Hedging risks rethink

Sharp moves in foreign exchange currency pairs during the past 18 months have resulted in institutional investors reappraising their currency risks and hedging techniques. Some investors are using new instruments to better match their liquidity profiles. Others are opting for currency overlay.

Retirement funds and other long-term asset managers are learning the cost of being complacent about short-term currency risks. Often using strategic asset allocations (SAAs) to build their portfolios, with reviews done only at three- to five- year intervals, currency risks related to foreign assets were often subject to medium-term views. Discussions about hedge ratios applied to foreign assets, or how to achieve higher efficiencies with currency hedge programmes, ranked only low on the management agendas of fund managers and trustees.

Australia’s superannuation funds were a case in point. With guaranteed new inflows of cash – Australians must put aside 9% of their earnings for retirement by law – Australia’s ‘supers’ tended to fret about how best to invest the ever-increasing levels of funds pouring into their schemes. Living with the volatility of the Australian dollar for years, they did have concerns about foreign exchange exposures, as they have been forced to look overseas for investment opportunities due to the limited size of Australia’s debt and equity markets. But they had little concern for margin calls associated with hedge positions as new capital inflows meant they generally never needed to scramble for cash to meet their hedging capital needs. In short, they were awash with liquidity and tended to spend little attention on liquidity management related to currency risks.

This all changed in late 2008, when Australian supers – which managed A$1.2 trillion in assets at the end of 2009 and had 32% of these asset allocations in international fixed interest and shares, according to the Association of Superannuation Funds of Australia – saw the Australian dollar plunge 38% in three months against the greenback.

Australia’s 4,914 superannuation funds regulated by the Australian Prudential Regulation Authority (Apra) suffered a net investment loss of assets of A$66.4 billion in the financial year 2009 (which ends on June 30), according to figures released by Apra on February 10 this year. A typical ‘balanced options’ fund, where 80% of the super fund members park their savings and is the default option when a member does not exercise an investment choice, invest about 20% of their money in global shares. But, given the broad classifications of asset investments, it is difficult to gauge their losses from international investments, let alone due to hedging miscalculations.

The sudden currency move from mid-July 2008, when the Australian dollar was worth $0.97, to $0.60 by end of October 2008, resulted in superannuation fund managers actively engaging consultants to work out how better to hedge their international investment currency exposures before giving out new investment mandates.

That is because many superannuation funds faced cash calls related to their currency hedge positions after having been caught off-guard by the sudden plunge in the Australian dollar during a period of confidence in counterparty liquidity and the credit health of banks operating in the capital markets collapsed. While most superannuation funds were able to raise cash to meet those cash calls, they were faced with large cash payment obligations. And, in some cases, hedges were taken off at a fund level due to an inability by the fund to meet margin calls or underlying assets had to be sold at ‘forced-sale’ prices to meet margin calls.

“In the past two to three years we have seen a high degree of volatility, more importantly, a high correlation between international equities and the Australian dollar. The longer you wait to adjust your hedge the worse you do,” says Troy Rieck, managing director of capital markets at QIC in Brisbane, a government-owned fund manager for super funds and other institutional clients with A$65 billion ($58 billion) in assets under management.

The liquidity concern related to these currency hedge positions resulted in fund trustees and executive management having more protracted discussions about the ‘right’ levels of cash reserves needed to guard against liquidity shortfalls. Questions were also asked about how to construct hedges that would not place too much strain on liquidity and at what levels these hedges should be put on.

Hedge efficiency
Andrew Harrex, a principal at financial consultancy Mercer in Melbourne, says after the liquidity pressure faced by superannuations during the fourth quarter of 2008, many investment managers now require their global asset managers to shorten the period of the rollover related to their currency forward or futures contract to minimise any negative cashflow impact on their portfolio.

“More of our clients are now doing shorter rolls on their [derivatives contract positions] so that, as opposed to rolling over the contract every six months, they are now choosing to make a monthly rollover,” says Harrex. “If over a six-month period the Australian dollar fell by 7%, the cashflow impact on an A$10 billion fund will be much more significant than had it been willing to wash this up on a monthly basis.”

Besides rolling over contracts on a monthly basis instead of quarterly, Keith Fleming, executive director at JP Morgan securities services in Sydney, says some larger superannuation programmes are insisting on an earlier termination period for their forex forward contracts. For example, instead of terminating contracts two days prior to maturity, they are now terminating the contract one week prior to give themselves more time to prepare for any cashflow implications related with their hedge positions.

But this may not remain the case in the medium term as some supers are seeking to slowly extend hedge maturities. Rieck says QIC has held discussions with two of its clients that focused on how the investment firm could help them better manage their liquidity management by pushing out maturities to six months to a year, instead of the one- to three-month contracts that they used previously.

