Currency management is not optional
It is no surprise that Aussie superannuation and institutional funds are proportionately more exposed to global markets than their international counterparts. Faced with a local investible market that, at best, represents just over 2 per cent of equities worldwide, an appetite for global investing is a prerequisite for success.
What is often underestimated, however, is the extent to which success can be distinguished by a robust currency management framework. For many funds, currency management has been superficial and ad hoc – treated as peripheral or an afterthought, rather than as a strategy in its own right. In fact, for many institutional investors, currency is not even considered an asset class. As a result, it is subordinated in asset allocation decisions, and does not feature in fund documents or asset allocation tables.
But increasing exposure to global assets means increasing exposure to foreign currency. It doesn’t make sense to ignore the benefits of astutely managing currency exposure when a robust hedging strategy can play a crucial role in managing and diversifying portfolio risk and achieving portfolio objectives.
Discipline and clarity
It’s easier said than done. In currency management, as in investment generally, success is not guaranteed. Even with the most advanced tools and analytics, it will remain an inexact mix of science and art. But there’s no question that using a coherent, logical framework to inform decisions – and plan eventualities ahead of time – can skew the odds in your favour.
Creating a framework is not about taking a view on where individual currencies are likely to go. It is about determining an optimal hedge ratio – and not just as a static consideration, but in a way that allows for shifting allocations as conditions change. Once you have clarified your objectives (which may not be simply return-based and may consider factors such as liquidity and peer risk), you must then apply a logical process to achieve them. This includes documenting how and when ratios will be moved, what your triggers would be, and what the underlying currency mix should look like in each instance.
While what constitutes an ideal framework will inevitably vary from institution to institution, here are three themes that can inform decision-making for 2018:
The A$ and risk assets
History shows that when equities fall, the Australian dollar typically falls, too, and when equities rise, the dollar also rises. In an extended bull market, however, the dollar does not rally indefinitely and will at some point hit a ceiling. This typically occurs in the late stages of a risk rally. We appear to be at precisely this late stage in the risk rally. If, as the evidence suggests, the currency is not a safe haven in times of stress, then this asymmetric reaction function is cause for a higher foreign currency weight in diversified portfolios.
Hedging emerging markets
Developed-market currencies are usually well understood, even if not well-managed, but the same cannot be said of emerging-market currencies. These are often left to run free in institutional portfolios, on the basis that transaction costs are too high and market liquidity too variable, along with the understandable concern that hedging could erode any interest-rate carry advantage. But an intelligent approach to the hedging of emerging-market currencies, one that addresses these hurdles, can be beneficial, particularly when investors are looking to tactically underweight emerging markets without selling down equity holdings.
Currencies help manage and diversify portfolio risk and it’s important to remember that foreign currency weights need not be static. The Australian tendency has been to see currency exposures in binary terms (exposure to either the local dollar or overseas currency) and not appreciate the dynamics of the individual underlying currencies.
This approach need to change to one of enhanced diversification: looking at relationships between developed market currencies and risk assets, identifying the persistence of negative correlations, and using these to enhance diversification.
We are seeing gradual improvements in currency management, but we believe much more is possible, and our superannuation and institutional industry should lead the way when it comes to demonstrating a more enlightened and strategic approach.
Stuart Simmons is senior portfolio manager at QIC. He will speak at next month’s Investment Magazine Fiduciary Investors Symposium in the Blue Mountains, NSW, during a session titled, “Managing dollar pains: monetary policy, yield gaps and jawboning.