“It’s a gut-wrenching experience,” Rieck told NAB’s FX Super Funds Conference in Melbourne on August 27. QIC, along with other big funds with large international exposures, suffered calls of hundreds of millions of dollars – the so-called cashflow risk of currency – to cover their hedges. And Rieck pointed out that with any crisis, you never quite know when it is over. Generally speaking, Australia has more room to move than our competitors, with bond yields higher than most countries, a current account deficit which is lower than in the US and an exchange rate “that’s doing its job”. “But what happens if our luck runs out?” Rieck asked. About 100 senior fund representatives, consultants and managers were present at the inaugural conference to dissect the issues surrounding foreign exchange. The major themes were: whether or not to hedge, and if so by how much, and whether an active or passive approach is better.
The only sure thing is that if super funds have any international assets, they have to form a view on currency. They cannot ignore it. However, annoyingly, there is no optimum single benchmark for them to choose. To put the importance of the currency decision into perspective, if an Australian fund invested in the MSCI World Index over 2008 was 100 per cent hedged it would have returned a positive 3.5 per cent. If it was 100 per cent unhedged, it would have returned a positive 22 per cent. That would have been the difference between making it a top-quartile fund or a bottom-quartile one. Leigh Watson, executive general manager, Asset Servicing, for NAB, said that currency was one of the most important issues facing super funds and many funds managers, which has been highlighted by the events of the past year or so.
The biannual NAB Superannuation FX survey of super funds’ attitudes to currency management and aggregate positions shows that the most important change among funds is that they tend to be adopting a total portfolio approach to what they hedge, rather than having separate currency benchmarks for each asset class. Another trend is a recent swing back to active currency management which peaked in the late 1990s and fell away after the technology bubble burst (see separate survey report: page 17). Steve Merlicek, the former chief investment officer for Telstra Super, who last month resigned to move to funds manager IOOF, said Telstra Super had been using a dynamic currency overlay, managed by Pareto Partners, for about 10 years.
“It means our losses have usually been not that bad and we have received most of the gains,” he said. Telstra Super also has a passive hedge, through National Australia Bank’s Asset Servicing, for 50 per cent over its international alternatives. It has historically hedged separately by asset class but was looking at a portfolio approach, Merlicek said. The fund was also looking at using option-based strategies to enhance returns. To h edg e or n ot t o h edg e On the question of whether or not to hedge, currency had the potential for risk and return and so should be evaluated in the same way as any asset exposure, Graeme Miller, the head of investment consulting for Watson Wyatt, said. “Watson Wyatt has a view, which is somewhat controversial, that Australian interest rates are persistently higher … so the carry trade will persist (borrowing in lower interest rate countries, such as Japan or USA, and lending in higher rate countries like Australia),” he said. “But there are diversification benefits.
A currency hedge can act as a powerful diversifier, especially in stressed times, and this alone makes hedging very attractive. In times of stress, the correlation spikes to negative one for currency.” Miller asked whether a super fund could afford to have a currency hedge which was radically different to its peers. “We find that peer considerations push organisations to have a greater hedging position than they otherwise would have,” he said. The currency hedging decision is often the most difficult for an investment committee or consultant to put to a board because of its binary nature – you can plainly see at the end of the year whether or not your decision was correct. As a result, many funds opt for a 50:50 hedge ratio to, rightly or wrongly, avoid regret. In terms of short-to-medium-term opportunities, Watson Wyatt believes that emerging market currencies are undervalued compared with developed market currencies. “There are good systemic reasons over the medium term to benefit from the strength of emerging markets, plus to pick up the carry trade effect,” Miller said.
The average volatility of the Aussie dollar versus the greenback since 1985, after the dollar settled down following its 1983 float has been 11.6 per cent, which is quite high, according to Ed Smith, senior consultant at Frontier Investment Consulting. It compares with the typical volatility of Australian equities of between 15-18 per cent. Smith echoes Miller’s view that when investing from a high interest rate currency can have a negative expected return (equivalent to saying ‘currency hedging back to high interest rate countries has a positive expected return’). However, currency has substantial diversification benefits that can help in overall portfolio performance, as amply demonstrated over the last year. One of the problems facing currency managers, as well as funds, is that even if they believe they can earn a return from currency, currencies can spend years being a significant distance from true value. Steven Carew, head of investment research for JANA Investment Consulting, said that while there was some return, volatility was “enormous”, so it came down to a risk management issue.
