THIS ROUNDTABLE IS SPONSORED BY QIC
Understanding the vicissitudes of the Australian dollar is more important – and simultaneously more challenging – than it has been in the past, a group of high-level investment experts have said.
With currency moving to the forefront as institutional investors hold increasing amounts of assets offshore, there are question marks over whether the Aussie dollar is undergoing structural changes that could cause it to behave differently to how it has in the past in various market environments, said participants at the recent QIC-sponsored Investment Magazine roundtable “Currency: Reserve, reset and war”.
At investment consulting firm JANA, currency is looked at on a whole-ofportfolio basis, and the economic backdrop is an important consideration in strategic decision-making around exposure to certain currencies, said David Van Ryn, senior consultant, head of specialised investments at JANA.
“We certainly look at it on a wholeportfolio basis and then from a hedging perspective we look at it in reality as to whether the volatility of currency overwhelms the asset class,” Van Ryn said.
With the risk of the Australian dollar being impacted by macroeconomic factors – such as the falling Australian housing market – Australian investors with Australian-dollar denominated portfolios can increase their offshore currency exposure, said Angus Nicholson, investment strategist at AMP Capital Investors.
This could be particularly beneficial in developed market currencies in Japan, Europe and the US.
Particularly if it’s in developed markets…in a risk-off scenario that’s going to outperform against the Aussie dollar,” Nicholson said. “So you’re sort of winning on two legs of that trade, potentially.”
The pitfall of doing this is the negative carry cost, with Aussie rates much higher than Europe or Japan, Nicholson said.
“You can hold that position for a while, expecting the risk-off scenario to occur whilst that negative carry just continues to eat away,” he said.
A changing Aussie?
David Hartley, chair of the investment committee at Australian Catholic Superannuation and Retirement Fund, questioned whether the Australian dollar’s historical pro-cyclical nature would continue. Recent “risk-off-type events” had not caused the Australian dollar to fall as much as it had in the past, he said.
“I think that part of [the character] of the Australian dollar in the past was because of it being a high-interest-rate currency and, therefore, being the long leg of the carry trade,” Hartley said. “That’s certainly not the case at the moment.”
The Australian dollar’s perceived status as a pro-cyclical currency was also being impacted by Australia’s massive superannuation pool, said Doyle Mallett, senior investment consultant at Mercer.
The superannuation industry’s enormous overseas equity holdings were “actually starting to negate our foreign debt”, Mallett said. “It’s always been the Australian dollar would sell off because Australia is a debtor country, per se.”
Against a downturn
Facilitator Alex Proimos, Conexus Financial’s head of institutional content, domestic events, asked how investors factor in the potential downside risk of the Australian dollar falling, with funds increasingly investing in offshore assets.
Allison Hill, director of investments, global multi-asset at QIC, said the starting point is to look at the historical distribution of returns and the patterns of the Australian dollar against a diversified basket of foreign currencies.
“Ultimately, from a QIC perspective, we see the Aussie dollar as being positively correlated to risk assets, so then we factor that into the benefits in a total portfolio context, which relies on those historical distributions,” Hill said.
When the topic of whether to hedge came up, Nick Barrett at Willis Towers Watson said holding some developed market currency exposures could hedge against potential downside risks.
“We’re very much thinking about holding foreign currency from that point of view, and from there the three key questions are, really, how much you hold, what currencies you hold, and whether and how dynamic you are around both of those things,” Barrett said.
Stuart Simmons, senior portfolio manager, global liquid strategies at QIC, said investors had “gotten a lot smarter” about the liquidity issues that came up when hedging programs were set monthly and settled on one date, which led to “quite a significant risk”.
“So the approach that people have moved towards is staggering the hedges over different maturity dates and also incorporating other instruments like crosscurrency basis swaps,” Simmons said.
A currency framework
There were a range of opinions around creating frameworks governing how to move in and out of currencies. Hartley said currencies could be treated differently depending on what kind of asset the exposure comes from.
“I think there’s an argument for treating it differently if it’s illiquid assets because you can’t cash those things in and meet your currency call,” Hartley said.
Exposure to different currencies can provide a “whole heap of volatility”, JANA’s Van Ryn said, and this was good for some asset classes and bad for others. “If I’ve got my international bonds for example sitting in my conservative option, I don’t want that conservative option to have too much foreign exchange exposure,” he said.
Hartley said currency was “one of the tools in the tool box” and it needed to be looked at strategically in terms of the value of exposure to different currencies, and tactically according to the fund’s view of particular currencies at a point in time. Proimos asked if the hedging ratio should evolve over time in lifecycle products.
Mallett said as members get closer to retirement and their percentage in growth assets goes down while defensive assets increase, members naturally end up having lower overseas exposure.
“But it’s interesting, when you sometimes go to post-retirement, clients are involved there that do want to have currency in the portfolios, some form of protection,” Mallett said.
The balancing act
Implementation of hedges has its own set of costs and complexities. A common approach in the industry is to hedge the MSCI index at the start of the month and repeat again the following month without rebalancing, Simmons said. But with the Australian dollar being pro-cyclical, this approach can “systematically harm the investor in both uptrends and downtrends”, he said.
In an environment where “equities are going down by 10 per cent, the AUD is probably following it as well, so you’re overhedged in a falling environment,” Simmons explained. “Similarly, if there’s an uptrend you’re under hedged in a rising market.”
The solution is to have the hedge follow the underlying movements in your assets, he said, avoiding problems arising from market movements intra-month.
“You can synthetically track how that portfolio is going,” Simmons said. “And then if you were outside of a tolerance, you rebalance the hedge. In both a rising and falling market, systematically rebalancing the hedging ensures the investor isn’t disadvantaged over the long term.”
How to measure the performance of hedging varies from client to client, Van Ryn said. Funds with low liquidity or tolerance for large drawdowns may avoid monthly rolls by laddering investments so they are settled at different times, but this results in greater tracking error against the index.
“So that’s trading off tracking error for fewer issues with liquidity,” Van Ryn said.
Return enhancer or risk mitigator
Frontier Advisors senior consultant Philip Naylor added that in measuring currency performance, investors needed to “take the whole portfolio view” and consider whether they viewed currency as a return enhancer or a risk mitigator. If it is a risk mitigator, the investors should look at how it is performing against other downside protection options.
QIC’s Hill said she manages currency exposure from a risk-mitigation perspective rather than as a return enhancer.
“Ultimately, we start from a position of being fully hedged and then think about what volatility we’re adding to the portfolio and what diversification currency brings in,” Hill said. “We’re less worried about tracking error as a specific risk.”
QIC does, however, have a separate dynamic asset allocation program, which takes tactical tilts in up to 10 currencies, Hill said.
“But that is like an alpha engine, incorporating other asset classes in that dynamic asset allocation framework, operating as a separate return stream from the currency we have exposure to as a diversifying risk-mitigation position,” Hill said.
Naylor said fees are a significant part of the debate, and active currency management can be expensive. Investors were increasingly looking closely at their currency strategies to determine how they can get the best value. Due diligence on currency managers was very important, he said.
In assessing currency managers, investors needed to consider the political environment and how it impacts currency. The current low interest rate environment has been hard for active currency management, he said, and this needed to be factored in when assessing the performance of a currency manager and what the manager’s future performance might be in a different macroeconomic environment