Rieck says these investors, which are finding new attractive investment opportunities after the financial crisis, wanted to ensure that liquidity risk from potential margin call obligations related to their currency hedges would not be a problem they would address for a period of up to a year.

“It doesn’t remove the problem, if currency falls they need money,” Rieck says. “But longer contracts would give [the funds] six to 12 months of breathing room. As their members continue to contribute, they build up cash over time, so in six to 12 months they would have more cash than now.”

Effectively, these funds want to use up as much liquidity as possible to snap up what they consider bargain investments now, but at the same time not have to worry that a large move in the value of the Australian dollar, such as the drop experienced in 2008, would leave them with a liquidity shortfall related to their hedge positions that could only be met by selling assets.

Rieck says the use of longer-dated forwards as the core part of the portfolio’s hedge, combined with more liquid, shorter-dated forward contracts used to dynamically re-adjust hedge positions, may represent the optimal solution.

Hong Kong-based, Hai Xin, managing director of Overlay Asset Management Asia Pacific, a specialised foreign exchange overlay asset manager established in Geneva in 1998 and now owned by BNP Paribas, agrees that superannuation funds are taking a more active approach towards their currency hedging through more frequently rebalancing their hedge ratios. But, he says, supers have started to adjust their hedge ratio every one or two months during the past couple of years, instead of reviewing it only every three to five years during the entire SAA review.

“We are seeing them rebalancing the hedge ratio more frequently,” Xin says. “Rather than based on the overall portfolio optimisation review process and on consultants’ advice, they are now readjusting their hedge ratio based on recent market price changes.”

Additionally, many supers have lowered their hedge ratios. That’s because many supers went into the crisis with high hedge ratios as the volatility of the Australian dollar and high interest rates in Australia versus other markets traditionally supported high hedge ratios among the superannuation funds. While different funds maintain different hedge programmes, Xin says his pension fund clients in Australia usually maintain a hedge ratio of their international portfolio of between 40% and 60%.

“Over the last cycle when the Australian dollar was appreciating, they increased the hedge ratio as that would bring in cash [for them],” Xin says. “Going into the crisis, the only action for them was to reduce it – by reducing it they are looking to reduce potential future cashflow caused by cash calls related with their forward positions.”

For example, when the Australian dollar was trading at its lows against the US dollar – around $0.60 – investors were concerned about the Australian dollar strengthening and hurting the value of their foreign assets, as these assets would then be worth less in local currency terms. As a result, they maintained a high hedge ratio to protect the assets’ values. But, if the Australian dollar is at a high level, say around $0.90 and is believed to be trending down, then investors would not want to hedge at all as these foreign assets could worth more in local currency terms.

“Some of the superannuation funds went into crisis with a very high hedge ratio, so when the Australian dollar started depreciating, the high hedge ratio means that they had to pay out every month,” says Xin. “That high hedge ratio was hurting them badly as they needed cash for their forward rollover.”

Udi Epstein, director of foreign exchange structuring at Deutsche Bank in Singapore, says the key to determining what should be the ‘optimal’ hedge ratio for a particular asset class, be they bonds or equities, can be determined as a hedge ratio that either minimises the volatility of the currency-hedged portfolio or minimises the annual tracking error of the currency-hedged portfolio against the underlying asset portfolio in local currency terms.

“Our view is that institutions should manage their own currency risk,” he says. “The requirements are really not that onerous. Looking at an equity portfolio benchmarked to the MSCI World Index, a very strong currency proxy basket can be built using six out of the 35 currencies in the index. Rolling six currencies in vanilla one-month forwards, and settling these rolls monthly, should not require a great deal of infrastructure for asset allocators.”

Proxy hedging in this instance involves the removal of the smaller-weighted currencies in the benchmark asset index. While this affects the tightness of the hedge, any negative impact is expected to be outweighed by not paying bid-offer spreads on illiquid currency hedges. “For example, investors tracking the 23-country Citigroup World Government Bond Index, which comprises 13 distinct currencies, would be able to execute a proxy hedge using a basket of five of those currencies, which is still more than 95% effective,” Epstein says.

Sornchai Suneta, head of the fixed income and foreign exchange department of the Government Pension Fund (GPF) – Thailand’s biggest institutional investor – says selecting the ‘optimal’ hedge ratio level boils down to how well the diversified currencies are linked with the underlying investment.