“It comes down to the goals of each individual client,” he said. “You should have the exposure you’re comfortable with, but move away from that from time to time when valuations move.” Acti ve or pasi ve? Funds need to be aware of the two types of active management when considering the active versus passive issue with currencies: alpha-seeking strategies and risk-reducing strategies. About one-in-four super funds is using an active currency overlay. Many investors had believed that if their base currency was weak, then they did not need to hedge. But the events of last year have meant that most investors are now concerned about the US dollar. “Even in the US, they’re worried,” said Ron Liesching, the chairman of US-based currency and commodities manager Mountain Pacific Group. NAB’s conference audience was asked: ‘in the role of an active currency manager, what is the most important – a) to add returns, b) to protect downside risk, c) both, but risk management is more important, or d) both, but added return is more important. A total of 52 per cent of respondents said ‘c’ and 24 per cent said ‘d’.
But whether the decision is active or passive, currency risk is inescapable. “It has a larger impact on performance than all active alpha programs,” Liesching said. James Coleman, senior vice president of Pareto Partners, based in Australia, said it was not possible to remove all risks with a passive hedge. “You can remove performance risk by fully hedging or you can remove cashflow risk (having to top up a hedged position with cash) by not hedging,” he said. “But you can’t do both.” Industry funds, which tended to be concerned about peer risk, most often had hedges of 30-40 per cent. Most consultants advised 50 per cent but the problem with this position was that it always guaranteed some regret. “We can take a policy which trades off the risks, but we can’t minimise them all,” Coleman said. Funds with a high exposure to alternatives had a different view of currency than other funds.
They tended to be more defensive, being highly hedged, but they then had a problem with cashflow risk. Whether or not currency is an asset class is a moot point. If it is, then it is a very different asset class. According to Liesching, currency is not a “strategic asset class”. It is an exposure, with no direct capital being invested. Currency forwards offer no cashflow. And there is no expected return to developed market currencies. He said currency was a “tactical asset class”. Currency exposure placed capital at risk, by investing contingent capital. The return came from active management, not passive exposure, he said. “It is an asset class as it can bring desirable risk reduction and return enhancement into the investment portfolio.” Because risks and issues change, so should a fund’s currency policy. “Some movement in the Australian dollar will force you to change your currency hedging position,” Liesching said.
Risk, count erparti es and liquidity Risk is not volatility, according to Michael Block. Nor is it something with reference to correlations alone. The general manager, investments, for FuturePlus Financial Services said risk should include some consideration of liquidity and valuations. “Thus, I believe that recent low equity prices have significantly less risk than equities in 2007 despite the increased volatility,” he said. “After all, equities can only fall half as much as they could in 2007.” Block said if you believed asset consultants and quantitative analysts then you would believe that a dangerously overpriced equity market which had exhibited low volatility was a low-risk investment and that corporate bonds with dangerously low credit spreads and low recent correlations to equities was a low-risk investment. A lesson from the financial crisis is that an investment in international equities may not be what it seems, due to securities lending and changes in value for the collateral used. “How many of you thought that your international equity trust could give you unwanted exposure to debt in place of equities?” Block asked.
“Regardless of the investment fundamentals, I would have thought that if I invested $100 million in an international equities trust I would have $100 million of exposure to equities and would be protected from changes in value to collateral used for securities lending. Lesson learned.” He said pooled investment vehicles, compared with segregated or discrete mandates, added to investment risk because of the lack of control for the beneficial owner. Liquidity – the ability to trade at a fair price in a reasonable time – was not guaranteed in listed markets, Block said. “How long would it take to realise a small-cap portfolio and could it be done at existing market prices?” The two paths confronted by defined contribution funds were to divest themselves of all-but liquid listed investments and/or to refine their offerings to avoid mismatches (of daily or weekly liquidity for members but not with their investments).
Block also questioned whether alternatives really were diversifiers. “In my mind, hedge funds of funds (FoFs) have clearly missed a golden opportunity in Australia because of recent performance. “Clearly, they are correlated with equities, thus exploding the ‘uncorrelated’ myth. At least traditional longonly equities performed in line with expectations. “Hedge FoFs claimed a volatility of 4 per cent and exhibited returns of 30 per cent below benchmark – some seven or eight times expected drawdowns. “The experience is similar with other alternatives that promised high returns and no correlation with equities.” Counterparties and investment engineering have been severely hampered by the financial crisis. Block said that funds should look at aggregated exposures.
