This third instalment in our currency management series builds on ideas we shared in the first and second parts of the compendium, Transparency in FX Trades and Dynamic Currency Hedging, respectively. The motivation for our latest thoughts is a conviction that currency hedging decisions can be a source of extra return, without undue risk, in a world of historically low yields.
There is no use in investment professionals crying woe is me over how hard is it to achieve good returns. Clients want solutions, not complaints.
Taking a can-do attitude to the return challenge, we think that currency management, an often-neglected component of asset allocation, deserves more attention.
Any claims that currency decisions are too difficult or too esoteric smack of patronising attitudes. Likewise, it is insufficient to default to a status-quo solution when it means leaving potential returns on the table. Every basis point matters for investors and those they serve.
Most Australian superannuation funds frame their return targets in terms of a premium over inflation. However, even with current consumer price index (CPI) numbers sitting below the Reserve Bank’s 2-3 per cent range, achieving return targets is challenging. For a typical balanced fund, return targets sit around CPI +3.5 per cent, meaning a total return of 5 per cent is sought.
That might have been very doable in the pre-GFC era when the cash rate was above 6 per cent and bonds were north of 7 per cent. But times have changed.
The current Australian cash rate is 1.5 per cent and negative bond yields are commonplace (Figure 1). The structural decline in interest rates and yield curves has provided a windfall for bond prices as yields have plunged.
However, the yield decline is not sustainable as policy rates are nearing a lower-bound where further cuts will negatively impact the markets and economies they are supposed to stimulate. Investors are in a precarious position where rates will either remain mired at these depths, or, yields will rise — bond prices will fall bringing an end to a long-run of capital gains.
The unprecedented move to negative interest rates, by a number of central banks, was explored at length in a recent Red Paper, Navigating negative interest rates and liquidity challenges.
As yield is more difficult to come by than ever, superannuation funds face the dilemma of either lowering return targets or increasing allocations to high-risk assets at a time when valuation levels are already steep.
Moreover, this environment does not appear to be transitory. A lively debate amongst the most influential central banks points to a structural lowering of the ‘natural rate of interest’, or ‘r-star’. This is the inflation-adjusted rate that is ‘neutral’, consistent with an economy operating at capacity — neither accommodative nor contractionary.
A lower ‘r-star’ baseline figure necessitates lower cash rate estimates.
US Federal Reserve members have dramatically shifted their cash rate projections for the end of 2017 (Figure 2). Longer term estimates too have been tempered in recognition of a structurally changed interest rate environment.
Lower discount rates and central banks’ persistence with other highly accommodative policies have buoyed equities and other asset prices. The upshot is that the opportunity set for investors seeking favourable risk-adjusted returns is shrinking.
Morgan Stanley represented this (Figure 3) with their estimated efficient frontier across US equities, Treasuries, credit and cash. Higher risk is no longer being compensated with sufficiently high return potential.
So many of the truths investment professionals have grown up with are being challenged. Clearly, doing just more of what has always been done will not work. The task is to find return drivers that don’t depend simply on increasing risk.
We believe that currency can be a source of prospectively better return without excessive risk.
In a low return environment, the currency decision has a far greater impact as a proportion of returns than in a high-return environment. Essentially, it can mean the difference between hitting a return target or not.
One way to assess this phenomenon is to observe returns for a representative balanced portfolio over the past decade and the return implications of a 25 per cent difference in the hedge ratio (either up or down), applied to foreign assets.
When looking at years in which underlying asset moves are relatively large, i.e. over 10 per cent, the shift in the hedge has very little impact. In fact, the influence of the currency decision, as measured by the proportion of total asset returns, does not rise above 10 per cent and the average is under 5 per cent (Figure 4).
However, when asset moves are below 10 per cent, the impact of a hedge ratio adjustment can be very large (Figure 5). In 2010 when asset returns were particularly low, the influence of a 25 per cent change in hedge ratio was even greater than the return of the underlying assets themselves.
In the current environment of modest expected returns, the currency decision could make the difference between being in the top quartile or slipping into the lower ranks.
Investors are becoming increasingly creative in their search for yield and in their attempts to differentiate themselves from peers. But for many, there exist opportunities around their currency decisions that may be far more simple, influential and cost-effective.
