consuming and complex for any investor. This is particularly true during periods of significant volatility because of the speed and magnitude of moves in the currency markets.
An alternative strategy
As with other asset classes, Canadian investors might find it valuable to reflect on the amount of exposure to currencies that would satisfy the risk objectives of their portfolios. For example, an investor may decide that the target allocation to Canadian equities in the investment policy is 20% of the portfolio’s assets, with a minimum of 17.5% and a maximum of 22.5%. The investor may also determine that an appropriate currency policy is to have a target exposure of 15% of the portfolio’s assets exposed to a well-diversified portfolio of foreign developed-market currencies with a minimum and maximum deviation of +/- 2.5%. For instance, a well-diversified portfolio of currencies can consist of a maximum allocation of 3% to 4% to the U.S. dollar, euro, Japanese yen and British pound, respectively.
Instead of considering how much should be hedged (i.e., 50% or other fixed ratios), it may be more beneficial to determine how much currency exposure the investor wants to own and make this a currency investment policy. By imposing limits on the currency exposure that the portfolio is allowed to own, a specialized currency manager will hedge away any additional currency risk. The hedge ratio for each individual currency would vary according to its importance in the overall asset mix, but the ownership or exposure to major currencies will be fairly constant and will be managed appropriately.
The critical asset allocation decision to hedge currency will permit investors to build, manage and benchmark a suitable policy framework. It will enable investors to improve the risk characteristics of a static hedge ratio policy by allowing them to benefit from the full spectrum of global opportunities. It will limit residual currency risk stemming from major investments to one particular region or country, satisfying the risk management objectives of an appropriate investment management policy. Finally, it will permit investors to establish the proper framework for active strategies that seek to benefit from the currency markets. BC
Yann Depin is vice-president of the currency management group with State Street Global Advisors (Canada) Ltd.
yann_depin@ssga.com
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