For the fund’s $1 billion global equities portfolio, GPF currently hedges around 50% of the portfolio to reflect the US dollar currency exposure in that investment portfolio, which tracks the MSCI World Index – about 50% of the index’s market capitalisation is accounted by US-dollar-denominated stocks. “The remaining MSCI World Index weighting is accounted for by other currencies, which are diversified enough, so we leave them unhedged,” Sornchai says.
The $10 billion, Bangkok-based civil servant pension fund manager says it maintains a higher hedge ratio for fixed income, at 95%–105%, as the benchmark it uses is fully hedged. Sornchai says the extra 5% is a way his team tries to minimise transaction costs related with constantly rebalancing the hedges in case the net asset value of its global fixed income portfolio is fluctuating.

Active overlay
When allocating their investment overseas, some Australian funds have in the past relied on international investment managers to provide them with the currency hedge. For example, if a fund decides to impose a 50% hedge ratio on a A$40 million international equities investment portfolio, some of these funds would then allocate A$20 million into buying investment units from a hedged-investment fund while putting the remaining A$20 million into the same fund, which is unhedged.

These asset managers, such as BlackRock Investment Management in Australia, offer both a ‘global conviction fund – hedged’ and a ‘global conviction fund – unhedged’ from which investors could choose.

But Stephen Goode, director of Tactical Global Management, a specialised currency overlay manager in Brisbane, says some superannuation funds in Australia have started to engage currency overlay managers during the financial crisis because the liquidity challenges raised by the collapse of the Australian dollar resulted in some overseas unit trust investments becoming unhedged as their asset managers could not meet hedge margin calls.

This tended to happen to asset managers of alternative assets, such as managers that invest in hedge funds. “What I found unusual during that time is that some of their overseas managers had to close out the contract as the hedges were going against them,” Goode says. “As they invested in alternative investment, they couldn’t sell them quickly to generate cash to cover the cash requirement from their currency hedge positions, so they had to close the contracts. The superannuation funds then lost their hedges on that investment.”

Xin also says he has seen more interest from Australian superannuation funds in changing their investment style altogether. Previously supers would seek passive currency management, which often could be dedicated to the fund’s custodians as they would help clients hedge their foreign exchange risks often using vanilla instruments as part of their custodian service. But, in the past 18 months, Australian funds are using more active currency overlay managers, Xin claims.

Many of these active currency overlay managers would have a view on currencies and implement their views on behalf of the clients to seek alpha from currency exposure. They invest in currencies as an asset class and operate in similar ways like an absolute hedge fund return strategy. In essence, they are targeting an investment return as measured against the initial investment, instead of measuring it against a benchmark index as generally used in traditional asset management.

Tactical Global Management, which has a presence in Australia and the UK, is currently running a team of eight fund managers that are also in charge of currency trading. But Goode says the firm’s biggest programme is to run passive hedging for superannuation funds and help them with their dynamic asset allocation on top of their SAA.

Outside Australia, the concept of generating alpha from using active currency overlay still remains uncharted territory for the majority of Asian pension funds, many of which are still regulated and controlled by the government.

Sornchai says GPF’s investment guidelines only allow his team to use foreign exchange instruments for hedging purposes. Regulated by the Ministry of Finance, it is not allowed to use foreign exchange derivatives to seek returns. “For us, forex derivatives are only for hedging purposes, I don’t think we would view the use of forex derivatives differently in the near future because it would entail amendment to our investment act,” he says.

Active alpha management in Asia still seems some way off. 

Liquidity management
When QIC began managing its alpha and beta asset exposures separately in 2006 for major clients, it also made an important decision related to the way the firm budgets for a fund’s liquidity position. It did this by separating, where possible, the decisions related to the physical exposure from the effective exposure of the portfolio, according to Andriaan Ryder, managing director of strategy at QIC in Brisbane.

Physical exposure is the proportion of the investment portfolio that is invested in cash market instruments, as distinct from derivatives instruments. Effective exposure is the exposure to the underlying asset or liability that arises from holding the derivatives. For futures and forward contracts, the effective exposure is the value of the underlying asset or liability at current market rates.

So, if QIC decides to allocate 40% of the portfolio into equities and 60% into cash, that 40% of the equity asset class could be invested into equity derivatives or synthetic instruments to maintain a 40% effective exposure into equities. This also means QIC could then maintain a cash physical exposure of more than 60% and thus have more flexibility when deciding the ‘optimal’ level of cash to hold pending on conditions of the spot and derivatives market.

“Where we have physical exposure, for example, to international equities, we might decide after our stress testing that we want to have more physical cash to meet collateral calls or [the need for liquid assets from] some major events occurring. So we just swap physical exposure to international equities, into some type of synthetic exposure to international equities,” says Ryder. “It does not affect the asset allocation, but it does change the underlying liquidity management. That has been an important change to our liquidity management over the last three years. Clearly, issues such as taxation implications, counterparty risk, etc., need to be taken into account, but it does increase flexibility enormously.”