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  Institutional Investment in Foreign Exchange hedge funds

Currency Hedging - impact of FX risk on performance and the investment process

By David Poole

Hedging is a key tool in investment strategy, accounting for almost half of all FX trades globally, but is undertaken in a variety of ways. Those using purely systematic methods of hedging are at the conservative end of the hedging spectrum; however, more often a mixed approach is taken using a combination of models and manual involvement, and covering a range of instruments, depending on the nature of the underlying investment. For example, one portfolio manager described their approach as: "systematic and methodical, we develop portfolios and manage the models but we are not tied to them." Other feedback indicated that, while models are often used for day-to-day transactions (simple products and major currencies), if a transaction is more complex, people become involved.

Source ClientKnowledge

While hedging is considered to be an everyday tool, it is debatable as to whether it is used efficiently and effectively. The most obvious indication of this occurred in 2008, when unhedged and poorly hedged funds performed badly during times of extreme stress. The majority of funds operate on a long-term basis, and therefore need a long-term hedging strategy - one which requires risk-assessment and stress-testing in order to more closely align the hedging strategy with the purpose of the hedge. However, managing the short-term performance of a fund is also very important, in order to appeal to new and existing clients who often use the NAV of a fund as a key indicator to differentiate funds' performance. Naturally there are costs associated with hedging, just as with any form of insurance, which must be assessed and incorporated into the understanding of the true risk of the investment.

A recent example of evaluating the cost of hedging is the reluctance to hedge counterparty risk on super-senior tranches of CDO's leading up to the credit crisis. The cost of hedging was often calculated to be "too expensive" for the structures and much debt was left unhedged, resulting in large losses when the credit worthiness eroded. Using a hedge effectively might impair short term performance, but in this case invalidating the attractiveness of the investment through the cost of hedging would have been invaluable.

For longer-term equity and fixed income pension funds the cost and effectiveness of hedging needs to be carefully considered to balance the short-term cashflow hedging requirements against the longer term nature of the fund.

Assessment of hedging

There are differences between European and American attitudes to hedging when it comes to their view of the impact on hedging of the low-yield environment. Half European investors see a better opportunity as a result of low yields, compared to less than a third of North American investors.

Approximately a quarter of investors take interest rates and currency moves into account when formulating hedging strategy; the remainder focus more on the type of product and the style of trading, particularly in Europe, and on trading fees, particularly in North America.

The majority of people do not use the whole range of available indicators when assessing the cost of a hedging strategy, for example, in our study a third of US fund and fewer than 20% of European managers looked at market trends.

Factors taken into account when evaluating cost and value of hedging
Source ClientKnowledge

Client-side risk awareness has also developed into a driver for fund managers as the costs and risk-reduction of hedging has a relatively bigger impact on performance than before and has become a client concern. The differentiation that can be achieved by managers on the basis of their hedging strategies may attract clients.

Volumes

Trading volumes and risk taking have reduced considerably since the beginning of the crisis, and, while there has been a recovery, the effects have been felt globally In Europe, interest rates are held to have had a considerably lesser effect than volatility, whereas in North America the impact of both factors has been felt equally.

The difference between Europe and North America is, to some extent, explained by their different attitudes to hedging; Europeans tend to favour a more conservative approach with more volume used to actively manage risk (hedging) rather than the more polarised approach in the US between a sophisticated search for alpha and a simple translation strategy. . In addition, more North Americans take currency and interest rate fluctuations into account when evaluating a hedge, and are therefore more likely to notice their impact.

Average % of business split between trading models
Source ClientKnowledge

The low-yield environment

The effects of the changes to low-yield currency volumes have been felt by 63% of investors, some of whom have adjusted their strategy on high-yield currencies accordingly. However, more than 80% surveyed recognise the opportunity to be short-term.

This short-term view considers the highly cyclical historic nature of yields as demonstrated by the USD/JPY yield gap data above. The yield gap plunged to even lower levels during the recession of the early 1990s and has seen two more significant downturns in the last 25 years. While interest and exchange rates are important influences on hedging strategy, they should not be the only considerations taken into account. More in-depth investigation into rate cycles, and their incorporation into the risk assessment of hedging, can only benefit the investment, allowing the timing of the investment to be a factor in the hedge.

