The breakdown of historic trends in foreign exchange since the financial crisis has driven institutional investors to consider a higher hedge ratio on their international portfolios, but cost remains a thorny consideration.

Historically, exchange rates were regarded as mean-reverting over the long term, as growth and interest rate cycles would lead to gradual waves of appreciation and depreciation for each currency pair. This encouraged pension funds, insurance companies and asset managers with an extended investment period to take the view that foreign exchange (FX) moves would be neutral for their international portfolios of debt or equities, at least over the long-term horizon of their operations.

This was reinforced by the deepening of major FX markets over the decade to 2008, so that even short-term volatility became less severe. However, several factors have forced a reappraisal of that view since 2008. Rashid Hoosenally, head of structuring for global FX at Deutsche Bank, says institutional investors are now focusing on currency risk in a way he has not seen before.

“That is largely down to the significant volatility in both developed and emerging market FX from the Lehman crisis until now. Since then, realised volatility and the type of swings we have seen have been extremely dramatic, and more investors are aware that a substantial part of their investment performance is being driven by FX moves,” he says.

Lack of symmetry 

The mean reversion trend is beginning to break down, especially for Asian currencies. A number of Asian countries that had previously been operating de facto pegs to the dollar – above all, the Chinese renminbi – are now allowing greater flexibility in their regimes in view of relatively strong local economies and rising inflation.

“Since 2007, if you look at the way that currencies have moved, especially in emerging markets, there has not been a lot of mean reversion, currencies are just trending one way,” says Claude Goulet, co-head of European institutional FX and commodities sales at HSBC in London.

The breakdown of mean reversion has also been a feature of the dollar itself, as US investors appeared to repatriate a significant proportion of assets at each new sign of volatility, prompting dollar strength despite the country’s economic weakness. As a result, the evolution of attitudes toward hedging has partly depended on where investors are based, says Andrew Kaufmann, global head of FX structuring for UBS investment bank.

Since 2007, if you look at the way that currencies have moved, especially in emerging markets, there has not been a lot of mean reversion, currencies are just trending one way

Claude Goulet

Shaking up the asset mix

For eurozone investors, dollar strength has partially offset the fall in US equity markets. But for US investors into European markets, that same dollar strength has exacerbated their losses on the equity markets. Other markets with sustained appreciation in their home currencies, such as Australia, have also witnessed increases in hedge ratios applied to international portfolios by domestic investors.

Regulatory change is a further element driving a rethink at institutional investors in the pension and insurance sectors. Solvency II capital regulations for insurers that come into effect from 2013, together with tighter accountancy guidelines for pension funds, are driving closer asset liability management.

“These investors are regulated for solvency ratios, and with that comes stress-testing of portfolios for foreign exchange moves. So they are almost bound to a high hedge ratio for their portfolio, rebalanced weekly or monthly for changes in the asset mix. With low solvency ratios due to recent asset declines, low interest rates and increasing life expectancies, there is very little room for taking excess FX risk,” says Robbert Sijbrandij, co-head of European institutional FX and commodities sales at HSBC in London.

Emerging market plays

The expansion of FX hedging is also partly a reflection of increasingly internationalised portfolios, as investment funds seek more exposure to the faster-growing and less indebted emerging market economies. However, John Cleary, who runs fund of emerging market funds Focus Capital, says hedging by dedicated emerging market funds is relatively rare at present.

In the case of local currency debt funds, the FX risk component is part of the investment strategy, as portfolio managers specifically analyse inputs such as inflation and interest rates that affect both bond prices and exchange rate moves. Even with emerging market equities, Mr Cleary says that fund managers tend to take the view that they will naturally underweight or zero weight markets that have a depreciating currency trend, because it tends to go hand in hand with low economic growth rates.

“We have found that, of the managers that claimed to offer returns hedged back into US dollars, actually very few of them were able to achieve it. They may have many different currencies in their portfolio and the ability to hedge is still very limited compared with developed markets, so they could hedge aspects of their portfolio, but not the whole of it,” says Mr Cleary.