For funds seeking to generate superior risk-adjusted returns, we have identified a number of straight forward strategies that may have been overlooked.
It may seem obvious, but managing currency costs is ‘low-hanging fruit’ that can offer substantial, compounding returns.
There are generally two categories of costs; transaction costs and management costs.
Transaction costs are especially corrosive as even small cost slippages can have outsized negative impacts when large sums are involved. We addressed this in detail in the first instalment of our Currency Management Series, Transparency in FX Trades. It explored the opaque world of currency trading where persistent scandals have underscored the hazards that exist in these markets.
A slew of major banks have paid multi-million dollar fines for collusion and rate-fixing, the Libor and exchange rate fixing scandals showed the potential for ethical compromise, and there have been many instances of banks overcharging for FX services.
These conflicts underscore the value in the appointment of a manager with a fiduciary mindset.
This is where management costs become a growing concern as the roles of manager responsible solely to the client and principal become increasingly blurred.
This distinction is an important one for all parties in a currency transaction, but for investors who don’t have the size and scale to manage their own hedge transactions, it can be particularly difficult to negotiate.
Hurdles to carrying out currency trades include new regulations, technology requirements and a lack of scale (including comprehensive operations and legal departments, and counterparty due-diligence capabilities). As management fees trend lower, even the largest funds are facing resourcing challenges.
How then to choose a trader?
The first step is to find a manager with a reputation for integrity and transparency, and with strong risk management frameworks tied with modern trading platforms. It’s also highly advisable not to appoint a manager with related-party trading arrangements, as there is every possibility that funds may be receiving spreads far wider than is competitive. Regrettably, there are many examples of dubious pricing in this space.
It is vital that investors understand the distinction between principal and agent, and that their currency managers are not acting in both roles.
All too often investors are drawn in by seemingly low management fees only to find out further down the track that transaction costs were many multiples of those in the broader market.
There may be little academic consensus on an optimal hedge ratio, but it’s clear that exchange rate moves can make already volatile assets even more so as we first addressed in the second part of our Currency Management series, The Right Time for Dynamic Currency Hedging.
An investor’s unique asset mix, priorities and risk appetite are all important factors in the choice of hedge ratio. Some frameworks focus on minimising variance while others maximise the Sharpe ratio and risk adjusted returns.
In any one year, a hedge ratio of 0 per cent or of 100 per cent will provide the highest return, but this can only be accomplished with perfect foresight. It’s a difficult task and all too often a compromise is made to go with the status-quo choice of a 50 per cent hedge, or what is known as the ‘hedge ratio of least regret’.
One certainty is that the hedge ratio will be influential over the course of the cycle. Re-visiting our representative balanced fund; a 25 per cent difference in hedging has generated up to 2.5 per cent variation in annual returns over the past decade (Figure 6).
The optimal hedge ratio may seem elusive, but as it becomes a greater source of differentiation, it’s essential for investors to have a well-defined, methodical and articulate approach to their hedging policy framework.
What if you could benefit from adapting to the environment? What if you could adjust your hedge ratio to exploit exchange rate misvaluation? Enter Dynamic Currency Hedging (DCH).
A DCH strategy can shift hedge levels to exploit volatility—and has a proven track record of superior risk adjusted returns as we detailed in Part 2.
When asset moves are lean, the greater returns from dynamically hedged positions can become material.
To understand the benefits of a DCH strategy we’ve run a synthetic model over the past decade. The model assessed the hedging return outcomes of a static benchmark hedge ratio at 30 per cent and a DCH strategy with a hedging range of 0-75 per cent.
Returns were considerably higher for the DCH option (Figure 7). In fact a DCH strategy outperformed the benchmark in all but one calendar year (Figure 8).
For a balanced fund — over an extended period — the bulk of the risk is generated through variance in underlying asset returns. However, just as shifts in the benchmark hedge are more influential during a low return environment, the impact of a well-calibrated dynamic hedging strategy increases during the lean times, when additional returns are craved the most (Figure 9 and 10).
Moreover, a DCH strategy smooths drawdowns and sees a faster return to high watermarks. This is vital at times of stress, as it can avoid the need to sell assets at times of depressed values.
