As with all assets, inflation-hedging assets exhibit different levels of attractiveness at different periods and are, at times, influenced by investor sentiment more than by underlying fundamentals. Identifying such points is crucial for investors. Even though these investments are meant to hedge against inflation and inflation potential, the risk and return attributes on an historical and go-forward basis are paramount to determining an attractive entry point.
Currency Management
With the removal of the foreign content rules in Canada, many institutions have widened their investment universe to include broader regional and sector allocations to equities. Until recently, the primary focus with currency risk was the historically stable relationship between the Canadian and U.S. dollars. Investors may have tolerated unhedged currency exposure as a diversifier at a time when foreign content was low.
However, several changes have made currency management a more central asset allocation issue. The growing foreign content of Canadian institutional portfolios means that exposures to currencies other than the U.S. dollar—such as the euro, the British pound and the Japanese yen—can contribute significantly to risk. As a result, the volatility associated with currency exposures has become a meaningful part of a plan’s risk profile.
Each currency’s fluctuation is affected by different economic fundamentals that need to be considered separately. In the case of growing exposures to alternative or absolute return investments, these serve their purpose only when brought back to Canadian dollars. Moreover, in the case of Canadian pension plans trying to manage funded ratio volatility in a disciplined way, the unrewarded risks associated with multiple currency exposures can no longer be supported. All of these factors explain the need to understand the effects of any embedded currency exposures on the plan’s risk profile and create a strategy to manage those risks. Unlike other asset classes that offer positive risk premiums over long horizons, unmanaged exposure to currency introduces risk with no long-run expected return.
Historically, unmanaged currency risk contributes roughly 60% of the volatility on international bond returns and 30% of the volatility of international equity returns. Investors have traditionally sought to reduce currency risk with passive strategies that apply a uniform strategic hedge ratio to all of the different currency exposures in their portfolios.
One of the problems with a passive approach is that the static strategic hedge ratio, which is designed for the long term (10-plus years), may be suboptimal in the short to medium terms. If the investor’s base currency depreciates after the implementation of a static strategic hedge, the investor would realize currency losses when the forward currency contracts expire. The size of these currency losses would fluctuate according to the volatility of the currency market. In contrast to static hedging, a dynamic strategic hedging approach tailors the hedge ratio applied to each currency pair in a portfolio, according to each currency’s divergence from fair value.
Liquidity in a Cash Portfolio
Cash is a low-yielding asset class historically associated with safety of principal achieved through investment in high-quality short-duration bonds. However, this asset class should not solely be viewed through the lens of yield. The financial crisis post-Lehman exposed risks previously unknown to money market and cash funds. Cash funds that stretched for yield during the credit bubble were burned when their holdings became illiquid. The resulting stampede for redemptions caused several funds to inject capital to preserve principal and the U.S. government to offer a safety net for some to protect against runs on money market funds. Most notably, in the U.S., the Reserve Primary Fund (which had heavy exposure to Lehman debt) “broke the buck” during the 2008 crisis, losing investor principal in a class that hadn’t done so in nearly 15 years.
Institutional investors searching for cash managers should consider a manager’s yield history and risk management approach. Cash should be unexciting; it should aim to deliver incremental yield when appropriate, liquidity and principal preservation. The best approach is through internal, independent credit analysis and rigorous research. Investment decisions should not rely on ratings agencies to determine asset quality. One of the hardest lessons learned during the crisis was that AAA labels were given to thousands of securities that didn’t deserve them. Cash managers who recognized this before the subprime crisis began likely had lower-yielding strategies but also had the discipline to avoid the mistakes made by those who relied heavily on ratings agencies.
Sourcing Growth Opportunities
Developing an asset growth strategy that puts portfolios in a position to meet their investment objectives will be a chief concern for all investors. This could mean taking more risk, considering return drivers from alternatives or adding fixed income to the growth side, depending on where investors see the best risk/return opportunities. If we are indeed in the middle of a long-term secular bear equity market, as some claim, relying solely on equities to provide portfolio growth will be challenging. This is where alternative and absolute return strategies can help.
Hedge funds and funds of hedge funds are nimble and able to take advantage of the best investment opportunities when they arise, as opposed to long-only passive equity strategies, which remain hostage to roller-coaster markets. In examining the hedge fund landscape, however, there are many managers who failed to deliver the promise of “absolute returns” in 2008, exposing many in the industry as highly levered beta managers. Many strategies failed in 2008 because markets became irrational and asset prices failed to “converge” to their intrinsic values, diverging instead as investor irrationality ruled the day. The divergence in asset prices was likely caused by sharp and sudden de-leveraging. As stocks tend to be highly liquid, it wasn’t surprising that there was a major sell-off in equities to raise capital.
Having exposure to divergent strategies, such as global macro and managed futures, helped tremendously in 2008, allowing some managers to produce absolute returns under extreme conditions. Convergent strategies will perform under most conditions, but we believe that divergent strategies provide “insurance” for times like 2008, when asset prices are no longer determined by rational behaviour.
Absolute return strategies are not designed to mimic or match broad equity markets, which means they typically won’t provide outsize returns during periods when stocks outperform. But they are designed to protect against capital drawdown—an important feature for the long-term investor. Reducing drawdown can preserve capital and avoid lengthy periods spent recapturing large losses, which can happen when stocks are the chief growth component of a portfolio.
With so many different scenarios on the horizon, the landscape will become trickier, not easier. Institutional investors will want to look for an investment platform that offers:
• Strategies that are risk-managed, solutions-oriented or designed to manage against any market challenge;
• A range of active and passive strategies that can be utilized individually or combined toward a more specific need; and
• Capabilities such as exposure management or liability driven investing, which allow them to formulate total portfolio solutions.
Only by considering all of these factors can investors ensure that they are well positioned for recovery—whatever form and timeline it might take.
Peter Lindley is vice-president, head of investments, with State Street Global Advisors, Ltd.(Canada).
peter_lindley@ssga.com
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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the December 2009 edition of BENEFITS CANADA magazine.