WHAT’S IN A HEDGE?
With FX movements having a more meaningful impact on globally diversified portfolios at the same time as volatility increases, the case for currency hedging appears markedly stronger, especially for those keen to minimise the volatility of their overall portfolio in the long-term.
Ed Hails, investment consultant at Towers Watson says: “For most institutional investors, an element of hedging would be a good idea.”
Currency hedging strategies can produce very different results and warrant careful consideration, particularly in an environment of divergent monetary policy. In the UK, hedging strategies tend to be passive, whereby a constant ratio of FX exposure is hedged, typically 50% for overseas equity and 100% for fixed income (where currency volatility is a more significant contributor to the volatility of asset prices).
The preference for passive hedging appears to follow the same trend as many other areas, where the debate about whether active or passive is more efficient continues to rage.
According to Aon Hewitt principal consultant Calum Mackenzie: “A lot of institutions have had negative experiences with active currency funds through and post the financial crisis. Some market moves have also been very difficult to predict, including the devaluation of the Chinese renminbi in August.”
However, providers report a growing interest in more active strategies, commonly called dynamic currency hedging. The recent rise in the US dollar, which is widely expected to continue as the Fed begins hiking interest rates, is a key factor in favour of more dynamic strategies.
Passive strategies, because they operate on a constant hedge ratio, protect portfolios from the impact of falling foreign currency valuations, but also limit the upside potential available from currencies that are on an upward trajectory versus the base currency of the investor.
For example, Berenberg’s data shows while the S&P 500 was up +7.42% for the 12 months to the end of June 2015, the performance for an unhedged UK-based investor was even higher at +17.04% thanks to appreciation of the dollar versus sterling. An investor that had hedged 50% of that dollar exposure would have made significantly less additional gain.
Dynamic hedging typically allows the manager to adjust the proportion of each currency that is hedged, which allows for protection from falling currencies while also giving investors the opportunity to benefit from the upside potential too.
The Church Commissioners for England use an active approach to their currency hedging. “The manager has the discretion to be unhedged, 100% hedged and everything in between,” says Tom Joy, director of investments, “which is how they have added value. Having the opportunity to outperform is an added benefit of an active manager.”
FORTUITOUS TIMING
Joy calls the Church Commissioners’ decision to hedge its currency exposure, taken shortly before the financial crisis hit,“fortuitous”.
“The fund took a meaningful non-sterling position in 2006-2007, which raised the issue of currency risk,” he says. “We decided to appoint a currency manager with an unhedged benchmark, which means they only take a hedged position if sterling is rising against foreign currencies. As the crisis hit, the portfolio was unhedged and as sterling collapsed against the dollar that provided a boost to returns.”
With the Bank of England expected to follow closely on the heels of the Fed in raising interest rates in the UK, the most likely outcome in the coming years is a stronger pound versus the euro and other major currencies such as the yen. While the ECB looks set to ramp up its quantitative easing programme, the Japanese central bank is also likely to undertake further quantitative easing, pushing both currencies down against sterling and the dollar as central bank monetary policy looks increasingly divergent.
Even in the case of US investments, particularly absolute return strategies investing in dollar-based assets, Joy believes hedging offers benefits despite the expected rise in the greenback. “We deliberately want managers to generate returns with less market direction wherever they can,” he says. “We want a sterling share class where the manager hedges the currency exposure.
“I am surprised more UK investors don’t put more pressure on managers to offer sterling-hedged share classes in absolute return strategies,” Joy continues. “ Investors would pay a fee on the gains coming from the foreign currency going up against sterling even though it is not alpha.”
Towers Watson’s Hails issues a note of caution regarding sterling-hedged share classes over potential hidden costs.
“They can include costs that don’t flow into the total expense ratio or there can be questions about liquidity – for example, if the hedge loses 10%, does the fund have liquidity to sell assets. This is certainly not a problem across the board,” he adds, “but there is a strong case for careful selection.”
Comments