As equity risk dominates many portfolios and is relatively easy to understand, currency is often overlooked due to a lack of resourcing, even though it’s the second largest asset class.
While currency can be considered to be the second largest asset class, a lack of resourcing means it’s a blind spot, said Claire Thornton, manager of asset allocation implementation at AustralianSuper.
“Without providing sufficient resources, I think funds risk increasing the likelihood of the unknown unknowns in their currency exposure. I’m not sure if implementation is a blind spot, or an entire category of blind spots,” Thornton said.
She added the treatment of underlying currency positions is important, whichever way currency risk was viewed.
“If you are targeting hedge ratio you might think, ‘Well, I’m giving my managers unhedged benchmark to manage to, so off benchmark positions are going to be limited.’
“But once you have more than one manager, what does that look like? It’s a known unknown, but do you have visibility of the underlying currency risk that is taken when all your managers are keen for a particular stock? And do you have a plan or an idea where that would get uncomfortable for you?”
Mountains and icebergs
A cursory look at the resources and time spent on equities manager selection compared to currency becomes pretty clear.
“Equity risk dominates many of our portfolios and it’s a familiar story. Like a mountain, it is easily visible. It is relatively intuitive to understand, both by members who see equity returns on the TV screen every night and also for trustees.
“And as a result, a lot of management time and attention is spent on this equity risk part, and that’s fair enough; that’s right, actually.”
However, she added currency risk is more like an iceberg as it was less immediately visible and less actively considered.
The average balanced fund allocation to international equities is around 30 per cent, but there is additional offshore exposure coming from fixed income and unlisted allocations. As such, it is likely the average super fund has somewhere between 40 per cent and 60 per cent of assets offshore.
Similarly, the average balanced fund’s allocation to currency risk is around 20 per cent, so currency hedge alone is a large portfolio, perhaps between 20 and 40 per cent of total funds under management, Thornton said.
“So currency in many ways can be considered to be the second largest asset class, but the management of currency often attracts much less management time and focus and headcount.”
Guilty until proven innocent
Passive hedging mandates are often given in the management of these, but from a fund perspective, they often become more of an operations function, rather than a front office function.
“It is worth thinking about how much time we spend weighing up the small percentage allocation change in your total equity weight and how this compares to the time spent weighing up the change to currency exposure, either those that are driven by the increase of offshore assets, or those that are driven by an active change to the hedge ratio,” Thornton said.
“Similarly, most investment committees receive heaps of information about the equity managers, but I’m not so sure they receive the same level of information about their currency managers. And [I] am not sure how transparent the hedging approach used is.”
With these things in mind, AustralianSuper has a separate currency team who own all of the currency risk in the fund. They are responsible for determining which managers are creating intended active currency positions.
As such, managers are considered guilty until proven innocent, and Thornton said the experience has been that a lot of the currency risk that is arriving, on the active position of equity managers in particular, is not necessarily being made at a conscious level.