USD/JPY yeild and volatility
Source BNY Mellon Global Markets

Yields

Yields from the major currencies have converged and are now at the levels sustained by the JPY over the last decade. Inevitably this has created a new lower-yield market environment which has led to temporary adjustments to strategy among some investors.

This has led practical conditions under which it is possible for former high-yield developed currencies to become funding currencies, with more than 80% of investors from North America and Europe using USD and EUR respectively due to their low yields.

Funding currencies
Source ClientKnowledge

Chasing returns

Over half of investors use FX to generate alpha, more so in North America (71% of respondents) than in Europe (45% of respondents). This follows on from the earlier observation regarding the proportion of business North America allocates to generating excess returns compared to that in Europe.

The two central methods of generating alpha have major barriers to their becoming mainstream. Firstly, a strategy of latency arbitrage requires continual and substantial investment in advanced, ever-changing technology. This requires fast decision-making and implementation and leaves the majority of investors in a position where by the time the technology has been approved and installed it has already been superseded by a new innovation. Hedge funds, with their ability to turn a decision into implementation overnight, are therefore always one step ahead and thus able to monopolise this strategy.

Secondly, the pursuit of a carry trade strategy in the perceived uncertainty of the current market offers an unattractive risk-return ratio. Whilst returns can be smooth, the currency move when the market breaks out can be so fast a reversal the question has to be asked whether the strategy should be a carry trade or trying to position for the break of the carry trade. The speculative bubble created and destroyed by such investments adds to the uncertainty in an already volatile market. The carry trade is also often misleading and a consequence of investment strategy rather than the strategy itself. However, there is increasing emphasis on emerging markets and this has the consequence of affecting a carry trade if you are a USD-based investor.

How FX is used to generate alpha
Source ClientKnowledge

Looking forward

Is there a new investment strategy developing as a result of the credit crisis and consequent low-yield environment? At the moment, investors are optimistic about economic recovery and, while acknowledging this may take time, are not taking a long term view on the current conditions, merely using it opportunistically. If, on the other hand, this is not borne out by events and the assumption that things will return to "normal" is short-sighted, we may experience a paradigm shift in the forex market.

To follow this to the logical extreme would mean the development of forex into an asset class in its own right. However, this is fraught with issues and likely is the more nuanced use of FX as a hedge or addition to performance. Hence, foreign exchange products will continue to be used as a consequence of investment in other assets and hence hedging will increase in importance.

So far low yields, and the resultant low returns on cash, have intensified focus on currencies as the need to hedge has become more pressing (the currency effect has a proportionally greater impact in a low return environment as currency volatility is not necessarily lower). People have become more pro-active in their pursuit of currency returns, which is allowing them to reap the benefits of placing an effective hedge against their view at the beginning of an investment. In addition, the pursuit of alpha, both as a result of investment in underlying assets and proprietary trading, has increased this year, although currency returns as a result of investment, rather than as a strategy, are still dominant. "As a result of the new market environment, we have expanded our portfolios exposure to more currencies. Our hedging program is still the same and needs reviewing."

One possible outcome of the credit crisis is tighter alignment and greater clarity of the risk of currency and asset. There would be a need to show the link between the forex exposure and the underlying asset which would lead to more thorough reporting on FX. For this to come about, a more detailed system of liquidity management needs to be in place, including an aggregated view of the market; data mining and analytical tools; efficient back office processes and transaction cost analysis. These measures would allow investors to examine the efficiency of their hedging, taking into account when an asset was bought, when the hedge was placed and therefore whether the hedge is as efficient as possible in the scenario. This leads to the possibility of closer scrutiny of investors' FX strategy by customers, and consequently differentiation between players based on hedging strategies. "We are increasing our FX exposure and need to review our standard hedging procedures. Our investors are increasingly demanding to understand our policy".

The opportunity lies in having the appropriate, and attractive, balance between risk and reward in order to gain and to keep clients, and the challenge is to determine the thresholds of when and what to hedge. These will ensure that hedging strategies are relevant, necessary insurance measures, and not just a somewhat random balancing feature on performance. All market participants need to take responsibility to incorporate more predictable and effective FX hedging into the system.