Currencies balance out

It has become more practical to hedge emerging market FX as markets deepen. Richard Benson, currency portfolio manager at specialist investment manager Millennium Global, says several emerging market currencies see significant daily volumes.

“Currencies such as the South Korean won or Brazilian real are now more liquid than the Scandinavian currencies, which is as it should be given the relative population sizes. They also have central banks playing both sides of the market, building reserves during appreciation phases or stabilising during depreciation, so they are dampening volatility which also helps to deepen the market,” says Mr Benson.

But in terms of keeping hedge ratios permanently high, using FX forwards can be expensive as investors pay the spread differential between developed and emerging markets, which is currently very wide in view of the ultra-low interest rates in developed markets. Mr Kaufmann at UBS says investors are generally seeking assets they believe will yield significantly more than the base rate in that emerging market. So if the interest rate differential with developed markets is high, investors tend to assume they are getting a suitable risk premium in any case.

“That proves right a lot of the time, and the FX risk will be worth taking. But even for clients who do not generally want to pay away the interest rate for FX hedging, there may also be times to do so, at least on a short-term basis. Now is perhaps one of those times,” he says.

Keeping the cost down

The question of structural overlay or tactical hedging feeds into the broader debate about how to keep down the cost of FX hedging to avoid it eating into portfolio returns. FX forwards do not require cash up front, but they do need to be rolled at expiry. That can create a number of complications.

“The FX hedges need to be rolled at a different frequency to your realising investments, which can create cashflow implications that need to be carefully managed. A lot of work we have been doing with clients is on how to implement a strategy that combines managing not just value-at-risk, but also cashflow-at-risk,” says Mr Hoosenally at Deutsche Bank.

This problem means debt investors in developed markets are more likely to hedge than equity investors. A debt position is often held to maturity, and will pay fixed coupons at pre-set dates. Such predictable cashflows are much easier to hedge than on an equity position held for an undefined length of time and paying uncertain dividends.

Cashflow complications

A further difficulty is that forwards are priced against the interbank market, which means while the investor is hedged against FX moves, they are exposed at each roll date if there are sharp moves in interbank interest rates. This has taken on particular significance in recent months, as European banks have found it increasingly difficult to fund in dollars, causing sharp 100 basis point (bps) moves in the euro-dollar basis swap market.

“A European pension fund that is rolling short dollar hedges on its US investments every one to three months is not just taking on the base rate differential, but also getting punished for the fact that dollars are in short supply at some eurozone banks. The solution we have proposed is to enter a 10-year cross-currency swap every three months instead, on which they are paying only 20bps,” says Mr Sijbrandij at HSBC.

Using options provides more flexibility and fewer ongoing cashflow complications. But up-front options premia can be expensive, especially when markets are at their most volatile. Consequently, investors are increasingly examining the concept of dynamic hedging, which combines elements of a currency overlay with more active FX management.

Dynamic approach

Michael Huttman, chief investment officer at Millennium Global, says the market has effectively offered this product for about 25 years as a cost-efficient way to replicate the options pay-off in managing risk on an existing international portfolio. Clients would want to be as near as possible totally unhedged when the base currency of the investor is depreciating, and totally hedged when the base currency is appreciating.

“That process is very close to a momentum trading strategy, which is one-dimensional. Millennium believes that the factors that affect currencies are multi-dimensional, so we put together a framework that incorporates the same objective of tail-risk hedging implemented using forwards, but with an integrated multi-factor approach to the hedge ratio customised based on analysis of valuation, inflation and yields in addition to market momentum,” says Mr Huttman.

This new multi-dimensional dynamic hedging has about $900m of client funds allocated to it, mostly Australian and US-based investors hedging developed market portfolios. Millennium is already seeing client interest in the same techniques for emerging market currency pairs.

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