Staying current

Over the years, this currency effect has been fairly muted for most Canadians, as they have generally invested only a small portion of their overall portfolios in foreign markets. This phenomenon is referred to as the Home Country Bias. It’s a common practice around the world, but Canadians have gone beyond it: they have historically devoted almost 80% to local markets. That’s an extraordinarily high allocation when you consider that Canada represents less than 3% of the global market capitalization.

Federal tax laws, of course, played a big role in limiting how much foreign investment Canadians could hold in their retirement savings accounts. The FPR, which was introduced in 1971, originally restricted foreign content to 10% of a retirement plan’s book value, ostensibly to encourage the growth of Canadian capital markets. Over the next three decades, the limit was increased to 20%, then 30%, before this year’s federal budget eliminated it altogether.

The gradual increase in the foreign property limit, along with the adoption of Modern Portfolio Theory—which balances the risk/return tradeoff—by most plan sponsors, has led more and more pension plans to increase their allocations to international markets over the past 10 to 15 years. Nonetheless, many Canadian pension plans have not taken full advantage of the allowable foreign content room. The risk of paying a large financial penalty if they inadvertently exceeded the limit probably dissuaded some plans from increasing their foreign content exposures, despite the availability of synthetic strategies. For others, the regulatory limit may have imposed a psychological barrier.

With the elimination of the foreign property limit, Canadian investors should now be undeterred from investing more extensively overseas. As Modern Portfolio Theory states, investing abroad provides risk diversification benefits.

This is not to suggest that investors should or will rush out and sell their Canadian stocks and bonds. The commodity and resource-heavy sectors, combined with pension plan sponsors’ desire to align assets more closely with liabilities by holding Canadian long-term and real return bonds, are valid reasons to remain in Canadian markets. What this change does allow is for plans to seek more broadly diversified investment opportunities outside of Canada that may not only improve overall returns, but may also reduce risk.

This brings us to the topic at hand: currencies. The elimination of the FPR will inevitably lead to increased foreign market investment, so that currency translations will have an even more pronounced impact on portfolio returns. A case can be made for Canadian pension plan sponsors to consider hedging some or all of their foreign currency exposure.

THE VALUE IN HEDGING
The main reason to hedge currency exposure(s)is to manage shortterm performance volatility. Currencies tend to mean-revert over time, which means they offer little or no return over long periods. This theory holds because currencies don’t create any real economic value. They only serve as a means to purchase financial assets priced in different currencies. During shorter periods, though, currencies can have a significant impact on portfolio performance, both positive and negative.

A good example of this is the Canadian dollar’s performance relative to the U.S. dollar over a long and short period. U.S. equity market returns expressed in local currency terms for the 16 years ended Dec. 31, 2004 were 524.6%. In Canadian dollars it was 529.2%, suggesting that currency translation had little impact on returns over the long term. However, the difference in returns over the two-year period ended Dec. 31, 2004 tells a different story. The return in U.S. dollars was 42.6%, compared with the 8.8% in Canadian dollars. Clearly, currencies played a major role in short-term results.

The value currency hedging offers in the short term could benefit many Canadian plan sponsors. As pension plans introduce more foreign investments, the propensity of a mismatch between assets and liabilities could increase, since liabilities are denominated in Canadian dollars. From a diversification perspective, it is certainly prudent, and likely optimal, to have exposure to foreign markets as a long-term investment strategy. But currency exposure changes the risk/reward ratio in the short term.

HEDGE RATIO
When the decision to neutralize the foreign currency exposure of a portfolio is made, the appropriate amount to hedge will be determined. Generally the amount to hedge, or the “hedge ratio”, indicates the percentage of underlying assets to be protected from currency fluctuations(see “The pros and cons of currency hedging,” above.)

