FOCUSING ON RISK MANAGEMENT & INVESTMENT OPPORTUNITIES IN FX
In terms of bringing something new to the story of active hedging, one of the most obvious changes has been a renewed interest in hedging from both institutions and their consultants. "I think there's little new in the methodology of currency hedging and I don't think that there are many new strategies, but I think what is new is the understanding of the need to do this - a better understanding of why and what currency does to your portfolio performance and how to use it to your benefit," observes Gary Klopfenstein, head of Mesirow Financial's currency management group.
According to Klopfenstein interest has boomed, although everything is relative. "A few years ago we were getting two or three inquiries a year looking for active hedging, now its up by a factor of five and it's not because we're doing anything different, but the volatility of markets has made people reconsider currencies," he adds.
"There's certainly a bigger interest internationally about active hedging and we've had a lot of meetings and discussions," agrees Giulio Martini CIO of Currency Strategies at AllianceBernstein. Even so, making firm decisions is a lengthy process as there remains some confusion among managers as to which strategy is most suitable and is further complicated by what Neil Record, chairman of Record Currency Management, describes as the consultants default position of recommending passive hedging. "I wish I could say we're seeing a flourishing interest in active but although we are seeing some rising interest in active, so far it's more sporadic than general," reports Record. "But they are recognising a problem and doing something about it," reassures Martini.
The reason managers are taking a longer and more serious look at active hedging has been the hammering many investors have taken since the credit crunch began in 2008. Investors, in particular pension funds, have been taking a greater interest in international equity holdings. North American pensions have also joined the international party, moving away from an overwhelmingly home-dominated equity holdings.
"The fact is that as portfolios follow the globalisation story currency exposure is the uninvited guest at a global equity party," says Martini. "Investors often don't want it."
According to Neil Record, UK managers have as much as 50% of their portfolios in international equities and bonds, losing their home bias. The impact of the currency element should not be underestimated: "The reality is that the combination of currency appreciation and higher yield, means that about 40% of equity returns came from the currency element since 1998."
And the volatility of both equity markets and currencies since 2008 have brought home some harsh realities to investors who either had no hedging strategy or for those with the most basic of passive hedging.
A common viewpoint has been that hedging currencies is a waste of time, that over the longer-term currency differentials will balance out, with hedging only bringing an unnecessary cost to the portfolio. "The argument has long been that returns from currency over the long-term are neutral," explains Nigel Rayment, Head of Client Portfolio Management at the currency management group of JP Morgan Asset Management. "But few portfolios have that 20 year time horizon and can the trustees or managers live with the volatility over that period, especially if you look at what's been happening over the past few years?"
Passive hedging is not the norm around the world, even if it remains the consultants "default position". And for some currency proponents the weakness of the passive route has been well-illustrated.
"The passive route is static, maintaining the same level of hedge, driven by a process with changes only being made in relation to the balance of the underlying assets, it does not take into account actions in a marketplace, even massive ones like sterling leaving the ERM and more recently during the fourth quarter 2008 of the credit crisis," explains Arnaud Gerard, senior vice president, Europe & Middle East Business Development at Pareto Investment Management.
While the levels of the passive hedge can differ for each investment manager, depending on their viewpoint, the reality is that many institutions have chosen another default setting - the 50% hedge. "It's been a default setting for many consultants - they tend to go for a 50 per cent hedge as a solution of least resistance, but I see it as a position of permanent regret as you're never really where you want to be," warns Gerard. "In reality you never want to be hedged 50/50 because you're neither unhedged nor fully hedged. The 50% hedge recommendation can only be the product of averaging."
And the results of the passive route have been brought sharply into focus when compared with active hedging strategies, a term that can still bring a divergence of opinion among those in the industry.
"For UK pensions, 2008 saw unhedged international equities doing very well because sterling fell. If you'd held a passive hedge of 50 per cent the portfolio would have lost 15 per cent, or if it had been a 100 per cent hedge it would have lost 30 per cent," highlights Record. It was, he says, the year that a dynamic hedging strategy would have done well by allowing the manager to rebalance the hedge ratios.
The starting point for the active hedge, is the hedging element itself. In its purest form the active strategy starts by examining a portfolio's currency exposure and the clients attitude to risk. "What you're doing is looking at the exposures in there and moving the hedge ratios around, with an eye on client constraints and with the goal of reducing total negative currency impact on portfolio, while allowing positive currency gains to pass through," summaries Klopfenstein. It should also bring the benefit of reducing the size of the negative cash flows and settlements associated with the hedging process.And the primary way is the dynamic hedge, allowing managers to use their experience to move the hedge. "The ultimate objective for the client is to manage the risk and ask, what's the optimal ratio? Not always easy in the short term," warns Rayment. "We'd say adjust the hedge ratio framework by using metrics like valuation (PPP), effectively seeking to identify periods of serious mis-valuations and do so on a bilateral basis across each currency."
"At times when sterling is strong you might want a 100% hedge at other times you'll want to move to zero per cent hedge. You need to catch those 10 per cent moves but not every peak or trough," says Gerard.
Indeed it's worth noting that trying to catch every peak and trough not only brings added risk. "If you update the underlying exposure too frequently you can get churn bringing excessive costs so we suggest applying a balance update on a monthly basis, unless of course you have a material change in underlying circumstances," explains Rayment.
