Tuesday, April 26, 2011

Currency Risk: Are You Feeling Lucky?

Pierre Malo, my former supervisor at PSP Investments and now president of Pierre Malo Consulting, sent me an article he published in the Canadian Investment Review, Currency Risk: Are You Feeling Lucky?:
Since the elimination of the Foreign Property Rule in 2005, most Canadian pension plans have become more exposed to foreign investments and therefore to currency risk. While a lot of attention has been paid to strategic asset allocation (and rightly so), fiduciaries often don’t know their exact FX exposure. Furthermore, they rely on luck when it comes to currency risk. This article will consider the reasons why a clear FX hedging policy is so important and what plan sponsors should consider when implementing one.

How exposed are Canadian pensions?

According to data from PIAC, the typical Canadian Asset Mix as of December 2009 included 21% “alternative” asset classes (Real Estate, Venture Capital/Private Equity, Infrastructure and others), and 37.5% foreign equities and bonds. Determining how much foreign exposure pension funds have from the PIAC data is not a straightforward process. One needs to make some assumptions. For the purpose of this analysis, we assumed that “alternative” asset classes (real estate, venture capital/ private equity, infrastructure, other assets and hedge funds) involve 50% foreign content.

Given this assumption, the foreign content of the representative Canadian pension plan would be hovering around 50%. This means that currency movements have the potential to seriously impact the risk/return profile, at least in the short term. The surprising point is that most fiduciaries do not realize the importance of their exposure to currencies, and therefore do not think enough about how to manage it.

Currency volatility

Since foreign returns need to be reported in Canadian dollars, pension plans face a “translation” risk at the end of each fiscal year. As we all know, currencies can fluctuate wildly from year to year. For illustrative purposes, let us look at the 1999-2010 period, using the IMF database.

The average yearly change for the period is “only” -2.5%. However, the standard deviation stands at 11.8%. Moreover, the range of the annual changes is -23.9% and +18.2%, and the USD is down a whopping 29.3% for the period.

Few fiduciaries would be willing to accept such large swings on 50% of their assets without having seriously thought about it.

Possible impact

What are the potential consequences of not addressing the FX questions?

To say the least, the impact of currency volatility on 50% of the portfolio can potentially have disastrous effects. To illustrate this point, let us look at the returns of Canadian diversified portfolios since 2002. According to the Morneau Sobeco data, the average difference between the 1st and the 3rd quartile for a diversified fund is 3.9%, while the average difference between the 5th centile and the 95th centile is 10.3%.

Now, let us bring our currency volatility measure back into play. If 50% of your assets were exposed to a standard deviation of 11.8%, you would have about one chance out of three (one standard-deviation) that your overall returns would be impacted by more than 5.9%. If returns are normally distributed, this means that you would have a 15% chance to drop from 1st to last quartile (or vice versa if you were lucky). You also would have a 2.5% chance of dropping from 5th centile to 95th.

Yes, Foreign Exchange exposure should be managed.

Managing your FX risk.

At a minimum, fiduciaries need to know their exposure to foreign exchange in order to avoid surprises. Centralizing the information within a single department would help accomplish this. The collected information will serve as the basis for the development of a hedging policy. Fiduciaries also need to decide how this exposure is managed (passively or actively), and by whom.

Deciding on a hedging policy is not a simple task. Many conflicting theories have persisted over the years:

  1. The long term expected return of currencies is zero, therefore, the hedging ratio should be zero.
  2. Canadian pension plans have Canadians liabilities, therefore the hedging ratio should be 100%.
  3. Canadian inflation includes a portion of international inflation, therefore the hedge ratio should reflect this basket
  4. There is a high positive correlation between equities and the Canadian dollar. Therefore, Canadian pension plans should not hedge their foreign equity exposure, but they should hedge their fixed income exposure as it is negatively correlated to the Canadian dollar.

Discussing the issues related to the hedging policy is not the point of this analysis. The point is that fiduciaries need to align their hedging policy with their investment beliefs.

Once the hedging policy has been decided, fiduciaries need to address the question of active versus passive FX managing. This decision is by no means easy.

For many people, including Mr. Greenspan, it is impossible to forecast FX rates. He once compared this exercise to tossing a coin. Others see an opportunity in the long-term trends of many major currencies. Here again, the decision should be aligned with the investment beliefs of the fiduciaries.

The third decision relates to the implementation of the FX policy: who has the knowledge, and therefore is best suited to oversee the global exposure?

In many pension plans, mandates are given to external managers. These mandates often incorporate some sort of FX exposure, as would be the case for an EAFE-based or an emerging market debt mandate. This situation can cause two major problems. First, the fragmentation of mandates often makes it very difficult to know the overall FX exposure of the fund, unless there is a centralized FX function. Second, different managers probably have different (and maybe incoherent) hedging policies, resulting in suboptimal overall hedging.

A related question pertains to the external managers’ skill at managing currencies. The foreign exchange market reacts to different stimuli and has its own intricacies. One should question the implicit belief that an equity manager has the proper skills to trade foreign exchange. Fiduciaries would not likely give a real estate mandate to a commodities manager, so why is would they assume that an equity manager has foreign exchange skills? The manager should be required to prove their skill in this area.

Finally, the operational mechanic of hedging can result in important differences in returns. A professional FX manager will know the best orders to leave at a specific time, and will know the various hedging vehicles available, including currency options and non-deliverable forwards.

FX risk is one of the biggest investment risks investors face today. Yet, in many cases, fiduciaries do not give this topic as much attention as they do to other aspects of investment. They should carefully consider their decisions going forward.

History has shown that the short-term volatility of currencies can have a huge impact on the returns of pension plans. To avoid unwelcome surprises, fiduciaries need to implement four measures:

  1. Develop a clear foreign exchange hedging policy,
  2. Decide between passive or active FX management,
  3. Centralize foreign exchange operations,
  4. Ensure that FX professionals handle FX operations.

I thank Pierre for sending me this article. When it comes to currencies, he's an expert. And he's right, too many pension funds ignore currency risk, leaving it up to luck, which ends up costing them on their overall return. If you have any questions on your hedging policy, I recommend you contact him at Pierre Malo Consulting. Currency risk shouldn't be ignored and fiduciaries need to address it properly by implementing a well thought out, comprehensive hedging policy.

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