A 100% hedge ratio implies the portfolio is fully hedged against foreign currency exposure, and the opposite holds true with a 0% hedge ratio. Given that pension plans have different investment priorities, no fixed hedge ratio is applied; rather a customized approach to the hedging decision is taken. Many plans have defaulted to a 50% hedge ratio as a policy decision. Hedging 50% of a plan’s foreign investments allows them to take advantage of the partial protection on the downside as well as the partial participation on the upside, due to the foreign currency fluctuations. In other words, the decision to hedge 50% of the exposure is a “decision of least regret”, and that position will never be 100% incorrect.

CONSIDERING CURRENCY
Once a hedging policy decision is made, the decision to include currencies in the hedging program should be looked at. They should all be considered since they exhibit similar performance and variability behaviours over time.

Another issue to consider is whether the currency program should be managed on an active or passive basis. There is evidence that active currency managers have been able to add value over time. This is because currency markets, despite being among the most liquid markets in the world, tend to exhibit inefficiencies. These inefficiencies arise because many market participants virtually ignore the currency markets when they are maximizing profit elsewhere.

For instance, corporations are motivated by increasing their return on investment and trade currencies for balance sheet and hedging purposes that are independent of what is happening in the currency markets. International investment managers are motivated by profit on the underlying stocks and bonds they invest in and currencies are a byproduct of that decision.

Astute currency overlay managers have successfully exploited these opportunities to add value in the past. But, as we all know, past performance doesn’t necessarily guarantee future success. For that reason, it may be prudent to combine various active management styles, like fundamental and technical, as well as a passive strategic allocation in the overall mix.

An important factor to consider is the corporate risk associated with an adverse move in foreign exchange rates. For example, if a plan sponsor is an exporter to the U.S., the company is exposed to potential profit risk if the Canadian dollar strengthens relative to its U.S. counterpart. If the company’s pension assets take a hit at the same time, the sponsor may not be able to make a contribution to the pension plan. Therefore, plan sponsors should take their corporate risk into consideration in determining the appropriate amount of hedging.

Pension plans may need to review and update their Statement of Investment Policies and Procedures to allow for currency overlay strategies and the use of derivatives like currency forwards and options, as well as counterparty risk provisions, as these hedging instruments tend to trade in the over-the-counter market as opposed to on regulated exchanges.

PERFORMANCE EVALUATION
One obstacle that pension plan sponsors may need to overcome is the misunderstanding surrounding performance evaluation in a currency hedging program. They can mistakenly assume the return earned on their hedged market investments will equate to the local market return. Market dynamics dictate that there is a cost for hedging. Sometimes it is positive and other times it is negative. Either way, the cost is directly related to the difference between the interest rates of the country of the hedged currency and the country of the base currency.

In periods where interest rates in the base currency country are higher than those in the foreign country, sponsors will be compensated for hedging. For example, Canadians who hedged their U.S. currency exposure in 2003 and 2004 were compensated about 1.3% each year because interest rates in Canada were approximately 1.3% higher than in the U.S. However, the reverse could equally occur.

Another determinant of performance is the inability to be perfectly hedged at all times. Suppose you had $100 invested in foreign markets and you desired to be 100% hedged. You can easily and precisely hedge the currency risk associated with the whole $100. However, if the foreign market appreciates so that the market and currency exposure moves to $105, you would become underhedged by $5. If no additional hedging action is taken then this $5 is not hedged and would be subject to fluctuations in the foreign exchange rate.

With the eventual elimination of the FPR in Canada, the impact of foreign currency returns will become more pronounced at the total portfolio level if more plans seek investment opportunities abroad. History has shown that investors aren’t necessarily compensated for holding this currency risk, particularly during short periods. It’s also important to make informed and rational policy decisions on the appropriate currency hedging weight, and not merely accept the default currency allocation that falls out of a strategic asset allocation.

As defined above, there are several implementation issues to consider before initiating a currency hedging program. Future evaluation of the program is more likely to be successful if these issues are addressed at the outset. Undoubtedly, perfectly timing your currency hedging decision will be challenging. But when it comes to applying a currency hedging policy, it’s never too late.

Dino Bourdos, is vice-president and director at TD Asset Management Inc. in Toronto. dino.bourdos@tdam.com