This pure form usually works through each currency pair and its recent performance in the volatile markets of the past two years has been far more positive than passive hedges. One question the consultants ask is whether this brings any alpha to the table or whether this is even desirable in any hedging strategy. Arnaud Gerard's view is that even with hedging strategies, especially those called 'active', clients do have an expectation of constant alpha. "I don't think there can be - if the pound was weak over the next three years you can't guarantee alpha to your unhedged benchmark clients as strict hedging programme won't allow you to go below the unhedged position. Conversely, your fully hedged benchmark clients should generate good alpha. Over the cycle, you ought to be able to demonstrate value added as the clients' benchmark becomes sub-optimal. The key is to control costs (downside protection) during period of low or no opportunity, and to generate gains during period of high opportunity (upside capture)."
Kopfenstein feels that alpha is fed to the bottom line by reducing losses and cash flow to maintain positions. "A good currency manager should generate alpha based on what is embedded in the portfolio but some clients still get confused with the difference between risk management and generating alpha," he says.
But banging the alpha drum too loudly in the hedging world can have other reverberations. As Rayment and Record point out, the alpha strategies that followed between 2004 and 2007 (even within some 'active' hedges) with carry trades, ended in tears. "The story wasn't too good and the outcome not what the client expected and they didn't understand what was happening," outlines Rayment.
"Lots of clients had a terrible time with that in the end so they are now looking for something else that doesn't involve carry, or a more diversified approach with things like momentum and value," says Record.So all these implications have brought new elements to the active hedging business at least in terms of application, if not origination.
A more recent development has been to add to hedging programmes an alpha seeking (absolute return) programme as well. The later is no longer restricted to trade versus the client's base currency and against his existing foreign currency exposures but can enter into cross-trades positions. "These cross-trades positions allow the manager to exploit opportunity more broadly like expanding into emerging markets for example," notes Gerard.
"In the early days and because of the underlying asset structure, strategies had basic limits of being denominated in the four large currencies - sterling, dollars, yen and euro and that leaves you with limited scope to take actions in other currencies," observes Martini. Now the active element of the strategy can include cross-hedging, giving currency protection with an element of alpha opportunity.
Martini favours the Norwegian Krone for the same example, saying it can bring a more active dimension. "What you lose is the close linkage embedded in your assets because your exposure to Norwegian stocks might be very small, but it could be seen that as an alpha generator," he adds.
How exactly a currency manager might combine these elements is open to house-style and client demands. How much standard deviation for the underlying asset currency benchmark must be decided upon. It may be that half the hedge would be structured as a passive or dynamic hedge, while the other half takes more speculative positions based on the underlying assets.
Another new element has been the rise of the emerging market currencies and the role they now play in these more active hedges. Neil Record says he sees few clients with exposures above 10% of assets in these markets and his view is that their risk should not be hedged, indeed there is an underlying value proposition to view them as appreciating in the mid to long term. Rayment agrees but says the short-term volatility can provide alpha opportunities. Gerard warns however against the US dollar risk that is embedded within the emerging market exposures. Although the picture versus sterling is less clear as a result of the sterling depreciation during the credit crisis, there is a case for decomposing the true nature of the emerging currency risk (it is coincidentaly consistent with the way EM is also often traded - via the US dollar).
In 1995 emerging economies accounted for 15% of global GDP, 7% of global equities and emerging market debt was 1.5% of global debt capitalisation. Today the same economies make up 33% of global GDP, 14% of global equities and 3% of global debt capitalisation, according to Martini. "Why is this relevant? Think of it as an investment opportunity - debt and equity instruments are the only products on the public markets. If GDP shows the wealth of the underlying markets, private investment has more opportunity and these assets shows the public market is trailing in opportunity and you can catch that in the currency," he argues.
It is also a question Klopfenstein thinks is important: "Even if they take this view not to hedge because of emerging markets GDP rising faster than the developed world, they may also take the view that it's worth removing and exploiting some of their inherent volatility."
What has also added to the emerging markets story is the greater liquidity throughout the sector and a growing acceptance of NDFs, providing lower cost thresholds.
Of course as far as potential clients are concerned, the big question in implementing any strategy, is how much will it cost. And this may be the one area where 'new methodologies' have entered active currency hedging but in an evolutionary rather than revolutionary way.
"This is where Pareto's competitive advantage resides, as the active hedging programmes are run versus a maximum risk budget rather than a standard deviation limit. This provides clients with advanced knowledge of the ultimate absolute or opportunity cost relative to the passive hedging alternative," explains Arnaud Gerard.
"I'd say the industry has made slow but positive progress in the technology area and while we might still trade a lot by voice, electronic platforms have benefited on some cost level and new technology has changed our lives a lot. Computing and information technology has brought down costs and improved operational risk," says Record.
Across the industry fees have become more competitive, with passive hedges commanding 3-5 basis points and active hedges between 30-50 bps.
"There is a tendency for clients to focus on how much they're paying us and how much they're paying out on a yearly basis for the programme but they shouldn't see it as a cost at all, its reducing the cost of the underlying currency risk on their equities," advises Klopfenstein. "If they had a 100 per cent passive hedge and it goes against them, they write a cheque for 10 per cent as a loss. If they have an active hedge, instead of writing a cheque for 10 per cent, they're writing one for 3 per cent and that 7 per cent difference a can be an enormous difference."
Most managers are incorporating all these elements and arguments in their search for new active hedging business, an argument they feel consultants are finally beginning to take on board. And while there may be a shifting in acceptance of active hedging, an increasing exposure to international equities, a broadening of the markets to include the emerging economies, there seems to be little new in trading instruments or strategies. "There's nothing fundamentally new and I think we're past the point of the currency industry coming up with whizzy things that look fantastic. There may be complex instruments in the future, but we've invented all the basics and they're unlikely to change," concludes Neil Record.
