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Benefits and Pensions MonitorCurrency Volatility Is An Unrewarded Risk
The elimination of the foreign property rule by the federal government will enable Canadian investors to fully participate in the international opportunities created by the world markets. The increase in international diversification benefits will undoubtedly improve the performance of most pension fund portfolios. This added diversification, however, will also expose Canadian investors to an additional source of risk – currency risk. The prolonged depreciation of the Canadian dollar in the 1990s benefited most pension plans’ international asset allocation as few participants had a currency risk policy in their investment guidelines. However, the new century marked a new era for the Canadian dollar. In fact, the cumulative overperformance over a 10-year period of an unhedged Canadian investor in an S&P500 Index strategy reached a high of 35 per cent by the end of 2001. This overperformance was completely eliminated in less than 18 months. Moreover, in the last 10 years alone, an investor in the MSCI EAFE index strategy would have incurred more than 20 per cent currency impact to their portfolio’s returns on five separate occasions. Although currencies seem to exhibit a mean reverting behavior this is only in the very long-term. In the current environment of unfunded liabilities, this long-term time horizon represents a significant risk most plan sponsors cannot afford to bear. Thus, one can fairly assume that currencies report a higher short-term risk with no increase in long-term expected return. The Motivation For Hedging There are several possible motivations to be taken into account when considering a currency policy:
For plan sponsors who are strongly focused on the negative effects of currency exposure, or have been through a long period of base-currency strength, avoiding losses is perhaps the most obvious motivation. Such losses can be avoided by implementing a fully-hedged policy, but this approach is not without costs. In addition, the myopic avoidance of currency losses overlooks the fact that currency exposure can also be a diversifier in a portfolio context due to low or negative correlations between currency and asset returns of a given country.
For this reason, many plan sponsors often prefer to describe minimizing overall portfolio risk as their primary motivation. By considering currency exposure as a natural part of overall portfolio exposure, one can frame the currency decision as minimizing overall portfolio risk, or making the overall asset allocation more efficient. Furthermore, the recent focus on liabilities in the context of plan asset-allocation clearly has an important bearing on currency hedging policy. In particular, allowing for the risk and correlation characteristics of liabilities may result in a significantly different policy recommendation than that resulting from the consideration of assets alone. The partially hedged policy has grown in popularity in recent years as plan sponsors have shied away from the strong philosophical views required to advocate either polar benchmark options. Essentially, a partially-hedged benchmark is seen as a middle ground, bringing some of the benefits of risk-reduction whilst controlling costs, and minimizing the opportunity cost of incorrect benchmark selection. It is argued that a partially hedged stance is likely to be a better policy in the long term than either of the extremes. However, this does not necessarily imply the arbitrary choice of 50 per cent, unless regret minimization is of primary importance. Therefore, one of the questions which is often asked with regards to investments in international asset classes is what should be the strategic level of currency hedging in my benchmark? One of the reasons why investors have such difficulty determining a static hedge ratio is the inability to adjust to market conditions in the traditional framework, and implicitly, a fear of being wrong at some time in the currency cycle. Therefore, their implementation decision will be primary driven by the level of valuation of their base currency at that very specific moment. Dynamic Hedging Strategy A dynamic hedging strategy should satisfy the concerns of such investors as it can adjust to the changing market conditions in order to dampen the effects of currency volatility. The objective would be to provide a long-term dynamic strategy to adjust hedge ratios over a currency cycle, as the exchange rate moves from levels of overvaluation to undervaluation (or vice versa). One of the significant advantages of a dynamic strategy is the smoother return characteristics exhibited by the strategy which could limit the downside risk of the static hedging model without sacrificing the upside. This strategy would offer an opportunity to add value over the long-term from the currency exposures associated with global investing. A dynamic hedging strategy will appeal to those pension funds that wish to control the unrewarded risk of unmanaged currency exposure, as well as those that seek to profit from the active management of these risks. Yann Depin is vice-president, head of currency management, at State Street Global Advisors, Canada. |
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