Currency risk has been increasingly important over the last couple of years as pension plans strayed away from local investments towards foreign investments. For many pension plans, this has been the case, especially in equities, and more recently so, in fixed income, in order to gain higher yields and better diversification in the current low interest rate environment.
There have been many conflicting views over time on whether currency risk should be hedged or not. The Canadian dollar fell from parity against the U.S. dollar three years ago to around $0.76USD/CAD today. Consequently, many pension plans are wondering if they should crystalize the gains from the recent depreciation of the Canadian dollar, and how they should proceed.
There are typically three approaches that can be used to deal with currency risk. The approach that is the most appropriate for a pension plan will depend on the plan’s objectives, risk tolerance and time horizon. The decision should always be considered within a risk management framework.
Passive Management of Currency Risk
Passive hedging of currency risk is the easiest approach and the most cost effective solution in terms of transactions. It’s important to keep in mind that hedging the currency has a cost, though it can usually be reduced if only the major currencies were considered. Also, being exposed to currency risk can further diversify the portfolio and reduce the overall volatility in the long term.
However, in the short term, depending on the period of time, exposure to currency risk may increase the overall volatility. For example, if the horizon of the investments is short, a pension plan may want to fully hedge its currency risk to prevent short-term volatilities. In other situations, a pension plan may decide to passively hedge only half of its currency risk to crystalize some of its gains over the past few years and keep the portfolio exposed to some currency risk.
Dynamic Management of Currency Risk
The dynamic management of currency risk aims at taking advantage of the volatile currency environment, as we have seen over the past 40 years. Based on historical exchange rates, a schedule can be established for each foreign currency. The schedule will hedge a portion of the currency risk and crystalize some gains as the Canadian dollar depreciates against the foreign currency and as pre-established triggers are met. The opposite is done if the Canadian dollar appreciates.
As the number of triggers increase, the frequency of transactions will also increase, but the strategy will take advantage of smaller swings in exchange rates. This approach will be mostly advantageous if the volatility of the exchange rates is high. Over time, this approach can potentially reduce the overall risk of the portfolio. To reduce cost, the dynamic management can be done only on major currencies. This approach requires periodic monitoring of the exchange rates.
Active Management of Currency Risk
An active management of currency risk is usually more costly, as you are required to hire an active currency manager to take care of the pension plan’s currency exposure. This approach can be considered as having an overlay alpha strategy. An overlay alpha strategy is a strategy that does not require physical investments and has the objective of adding value on top of your current portfolio. Using macroeconomic views, the active manager will be able to actively decide the currencies that are most advantageous to invest in and alter your portfolio’s exposure accordingly. An active manager may be able to invest only in currencies that are part of the pension plan’s portfolio, or can use any currency to add value.
Having a good currency manager can add value over time, net of fees, and reduce the overall risk of the portfolio. In search of a good currency manager, it is important to determine the research capability and investment process of the investment team, as well as the skillset and experience of the active manager.
The decision whether or not to hire an active currency manager can be similar to hiring any active manager in fixed income or equities. As long as the manager is able to add value over time within an acceptable range of risk and/or assist in reducing the overall volatility of the portfolio, an active currency manager is an advantage to the plan.
Your turn: What is your currency risk hedging strategy? Use the comment box below to share your ideas.