Most compelling is a comparison isolating the hedging drawdown profile of a DCH strategy (with neutral position of 30 per cent hedge) and a 100 per cent static hedge, again for a representative balanced fund. The static hedge must endure a roller-coaster ride of volatility and contend with significantly more daunting funding requirements at various points in the cycle (Figure 11).
The Goldilocks environment — neither too hot nor too cold is the investor’s ideal. But such conditions can also induce complacency.
Now that return expectations are “cold” the influence of hedging is magnified. Institutional investors need to assess every link in their chain of trades. They need to cut costs, squeeze efficiencies and rather than fearing volatility, explore the benefits it can offer.
The potential benefits of reviewing currency management processes have grown considerably.
It’s here that a trustworthy and competent currency overlay manager can find pockets of return that an investor might otherwise have missed. Returns that could mean the difference between beating benchmarks and being left behind.
For more information
QIC Limited ACN 130 539 123 (“QIC”) is a wholesale funds manager and its products and services are not directly available to, and this document may not be provided to any, retail clients. QIC is a company government owned corporation constituted under the Queensland Investment Corporation Act 1991 (Qld). QIC is regulated by State Government legislation pertaining to government owned corporations in addition to the Corporations Act 2001 (Cth) (“Corporations Act”). QIC does not hold an Australian financial services (“AFS”) licence and certain provisions (including the financial product disclosure provisions) of the Corporations Act do not apply to QIC. Some wholly owned subsidiaries of QIC, including QIC Private Capital Pty Ltd, QIC Investments No 1 Pty Ltd and QIC Infrastructure Management No 2 Pty Ltd, have been issued with an AFS licence and are required to comply with the Corporations Act. QIC also has wholly owned subsidiaries authorised, registered or licensed by the United Kingdom Financial Conduct Authority (“FCA”), the United States Securities and Exchange Commission (“SEC”) and the Korean Financial Services Commission. For more information about QIC, our approach, clients and regulatory framework, please refer to our website www.qic.com or contact us directly.
To the extent permitted by law, QIC, its subsidiaries, associated entities, their directors, employees and representatives (the “QIC Parties”) disclaim all responsibility and liability for any loss or damage of any nature whatsoever which may be suffered by any person directly or indirectly through relying on the information contained in this document (the “Information”), whether that loss or damage is caused by any fault or negligence of the QIC Parties or otherwise. This Information does not constitute financial product advice and you should seek advice before relying on it. In preparing this Information, no QIC Party has taken into account any investor’s objectives, financial situations or needs. Investors should be aware that an investment in any financial product involves a degree of risk and no QIC Party, nor the State of Queensland guarantees the performance of any QIC fund or managed account, the repayment of capital or any particular amount of return. No investment with QIC is a deposit or other liability of any QIC Party. 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. Where the Information relates to a fund or services that have not yet been launched, all Information is preliminary information only and is subject to completion and/or amendment in any manner, which may be material, without notice. It should not be relied upon by potential investors. The Information may include statements and estimates in relation to future matters, many of which will be based on subjective judgements or proprietary internal modelling. No representation is made that such statements or estimates will prove correct. The reader should be aware that such Information is predictive in character and may be affected by inaccurate assumptions and/or by known or unknown risks and uncertainties. Forecast results may differ materially from results ultimately achieved. Past performance is not a reliable indicator of future performance.
This Information is being given solely for general information purposes. 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. This Information does not constitute an information memorandum, prospectus, offer document or similar document in respect of securities or any other investment proposal. This Information is private and confidential and it has not been deposited with, or reviewed or authorised by any regulatory authority in, and no action has been or will be taken that would allow an offering of securities in, any jurisdiction. Neither this Information nor any presentation in connection with it will form the basis of any contract or any obligation of any kind whatsoever. No such contract or obligation will be formed until all relevant parties execute a written contract. 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. Neither this Information nor any advertisement or other offering material may be distributed or published in any jurisdiction, except under circumstances that will result in compliance with any applicable laws and regulations.
Copyright QIC Limited, Australia. All rights are reserved. Do not copy, disseminate or use, except in accordance with the prior written consent of QIC.