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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:
- The long term expected return of currencies is zero, therefore, the hedging ratio should be zero.
- Canadian pension plans have Canadians liabilities, therefore the hedging ratio should be 100%.
- Canadian inflation includes a portion of international inflation, therefore the hedge ratio should reflect this basket
- 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:
- Develop a clear foreign exchange hedging policy,
- Decide between passive or active FX management,
- Centralize foreign exchange operations,
- 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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In normal times I would say this is a non-issue, since your pension liabilities are long-term in nature and the general take is that FX moves over the long-haul tend to balance out. I would keep the FX exposure and spare the drag that hedging places on the portfolio's performance. It has the added benefit of bringing yet another "asset class" into the mix since it is often difficult to get trustees to consider exposure to FX ... in that respect, it is a good thing that many are oblivious to the overall FX exposure. In normal times.
In times such as these, when it would appear that the US, which is nearly half of the FTSE All World, is hell bent on destroying its currency, this is not a trivial matter. May as well junk the asset allocation to overseas and simply load up on LDI bonds and swaps.
Obviously Leo is "watching Greece burn"--and of course "it's interest rates and inflation risk." What else you got Leo?
The AUDUSD has topped.
The USDCHF has bottomed.
tend to agree but FED seems so convinced in thier control powers that only chinese can stop this insanity by selling some US bonds
The USDCHF pair has created a massive bullish Gartley pattern on the weekly chart, while the AUDUSD has overstepped its Fibonacci level by a whole penny...all without any corrections to be seen.
Even the Fed, in its infinite wisdom, cannot possibly support these moves without having some drawback somewhere. It seems the reason for the press conference after the Fed decision today will be to reiterate that there will be no QE III. There may even be an announcement that they are going to phase-out the program early or reduce the amount of easing that is already priced in.
These markets are priced for perfection and there is no way these extreme levels can be supported going forward without the invisible hand of the Fed propping them up.
Australian real estate is about to take it on the chin, as we did in the US. Go to a random website in Australia and find a one-bedroom apartment in the middle of some town you've never heard of selling for $425,000. That is not an exaggeration.
The Swiss franc has problems of its own but we never hear about those...until we do.
The next three months are going to be wild for 4X traders.
:D
Thanks Orly. I am watching all this with particular attention cause some strategic family decisions need to be taken in due course.
Its always comforting to have same opinion about things even we both may be wrong :-D
There are even more arguments to back this up... probably you know too.
Expect CHF to take hit in second phase of EU crisis when some eastern RE markets will have to experience serious haircuts ... which will have to be splashed by more CHF if swiss bankers want to maintain their presence on markets
If your family decisions have to do with one of the many thousands of eastern European families who took mortgages denominated in Swiss francs, then I am afraid that there is little to be done about that. The value of the Swissie has peaked here against the US dollar and perhaps against the Euro but the weekly chart of the EURCHF shows a consolidation pattern in progress.
For instance, if you converted your note to Euros now, the fluctuation would give you a stomach-ache but the natural level for the pair is actually at ~ the 1.46 level. From here, that would be about an eighteen cent move, which is a lot of money when you're talking thousands of dollars in mortgage. Who knows when it would get there. It could take years. It could take thirty minutes. You just don't know.
If you converted now, though, you would find yourself in exactly the same boat, only rowing the other way. Just as the strengthening franc worked against you, the strengthening Euro, relative to the Swiss franc, would start to work against you.
Or, you could convert to local currency. I am hardly an expert on "peripheral" European economies but I do believe that there is another round of pain coming to the global economy, perhaps worse than the one we have been through already. Having your mortgage denominated into forints or hrivnias or whatever would be a gamble and you would have to be fairly well-versed in your local economy to make that decision.
And don't forget about conversion fees, etc. They can cost a bundle of money.
It is a terrible situation whereby we have allowed these global banksters to crush the middle class and walk away scot-free. There are many in the US who find themselves deeply underwater in a declining housing market and with a weakening US dollar.
Hopefully, you will be able to work your way out of it. I wish you the best of luck.
:D
on another note, the usa has 27% ariable land. It takes less than 1% of the population to farm all of it. We will not fail, we will not be allowed to fail. 1/4 of world would starve if we did. Simple goddamn fact. Leo had subprime right, he may not have everything correct but he is not some racist idiot. and he is not a bankster. he puts ideas forward and we are suppose to debate them not insult people. I do not always enjoy what he says but he has a real arguement rather tha buy 'xx' bitchez. I said silver two fucking years ago and was berated for it. Everybody said gold. guess what. 15-46 is better then 1000-1460. gold was the curency of kings, silver for the serfs like us. And I bought slv when it was below the mining cost (5-7) and silver mines where shutting down. today I spend my income on having fun. my investments are mainly adm bought at 22. this did not used to be a site for the tea party other than ron pauls tea party. not fucking palin. amongst other fucking f-tards. get a clue start reading, on ther wealth of nations, the political economy, even fucking the means and methods of capitolist production. read and read again. It will take you two fucking years to get to the middle of the 20th century. and that is if you are serious abouit learning it. this is not a god damn football game. this is life. and before you insult leo at least have a bit of history behind you. and a lot of math. BTW leo I have some arguments with some of your positions.
whose the girl oh high and mighty one?
I would love to hear your counterarguments. I never claimed to be God or hold a monopoly on wisdom on investments. :)
An even larger problem for less populated countries with huge Pension needs?
If the people running the pension plans really don't know what their real currency exposure is, they shouldn't be in their jobs. A 16 year old doing a basic economics course, would be better clued up.
so leo how is the cnp working on this because my folks think the rise in the cnd is great?