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Tailoring FX Solutions for Complex Investing
Dynamic models can help investors navigate currency hedging for their diversified portfolios.
Jeremy Adams, Vice President, Currency Management
Layering alternative assets, such as private equity, private debt, real estate, infrastructure and hedge funds, into a portfolio has been adopted by institutional investors in recent years as a mechanism to help achieve return and diversification goals. The growing popularity of alternative assets looks set to continue as investors search for broader diversification and higher yielding assets in an environment where alpha generation is harder to achieve. Over the next decade, the broad consensus is that the traditional 60/40 portfolio will most likely yield returns in the low single digits.i
In the last decade, institutional investors across the globe have significantly increased their allocations to alternatives. A recent survey of global asset managers conducted by Northern Trust found that 36% of respondents plan to launch or increase their allocations to alternatives within the next two years.ii In Canada, the Ontario Teachers’ Pension Plan recently announced plans to invest up to $1 billion in an offshore wind farm joint venture.iii In the U.S., the Arizona State Retirement System has invested more than 21% of its portfolio in private debt,iv and in the U.K., the Devon Pension fund has increased its alternatives allocation from 15% in 2016 to 29.6% in 2021.v
As the complexity of assets increases, the steps required for a currency hedging strategy to stay on track accelerate and become more complex. Institutional investors should take these challenges into consideration when enacting a currency overlay program, as these factors can impact the ability to effectively execute a hedge on that strategy. Alternative assets are typically illiquid, valued infrequently and can be “lumpy”. Time horizons can be longer and there are often lockups for committed capital. Also, when contrasted against traditional equity and fixed income, alternatives may have a less consistent benchmark.
When implementing a currency hedging program for a complex portfolio, several crucial factors may be considered, such as cash and liquidity management strategies as well as dynamic hedge models.
For portfolios with alternative allocations, liquidity management is a key factor to consider, particularly regarding drawdown risk. Events such as crystalizing gains and losses from rollovers can lead to difficulty for portfolio managers. Often, to satisfy a drawdown event, a manager will sell overweight and/or liquid assets to raise currency to satisfy a loss. This can have the undesired effect of detracting from strategic portfolio allocation. Fortunately, strategies exist that can help minimize this drawdown risk and contribute to a more efficient use of cash required to support an overlay program.
- Staggered hedges – Often, currency hedges are rolled periodically on a whole portfolio basis. By staggering hedge tenors, a currency manager can split the currency hedge notional of a portfolio into several smaller clips, rolling the hedge for these smaller iterations of the portfolio each cycle over staggered tenors as opposed to the whole portfolio at once. The effect of this approach may produce a drop in average and maximum drawdown as well as a lower standard deviation for significant drawdown effects. Furthermore, this approach allows the manager a degree of optionality with the hedge tenors being applied.
- Liquidity buffers – The potential to use cash on hand, liquid assets or an overlay of futures positions can act as a liquidity buffer when a portfolio has short-term cash needs. Such a program can also add a flexibility benefit to a portfolio when used as a tactical asset allocation tool.
- Credit facilities – Lines of credit can satisfy short-term cash needs and are readily available from sell-side providers. Their usage, however, has an interest cost and can act as a drag factor if there is a continued cost of drawn/undrawn amounts.
While passive models offer relative operational simplicity and ease of management, there can be drawbacks. Longer time horizons for an alternative asset passive hedge can amplify liquidity stress points. Even staggered rolls have the potential for performance differential where there are changes to the curve. A diversified portfolio might therefore benefit from a more dynamic overarching currency program.
Dynamic hedge models may be useful in several different scenarios. Where a portion of a portfolio is allocated to alternatives, a manager may decide to manage that allocation on a differentiated basis to the wider portfolio, or given the challenges posed, might look to utilize the exposures to introduce a dynamic element to the hedge profile. Some approaches include:
- Purchasing power parity (PPP) – A rules-based program that utilizes relative currency strength as a market indicator to dictate prevailing hedge ratios of currency exposures. This could be used as a slightly more active approach to hedging than a purely passive hedge whilst retaining the core objective of exposure management. This approach typically increases (decreases) hedge percentage where the base currency strengthens (weakens).
- Tactical tilts – Allows a portfolio manager to over/under hedge exposures versus their “would be” hedge ratio in the investment policy statement. Either on a discretionary or a factor-based framework, this gives the manager a degree of optionality and freedom to enact fundamental or technical views on the hedge program.
- Mean variance and the use of modern portfolio theory – Using a portfolio’s (or a listed index’s) currency weights, deploying quantitative techniques to measure the asset and currency performance correlation in order to derive each currency’s ‘optimal’ hedge ratio.
- Forward rate bias – Using portfolio exposures to establish forward positions that take advantage of positive interest rate differential or their expected shifts.
A currency overlay manager could look at any of these dynamic approaches in isolation or combine the different facets according to the underlying portfolio’s idiosyncratic needs and objectives.
Measuring a complex currency hedging program can be daunting. Therefore, careful consideration should be applied to performance measurement techniques.
A skilled currency manager can assist institutional investors in measuring their programs. The marketplace has increasingly sought detailed analysis and attribution of hedge returns, as well as transparency into techniques undertaken by outsourced managers. The response from currency managers has been to implement technology to satisfy more diverse client demands. For example, with access to interactive performance attribution dashboards, institutional investors can better assess the results of certain hedge strategies. The most meaningful measurement capabilities can provide insights on hedge performance not solely on an overall program but also offer greater resolution of hedge performance down to the asset class or even investment or instrument level.
The pace of adoption in the alternatives space shows no signs of cooling. However, as mentioned, alternative assets present unique challenges and complexities. Finding a currency hedging program that can be customized to fit a modern portfolio is crucial to meet portfolio objectives and returns. Investors, arguably now more than ever, should seek the appropriate tools to effectively manage all stages of the currency overlay cycle.
i The Portfolio for the Future | Portfolio for the Future | CAIA
ii Driving Growth in Asset Management: The Next Chapter (northerntrust.com)
iii Ontario Teachers, Corio partner on offshore wind projects | Pensions & Investments
iv Pension Funds Chase Returns in Private-Market Debt - WSJ
v Investment management costs soar as UK pension funds opt for higher allocations to private markets | Private Equity Wire
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