“After all, if one holds bank bills, shares, corporate bonds and swaps with the same organisation then there can be a very large, but often not measured or managed, exposure to that organisation. Custodians are not yet well advanced in providing funds with global exposures.” Passive managers tended to be the big winners because of the scrutiny on counterparties. Operational issues Unit pricing and other administrative concerns tend not to be front of mind for super fund executives or even funds managers, except when something goes wrong. Currency issues, when coupled with the increasing use of alternatives, have posed challenges for administrators and custodians. In fact, while unlisted assets make up on average about 8 per cent of a typical super fund’s portfolio, they can take up to 80 per cent of a custodian’s effort in pricing, according to National Australia Bank’s Ray Lester, director of delivery services for Asset Servicing.
“Are people taking into account valuation risk in their decisions?” he asked. “Custodians have policies in place but valuation risk is something which everyone needs to take on.” Lester said that about 2.5 per cent of asset servicing’s prices are not independently assessed, but, rather, are sent to the custodian by the fund. There is no industry standard for ex-pricing. With some securities, such as CDOs and CLOs, the valuations are performed by the same people who created the security. “Is that appropriate?” Lester asked. “It’s the client’s responsibility to understand the nature of the asset invested in and the valuation policies being followed.” With currency hedging over unlisted assets and other alternatives, revaluation frequency and underlying currency exposures are important, according to Ross Blakers, associate director of Access Capital Advisers.
He said currency hedging programs needed to have clear objectives, be designed to work at the whole portfolio level, be designed to withstand stress testing and have strong risk management controls. With alternatives, the investor needed to be extra mindful of liquidity issues, however, longer-dated instruments could be used because the underlying investments were generally longer-term. Currency hedges tend to vary between one-month and six-month contracts, using short-term FX forwards for the greatest liquidity and lowest transaction costs. If longerdated hedging instruments are used, say beyond three years, typically cross-currency swaps are more common. Blakers said that while “the longer the duration the better” was a general rule, there were important caveats: credit risk; instrument types (forwards versus swaps); and costs.
“Most of these issues are manageable,” he said. “But in doing so credit risk is transferred into systems, legal, operational and personnel risk.” However, some funds managers are bringing profits or losses to account more quickly, with pre-delivery of FX contracts rather than waiting for the full contract period. “We’re seeing more and more pre-delivery,” Lewis Bearman, the chief operating officer of Perennial Investment Partners, said. The top operational challenges to be aware of, he said, were: . Managing custodial relationships – ensuring effective global operation and strong relationship building . Varying international settlement standards and cutoffs, ensuring all times are met and there are no settlement issues .
Getting FX right – relationship, reconciliation and rapport . Managing corporate actions and stock lending, requiring up-to-date and accurate information . Managing the different time zones. Globa l p ortf olios and transiti on man – ag ement Transition management costs have doubled in the past 18 months and super funds need to factor this extra cost into their decisions to change managers, according to Jonathan Green, senior manager, investment facilities, NSW Treasury Corporation. While expressing his own, rather than T-Corp’s, views at the seminar, Green said that transitions had become more difficult since September 2007 due to the increased volatility in the domestic and international markets. “Costs have gone up in recent times,” he said. “They spiked last October. While they’ve normalised somewhat they could go back up. Eighteen months ago, it cost about 30bps for an Australian mandate to transition or 15bps for an international mandate.
Now you’re looking at double that.” Intra-day volatility could “really blow out” costs, he said, so the selection of the right transition manager was more important than ever. “You should use seasoned campaigners with market savvy, not just flow junkies. They should have multiple options and a real presence in the markets.” He added that Australia was serviced by more transition managers than anywhere else in the world – those based in the US and Europe as well as Australian-based managers. Green also advised the use of a range of benchmarks, not relying solely on the popular implementation shortfall assessment. “For example, have a look two weeks after the transaction and see what the stocks have done. And be prepared to stop (if the costs are too high).
Look at the risks from an end-to-end basis… We’ve had transitions where we’ve changed the strategy intra-day.” The custodian needs to be given as much notice of the transition as possible. In fact, according to NAB’s Michael Johnson, the head of transitions and implemented services for Asset Servicing, the notification period is the most important element in a transition. “You have to let us know as soon as possible, to allow accounts to be set up, resources allocated and touch points identified, interested parties notified and security identification provided,” he said.
Late notification could lead to missed applications and redemptions, missing the closure of markets, missed investment opportunities, incorrect processing and increased risk. From a funds manager’s point of view, the exposures are managed by the transition manager. “The old days of getting a stock list and then working out which ones you want to keep are long gone,” said Kimon Kouryialas, the Australian head of Martin Currie Investment Management. “Since 2005 we only deal in cash or where there’s a specialist transition manager.” He said that global equity managers wanted transition managers to have full global reach, execution skills and crossing networks, backoffice capabilities and good communications. Confidentiality was also very important, he said.