Currency management is vital

Thirty years ago currency management was little more than the introduction of a free-floating exchange rate. Now currency management is the coup d’état of global portfolio construction — the latest risk management tool of many financial analysts.

“Currency management is about mitigating risk, not about generating returns,” explained Zainul Ali, CFA, senior asset consultant at Towers Perrin, at a Toronto CFA Society event held yesterday at the National Club. By employing currency management, “you may give up a lot of upside, but you minimize risk; you give up the return, but you mitigate the downside.”

Ali explains that portfolio managers and institutional investors are feeling a great deal of anxiety lately due to the widening gap between hedged and unhedged portfolios. However, he adds that “volatility can be a good thing.”

“You have to look at extreme outcomes, not just volatility,” Ali explained. By hedging, a manager is able to remove the extremes on the tail side of the returns, says Ali. While that also means that the extreme upside is dampened, Ali believes that in a volatile global market — such as the current environment — a more strategic approach is required.

As a result, many institutional investors are now examining whether or not to hedge their portfolios. This is significant, as many retail trends start out on the institutional side.

For Leona Fields, York University Pension Fund manager, the decision to hedge came in 2006, with the fund committee agreeing to a 50% hedge ratio. At first, Fields was skeptical.

“I thought [the 50/50 ratio] was a big cop-out.” Then a colleague provided data, known as the Volatility Smile, that offered historical evidence that a 50/50 hedge ratio provided the best risk management in relation to return on equity. “When I saw that data, it really helped me support the decision. [According to the Volatility Smile data] the 50% hedge had the lowest volatility returns [over that historical period].”

Given their long-term investment horizons, mitigating risk is essential for institutional investors, explained Fields. “We made the decision to hedge, not to add value or to increase returns but to manage expected volatility.”

While there are three possible hedge stances — no hedging, ratio hedging or 100% hedge — Ali believes there is no proven mathematical formula to provide the optimal ratio.

“Volatility changes all the time,” he said. “If you take volatility over the last 20 years, it’s different than the volatility over the next 10 years — and [this historical comparison] can lead you astray.”

Even so, Ali, Fields and other analysts agree that currency hedging — whether it can be mathematically tracked and predicted or not — is an essential tool in mitigating market risks.

“There is no formula,” explains Ali. “Hedging is an art, rather than a science.”

Originally published Advisor.ca on June 19, 2008