By Khosrow Mehrzad and Arun Muralidhar, Vice Presidents at JP Morgan Investment Management.
Investors are getting more global in their search for returns and increasingly using hedge funds to achieve their objectives. For example, there has been considerable growth in European-based hedge funds and consequently, there is a growing investor base that is Euro-based. They try to find the most skillful managers whose portfolios can provide the highest returns, least volatilities, and lowest correlations with the regular asset classes. Giving weight to the base currencies of selected hedge funds usually is a secondary issue to many investors and overlooked by them. For example, a typical European investor may have access to hedge funds denominated in Euros, but could also invest in a number of strategies offered by US dollar-based hedge funds. While diversifying across different strategies and potentially different currencies is valuable, investing in a foreign currency engenders translational currency risk. Historically, investors have borne this risk with mixed results. For example, between January 1999 and May 2000, European investors had reaped the benefit of the Euro depreciation as the value of their dollar investments translated to Euro had increased by almost 23%. However, with the Euro gradual strengthening, these gains are being erased. The opposite would have been the case for an American investor who had invested in Euro-based hedge fund strategies. As can be seen, the size of currency impact on the overall performance of investment can be enormous. In this paper, we demonstrate that investors need not take a passive approach to currency risk and provide a 10-step guide to managing the risk effectively.
Over the last decade, there has been significant growth in the currency overlay business, whereby asset management firms provide clients with a specific service - managing the currency risk inherent in their international investments and avoiding capital losses due to currency depreciation. Successful strategies thus can generate excess returns. Pension funds and endowments have historically used the service to manage the currency exposures engendered in their international equity or bond investments. Currency overlay managers have been tasked with essentially hedging the exposure to the home currency when foreign currencies are expected to weaken, and allowing currency exposures to work in favor of the investor when foreign currencies are getting stronger. The success of these strategies over relatively long horizons has been highlighted in recent research by independent consultants at firms such as Currency Performance Analytics, Frank Russell and Watson Wyatt.
In this paper we take the simplistic example of a European investor who has 50% of her assets in Euro-based strategies and the balance in US dollar-based strategies. To manage the currency risk of holding 50% of the portfolio in foreign currency, the investor chooses to hire a currency overlay manager. The paper provides a ten-point implementation plan. We first discuss operational issues that need to be considered before examining the various styles that can be selected and basic contractual terms of such mandate.
1. Benchmarks: The benchmark for measuring whether the currency overlay manager has added value is to compare her returns versus the unmanaged approach. In this example, if the hedge fund portfolio is periodically rebalanced to 50-50 mix, the benchmark will simply consists of 50% Euros and 50% US dollars. If the returns of the currency overlay manager are greater than that of the benchmark the client has benefited. Reasonable measurement periods would be a three to five year horizon. However, as the underlying hedge fund portfolio changes the weights of Euro and US dollars of the basket also changes. Therefore, the overlay manager should be measured relative to a dynamic benchmark. This dynamic benchmark will need to be communicated to the currency overlay manager.
2. Return Objectives: In general, objectives are stated in terms of excess return over the dynamic benchmark and institutional investors have historically sought about 150 bps annualized alpha over the benchmark. Based on few studies, this expectation is reasonable. However, the return objective is a function of the currencies in the underlying portfolio and their mix, and the permissible hedging strategies.
3. Risk Expectations Since such programs are designed to generate excess returns, currency overlay programs involve tracking error (standard deviation of excess returns vis-a-vis the benchmark). As a general rule of thumb the tracking error would be approximately 2 times the alpha target. In return for the associated tracking error risk, the overlay strategy benefits the investor by: (a) adding alpha; (b) lowering the volatility of the foreign exchange and its impact on the translation of investment to home currency; and (c) producing an alpha stream that is uncorrelated with the returns from standard bond and equity investments. The correlation between the excess return of an unhedged currency portfolio and those of various hedge fund indices are generally very small. For example, the correlation to equity hedge funds such as statistical arbitrage, merger arbitrage, and short selling are close to zero. The same is applicable to equity sector strategy such as technology funds. The highest level of correlation is between the unhedged currency portfolio and the macro hedge fund indices (approximately 0.4). Therefore, currency overlay programs in general can have attractive risk control properties in an overall portfolio context.
