Introduction
Mark Hogg joined RBC Dexia in February 2010. As Director for FX Product Development, Mark has overall responsibility for driving foreign exchange product strategy and growth for RBC Dexia. Prior to this appointment, Mark spent 9 years with Fidelity International and progressed to the overall responsibility for all FX hedging and currency overlay activity for all Fidelity International Investment funds and products globally. Mark spent his early career in various analyst, trading, and market risk roles with the Bank of Ireland, Barclays, and ANZ. Mark is a graduate of Dublin City University, holding a BSc in business and finance and an MSc in investment and treasury.
Pension funds in the United Kingdom with substantial investments in overseas equities have to take foreign currency risk into account. How should they approach this?
If you are investing in a foreign asset or basket of assets, whether you like it or not your investment return is going to come from two different sources. You will see a return or a loss on the underlying asset, of course. But when you sell that asset you will also see a gain or a loss on the translation back into your home currency. A UK investor buying Apple also buys exposure to the dollar, whether they are aware of this or not. When you are faced with that opportunity set you have a choice to make—in fact, three choices. You can ignore the currency risk, which is very much an active decision that has consequences. Second, you can hedge a portion, or almost all, of the risk away. And finally, you can try to actively manage the risk in pursuit of an enhanced return.
This decision matrix can and should only be resolved with reference to the unique requirements of each fund. The underlying question you are asking is: how do we view this risk in relation to our investment policy or objectives? There are plenty of academic studies that demonstrate that unmanaged currency risk has no inherent positive value. So if you manage global equities as a fund manager, and if you believe that if that risk is left unattended it has no inherent value, the obvious decision to take is to hedge it out, since the only thing that is likely to emerge from it is damage. If you are unsure of the potential outcome, then one decision could be to hedge out half the risk. The downside of hedging away all the currency risk is that the fund cannot then benefit from currency swings that move in its favor. The downside of not hedging at all is that adverse currency movements can kill your performance.
Between these two extremes, a 50% “passive” hedge (passive in that it is set and then left to operate) may be termed the “least-regret” currency hedging policy. You get half the upside and protect against half the downside of currency movements. With a 50% hedge in place you could then choose to tactically tilt the hedge by either increasing or reducing the percentage, based on your strategic directional views of the currency exposures. On a quarterly review of the hedge, you might, for example, decide to tilt it 5% or 10% away from the mid-point if you were bullish on the movement of the foreign currency against the pound. This is a reasonable way of combining a passive “overlay,” as it is called, with some active management.
However, the question then is whether the fund manager should manage the hedging in-house, including putting in place the necessary foreign exchange trading infrastructure, or whether to outsource the maintenance of the hedge to an external provider. The question equity or bond fund managers have to ask themselves is: do they want to morph into being currency managers as well? It is a very different skill set. Many managers will simply want the currency risk managed in a sensible way that is aligned with their overall investment strategy. In this case, outsourcing can make perfect sense.
There is another major point to take into account here, and that is the view the fund manager’s investor client base is likely to take of the currency element. Investors are becoming much more savvy about interpreting the attribution of returns from the fund. If the investor looks within the returns and sees that they are getting random currency returns that are giving them off-benchmark exposure, they are going to be asking some sharp questions. They will want to know how your currency exposure aligns to your investment strategy.
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