QIC warns against herd behaviour in currency hedging
QIC has warned that rushing to rebalance currency hedges at the London fix during the wild currency swings in March has caused Australia’s asset owners to suffer enormous losses.
Simmons, who is head of currency at the $85 billion Queensland-based investor, said Australian investors should quit methodically and naively trading at the fix.
“Investors are often drawn to execute at the London 4pm fix comforted by high liquidity and narrow bid-ask spreads,” he said. The currency specialist said this sense of comfort is entirely misplaced as it ignores market impact costs and this was a crucial issue in March in particular. “Investors think they’re saving money but they would be shocked by the adverse market impacts that also take place, adding that the benefits of maximum liquidity are illusory and basically harmful to investors.”
Simmons was speaking at Investment Magazine’s Fiduciary Investors Digital Symposium.
The WM/Reuters London fix is a five-minute trading window used to calculate daily exchange rates that support a massive number of transactions. It uses a medium price within a five-minute window at 4pm that’s 2.5 minutes before and after. The rates are published daily and reflect the closing price which values benchmarks, asset price translations, and hedging programs.
Australian super funds typically allocate a big chunk of their investment portfolio to global equities which results in currency hedging needs. As equity markets rise or fall, the foreign currency exposure from international equities will move out of alignment with their currency hedge, forcing portfolio managers to rebalance the hedge. “This leads to a certain amount of predictability in investor flows,” he said.
Simmons said QIC analysis showed a clear co-movement between the 4pm fix and equities, an effect so pronounced that in March 2020 during the period of extreme market volatility, prior equity returns became a clear predictor of the daily Australian dollar trading patterns into the fix. “There are potentially billions of dollars that are being sold – and that 5-minute window is too small.”
“Moreover, the significant swings in equity prices meant trading volumes from investor rebalancing also surged, he added. “The combination of higher rebalancing activity during the volatility, coupled with a larger than average market impact into the fix, meant investors dealing at the fix during the period incurred a massive and largely unrecognised trading cost.”
In March, rebalancing trades were the largest in more than a decade and levels being set were a huge disadvantage to the investors. They got stuck with a fixed price which is systematically skewed to the edges of the trading range around the fix.
“With all investors moving in the same direction, herd behaviour leads to pre-hedging by the banks and a huge market impact ahead of the fix,” he said. This leads to major currency swings. “We have found the difference between executing at the 4pm fix and any other time of the day is enormous and has a major impact on portfolios’ performance.” He called the performance impact “really consequential.”
During the conference, Simmons was pushing the theme that investors often think liquidity considerations should drive hedging decisions whereas it is first and foremost an implementation issue. And that the tendency for the dollar to peak or trough at the fix is and persistent over time.
The currency specialist said March was “littered with egregious examples” of this but March 13 was the worst. The Aussie dollar spot rate moved 2 per cent lower in the hour before the fix so any investors dealing at the fix would have worn a significant market impact cost. Also, on February 28, in the 30 minutes of trading ahead of the fix, pre-hedging activity from banks pushed the Aussie dollar sharply lower by over 0.7 per cent, culminating in a fix near the lows just ahead of a sharp reversal.
He said avoidance of the London fix represents another implementation instance where avoiding industry standards generates a materially better outcome. “Avoiding the fix takes a lot more work because you are operating at a period of less liquidity,” he said. “ You have to be more thoughtful about your trading decisions, market conditions as well as the counterparty you use and the time of day you want to trade.”
Simmons said a back-of-the-envelope analysis of international equities funds through March showed that with a 50 per hedge the return difference between a fund that is rebalancing their hedge during the month versus one that rebalances at the end of the month blows out to 1 per cent at the bottom of the market.
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