4. Acceptable Strategies: Currency overlay managers analyze whether currencies are likely to appreciate or depreciate. Hence they have recommendations on whether a particular currency should be bought or sold. However, some investors restrict overlay managers to only hedge foreign currency exposure back into the home currency. For our hypothetical portfolio, this would involve selling dollars for Euros when the dollar is likely to weaken, and doing nothing if the dollar is likely to strengthen. One could also buy more dollars in the latter case. Either strategy is acceptable and the choice of strategy will impact the profile of returns. The more restrictive strategy of only selling dollars deprives the overlay manager of the opportunity to outperform when Euros is likely to weaken. The reader should remember that the dollar is the foreign currency for the Euro based investor.
5. Permissible Trades: Consistent with the chosen strategy, investors must determine what types of transactions will be permitted. In addition to outright trades between currency pairs such as the Euro and the USD, the investor must decide whether to allow proxy trades (e.g., using Swiss franc as a lower yielding substitute for Euros) and crosses (trading the Japanese yen - Canadian dollars cross rate). Further, the investor must also decide whether the currency overlay manager can sell more of a particular currency or all foreign currencies (e.g., sell 60% US dollars for Euros even though the hedge funds are only 50% invested in US dollars) or whether they can be net long a currency. Generally speaking, pure hedging mandates allow proxy hedging, but are much more constrained on the other trades. Investors more focused on returns usually permit some combination of the last three trades. Greater flexibility in establishing currency positions allows for a better risk/return profile as the risk of the portfolio is more diversified.
6. Permissible Contracts: For overlay strategies, managers can use forwards, futures or options though most strategies can be easily implemented with only forward contracts. The tenure of these contracts can range from a month to a year.
7. How to Fund this Strategy: Investors often wonder how they can fund an additional strategy when they are fully invested. The currency forward contract (at-the-money) requires no up-front payment (excluding the possible margin requirement) at initiation, and accrues profit or loss until the expiry when it will result in a cash inflow or outflow. These flows have to be managed by either the investor or the manager of a fund-of-funds strategy. A number of investors have chosen longer-term forward contracts to make these cash flows infrequent. The most critical point to remember is that if the currency overlay strategy is successful, it will finally result in a net cash inflow and will grow the total assets that can be deployed for the primary hedge fund strategies.
8. Operational Issues: In addition to managing the cash flows, the overlay manager and the investor will need to establish whether the benchmark exposures will be static or dynamic (i.e., evolving every month based on the performance of the underlying strategies). If it is dynamic, some arrangements should be made to ensure that accurate updates are sent to the overlay manager. The updates should provide information on the currency composition of the portfolio. The manager should be expected to provide performance data (i.e., returns of the benchmark and the active strategy) at least monthly with some ability to attribute performance by currency or factors used in the investment process.
9. Credit Lines/Risk: Since overlay strategies use forward contracts, investors have the credit risk of counterparty banks. Hence the overlay manager will need to establish credit lines on behalf of the investor or her agent. It is recommended that only the highest rated counterparty banks be utilized. Credit risk is limited, as the duration of the contracts tends to be short term.
10. Manager Styles: Experience with overlay has shown that managers with fundamental views (trading currencies based on an analysis of the relative economic value of currency pairs) and technical styles (trading currencies based on trending or momentum indicators) have consistently added value. Some managers offer blended styles, which combine fundamental and technical analyses to take advantage of the fact that the two styles are not highly correlated. Consequently, the mixed strategies tend to have higher information ratios over time.
Fee scales in the currency overlay business are usually tiered based on size of mandate. Typical contract terms for such mandates usually include a minimum fee of approximately $150,000 per year. Fees can be tiered in the following fashion: 0.30% per year for the first USD 50 million, 0.20% per year for the next USD 150 million and some 0.15%-0.10% per year for additional assets. Many currency overlay managers are willing to offer performance fees with a fixed component and a sharing rule. These are usually negotiated based on the size of the mandate.
To summarize, hedge fund investors who are worried about the currency risk from their investments can manage such risks and earn excess returns through currency overlay strategies. This 10-point program is designed to implement such strategies and allow investors to capture the currency alpha while enjoying the risk management benefits of such strategies.