Surprisingly little research has been done in the area of how a superannuation fund should hedge out its foreign currency exposure, says Robert Goodlad, former senior managing director of State Street Global Advisors.
As superannuation funds continue to invest more internationally, it is vital that more research be conducted to find better solutions to manage the impact that currencies have on portfolios. A much better path of least regret in managing exchange rates needs to be researched and adopted.
The impact on performance on an international equity portfolio from currency over the last decade has been over 60 per cent between fully hedged or unhedged. To counter the potential offsetting of performance risk and to better protect the Australian dollar value of offshore investments, superannuation funds usually employ external parties to implement currency hedging strategies. The problem is that few preconceived hedging strategies have actually achieved the desired objective.
Industry practice is to utilise a currency overlay manager, who uses FX forwards, currency options or swaps to preside over the activities of the superannuation fund. While altering the currency hedge ratio to take advantage of moves in the Australian dollar is quite common, the actual reduction in risk in an international equity portfolio is rarely achieved. Indeed, taking a stand or view on the direction of the Australian dollar has provided most superannuation funds with severe body blows at some stage.
It was the customary practice 20 years ago for a foreign asset value to remain unhedged and for foreign currency exposures to be held and maintained. Where there is a high correlation between foreign assets and foreign currencies, then the foreign asset value and Australian dollar will tend to move in the opposite direction. This potentially makes for good hedging opportunities, but often the underlying international equity markets however have poor linkages or correlations with their own currency for example the Japanese stock market is notoriously uncorrelated with the Yen. So it makes sense that investors look to diffuse or hedge out the additional impact of a foreign currency if it adds an unintended risk and return profile to a portfolio.
The problem is, that if foreign asset positions are fully hedged, then the Australian dollar fortunes relative to the underlying investment becomes the new influencing factor. If, for example, the Australian dollar strengthens and the international asset prices remain unchanged, then the total international investment strategy falls in value. Most superannuation funds know too well the significant losses that they had to endure over many years when the Australian dollar slowly reached $US1.05.
Many funds therefore adopt an average hedge ratio based on a simplistic regression analysis. If this remains static at say a 50:50 hedge, then currency movements and the associated running losses and profits still need to be managed.
The purpose of any hedge is to be an insurance policy. As a superannuation fund is holding onto foreign currencies as an investment, a fluctuation in currency can cause serious losses very quickly. A currency hedge strategy is supposed to be a way to soften or guard against this. Funds can carry substantial losses hoping for the currency to normalise ahead of currency rolls. As currency forward rolls off, losses need to be paid up or squared away. The impact of currency can often be a primary factor as to whether a superannuation fund is ranked in the 1st quartile or 4th quartile in industry performance surveys, so static hedge ratios can leave much to be desired.
A hedge by definition is the purchase of opposite positions in the market in order to ensure a certain amount of gain or loss on a trade. They are employed by portfolio managers to reduce a portfolio’s risk of downside or volatility. The term hedge as it relates to currency however can be quite contradictory. Whatever currency hedge ratio is deployed, the reality is that the risk is rarely rewarded. It is little wonder that funds identify the management of the exchange rate as a very significant issue that they would like to resolve.
Recent industry surveys suggest that 80 per cent of superannuation funds’ international currency exposures are passively managed using fund managers and/or bank treasury groups. Passive management strategies don’t look to achieve an alpha and its employment is utilised to rebalance currency exposures to a predetermined benchmark. It is a cost effective implementation process over the broader investment. While the connotation of passiveness suggests a cop out, the choice of hedge ratio and the subsequent size of tilting provides the risk and performance impact to a portfolio. This part is not done by the fund manager.
Decision makers of a superannuation fund however can’t resist tinkering with a hedge ratio. Often the initial decision to increase or decrease the hedge ratio is based on a knee jerk reaction to a big move in the Australian dollar. Our own exchange rate is infamously difficult to predict but investment committees of superannuation funds and asset consultants often feel that they have to do something if the Australian dollar falls to say $US0.75 or conversely rises to $US1.05. It becomes an irresistible investment exercise to action a buy or sell of the Australian dollar. The decision to alter the ratio often made good fundamental sense at the time. However, the Australian dollar can become overly stretched and remain there for protracted periods of time. Rarely does the Australian dollar sit in an orderly fair purchasing power parity band.
By their very nature, tilts or adjustments to a hedge ratio are essentially a view on the direction of the Australian dollar. It is speculation and therefore a risk. It becomes part of the risk and return profile and an enhancement to what was intended over the exposure to foreign asset. What’s worse is that very few investors get the direction of the exchange rate right, the magnitude of change, the timing of the move and how long it stays there.
So what do you do to reduce the currency risk? Before an investor does anything, certainly rather than look for a profit motive, look at the downside risk. Have a mindset to mitigate risk in setting a currency strategy and don’t bet the house on the Australian dollar based on a predetermined view on where the currencies might be headed.
In the interim, if you are going to forecast exchange rates and alter the hedge ratios accordingly, it’s probably not a good idea to call it hedging.
