Part 1 in the series Transparency in FX trades is vital, was published in November last year, you can read it here.
Amid an environment where asset return expectations are in the low single digits, it’s more important than ever to seek out an edge, either in the form of boosting returns, or providing downside protection.
Currency hedge decisions become proportionally more significant when returns are low and while static hedging approaches are commonly employed, asset managers need to be exploring ways to enhance risk adjusted returns more closely.
All international asset portfolios face currency risk, and Australian investors are no exception.
A dynamic hedging approach is an effective method of capitalising on departures from fair value. Its clearly-defined parameters can be tailored to a client’s risk/return preferences, it is cost-effective and is repeatable throughout the cycle.
The potential for regret is considerable. From mid-2014 to late-2015, the Australian dollar (AUD) depreciated by 28 per cent against the US dollar (USD) with the value of the AUD dropping from US$0.95 down to US$0.68 (Figure 1).
It represented a material depreciation, and for assets priced in USD it would have yielded positive gains when repatriated—unless of course all USD exposures were fully hedged.
Funds that were substantially hedged saw significant underperformance, as opposed to peers who were nimble enough to expose themselves to foreign currency gains.
Where there is the perception of a trade-off between risk and return, a dynamic approach offers a more nuanced alternative. The hedge level is adjusted according to strong fundamental trading signals, implementation is systematic, and the potential for greater returns are expanded while the risk of negative moves are curtailed.
If the strategy is designed well, it can trim a hedge during depreciation, effectively allowing a portfolio to ‘have its cake and eat it too’, which is a rare treat in the world of finance.
A systematic dynamic currency hedging framework can take the pain out of the decision-making process, but the first step, which is required whether a hedge is to be static or dynamic, is to establish the portfolio’s optimal hedge ratio.
Unfortunately there are no shortcuts on this score. Anyone looking for a sure-fire way to ignite debate amongst practitioners and finance academics alike, just needs to propose a one-size-fits-all optimal hedge ratio.
Decades of empirical research have failed to not only define an optimal hedging ratio, but also failed to conclude whether the case for hedging is even established (Figure 2). Such wide disparity makes a considered approach vital.
Currency fluctuations within a single cycle can be large, even for asset classes like equities which have an inherent variability. The annual return outcomes of the MSCI World developed market equity index shows broad divergence when represented across varied base currencies, (Figure 3). Over the past sixteen years the divergence in annual returns, simply due to translation effects, can at times exceed 33 per cent across currencies in a given year.
Discord on what is optimal is inevitable given the unique nature of individual portfolios. The issue is further clouded by various assumptions ranging from—the investment horizon, currency of domicile, underlying assets, return expectations, variances and correlations. We recommend an approach which goes beyond mean-variance optimisation.
While a fully-hedged strategy has offered a higher return over the course of multiple market cycles, not many managers have the luxury of being assessed across a purely long-term time horizon. The medium-term time frame is far more relevant due to the competitive nature of the industry, but it’s far less forgiving.
Furthermore, these returns have come at the expense of higher risk, both in terms of standard deviation and stomach-churning drawdowns.
In the end it is an individual investor’s unique objectives that will shape their hedging requirements. Some investors are returns focussed, some are looking to prioritise risk, and others are more peer aware. Transaction costs, funding requirements and tolerance for drawdown risk are also important factors to consider. (Figure 4).
An effective framework seeks to harness these investor preferences, and identify the optimal hedge ratio for each investor type. A universal optimal hedge ratio doesn’t exist, even when comparing funds with the same domicile and asset mix.
Once a hedge level is decided upon, then the investor can consider whether a static or dynamic hedge is appropriate. A static hedge ratio is just that – it is easy to administer and monitor, and dormant in the face of changing market conditions.
As soon as the environment changes, a static hedge may be less effective, or more costly. When the currency materially departs from fair value, we believe it can add value to ask whether the static hedge ratio should be changed.
This raises subjective questions around just what is “material”?
Further, exchange rates can stay at “material” mis-valuations for long periods. Investors don’t want to be removing or implementing the hedge too early.
Our approach recommends turning this quandary into an objective decision.
The potential to be left with an expensive hedge while your currency is depreciating is the eternal conundrum of those trying to cover their foreign currency exposure. It’s a situation that can be made worse if illiquid assets need to be sold off in order to cover realised currency losses.
Adopting a dynamic currency hedging strategy is the most effective solution. This will increase trading activity when there is an observed material deviation of the currency from fair value.
A suite of objective and proven valuation signals and systematic trading factors allows investors to maintain hedge protection when the currency is moving away from fair value, or conversely increase participation and conviction during a period of reversion to fair value.
It’s a strategy that demands no forecasting of short term currency moves. Instead, it shifts the hedge ratio, in real time, depending on a system of fundamental signals that react only to material deviations. Having a tailwind that increases participation in times of domestic currency appreciation is the cake, but being able to cut the hedge when the foreign currencies are moving in your favour means you get to eat it too.
While investor risk tolerance will help define the hedging range, it is the dynamic strategy framework which will set the position of the hedge within this range.
Valuations matter greatly and when looking at the AUD we see a currency that is very sensitive to its key fundamental drivers. At the same time the AUD often deviates from fair value, making it a good candidate for dynamic hedging. As discussed in “An ideal candidate for dynamic currency hedging”.
When the AUD is wallowing at the bottom of the cycle, it can feel like an abyss. While at the other extreme, at the top of the cycle, the gains can feel unstoppable.
In 2011, for example, the AUD saw a major run-up against the greenback. When it hit highs of US$1.10 it was easy to ignore the fundamental signs that were screaming a major over-valuation. Its anti-gravity seemed sustainable and exuberance led some to day-dream about its potential to head ever-higher.
A disciplined and systematic dynamic hedging strategy ignores this sentiment and instead seeks to profit from mis-valuation, with increasing effectiveness at cycle turning points. Pulling the hedge back, to increase foreign currency exposure, would have allowed the portfolio to profit through the subsequent period of reversion to fair value that was seen from the end of 2011 onwards.
A simulated dynamic hedging strategy offered superior returns in all but one of the last ten years (Figure 5). Further evidence of the perils of a set-and-forget strategy.
The systematic nature of a dynamic hedging strategy is very effective at mitigating time lags that can exist in large organisations that have complex decision making procedures.
All too often opportunities are missed when the delay between a signal and an action are clouded by operational protocols.
A track-record of solid returns is the tried and tested method of gauging the merits of an investment. But it’s not enough to simply perform in a rising AUD environment with a hedge covering translation losses.
Flexibility is also vital to reduce the hedge and increase exposure to foreign currency when the AUD is depreciating.
Drawdowns were markedly flatter for a simulated dynamic model with considerable consistency throughout the mean-reversion cycle of 2013-2015,(Figure 6), highlighting outperformance in a falling AUD environment.
The core aim of an effective dynamic strategy is to deliver strong risk adjusted returns, and it should do it objectively. Measuring key market signals should trigger trading decisions pragmatically, quickly and decisively, allowing investors the freedom to concentrate on the underlying portfolio.
Boosting returns and mitigating drawdowns are critical considerations, with the added benefit of improving liquidity outcomes. But qualitative factors play their part, either through low-cost implementation, responsiveness to high conviction, or in flexibility to meet individual investor parameters.
The best dynamic hedging strategy doesn’t have to be complicated, but it has to be smart. The key is to avoid over-engineering and it must be intuitive enough to ensure reliability. It treads a fine line to find a system that is clearly defined, but also repeatable through varied cycles. All the while being flexible enough to adapt to changing circumstances while meeting stated objectives.
It may be a daunting prospect, but in an environment of low asset returns it is vital that currency volatility is harnessed as a potential source of returns rather than regret.
For more information about QIC Limited ACN 130 539 123 (“QIC”), our approach, clients and regulatory framework, please refer to our website www.qic.com or contact us directly.
This information is being given solely for general information purposes. This information does not constitute financial product advice and you should seek advice before relying on it. This information may be based on information and research published by others. No QIC Party has confirmed, and QIC does not warrant, the accuracy or completeness of such statements.
QIC is not making any representation with respect to the eligibility of any recipients of this information to acquire securities or any other investment under the laws of any jurisdiction. It does not constitute, and should not be construed as, an offer to sell, or solicitation of an offer to buy, securities or any other investment, investment management or advisory services in any jurisdiction where such offer or solicitation would be illegal.
Past performance is not a reliable indicator of future performance.
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 The main assumptions for this simulated analysis are: A basket of underlying currencies of: USD 60%, EUR 25%, JPY 10%, GBP 5%.
It is hedged back to AUD with a benchmark of 50% hedge.
Has a range of hedging outcomes for dynamic strategy of 0-100% hedge.
Time period of 31/12/2005 to 31/12/2015.
Transaction costs not included.