A Combination of Passive Hedge + Currency Alpha Program
The objective of the combined passive hedge + currency alpha programme is return enhancement. The combination of passive hedge + currency alpha programme separates the risk reduction and return enhancement objectives of the investor. It is designed to overcome some of the shortcomings of the active overlay approach with respect to return enhancement.
An active hedging programme is simultaneously trying to manage risk and enhance return. In contrast, in the combined approach, the currency manager implements a passive hedge to remove a fixed percentage of the underlying portfolio’s currency risk (usually a 100% hedge is implemented). Then, to enhance returns, the currency manager implements a pure alpha currency programme. The pure alpha currency programme can take long and short positions on any currency, and its objective is to generate absolute returns – so its performance is not measured against a benchmark, but rather is measured against zero.
The key difference between the pure alpha currency programme and the active overlay is that the currency alpha programme makes no reference to the underlying portfolio. Taking a simple example of a U.K. Sterling based investor with an international portfolio which has 50% exposure to U.S. dollars, 40% exposure to Euros and 10% exposure to Japanese Yen, an active hedging programme would focus on hedging the U.S., Euro and Japanese currency exposures, adjusting the hedge ratio on each of these 3 currencies up and down according to their outlook for each currency. In the combined approach, the passive hedge takes care of hedging out the U.S. Euro and Japanese currency risk from the underlying portfolio, and the currency alpha programme can then take long and short positions on a much broader range of currencies than those of the underlying portfolio.
The advantages of the combined approach are:
- More Effective Allocation of Active Risk Budget
The combined approach allows the currency manager to take positions and allocate active risk towards currency pairs where the manager has high conviction views. E.g., just because the underlying portfolio has 50% exposure to U.S. dollars, it does not mean that the currency manager should necessarily allocate 50% of his or her risk budget to U.S. dollar currency trades. It may be the case that the manager’s strongest views are on the Japanese Yen, but in an active hedging program, the manager would be constrained to doing no more than a 10% notional allocation to Japanese Yen trades, because that is the exposure in the underlying portfolio.
- Broader Opportunity Set and More Diversification in Active Positions
The combined approach allows the currency manager to take positions and allocate risk across a much more diversified set of currencies. Going back to the example portfolio above, which has exposure to just 3 currencies, in this situation, the active hedging programme can implement only a very low breadth strategy, with all active currency positions highly concentrated in just three currencies versus sterling. The currency alpha programme allows for the manager to diversify his or her active positions across a much broader range of currencies.
A currency alpha programme also allows the currency manager to trade a broader range of currency crosses, as not all positions need to be viewed and traded via the base currency. In our example above, the active overlay manager can take positions on the USD Vs. GBP, EUR Vs.GBP and small positions on JPY Vs.GBP. Generally, the currency manager cannot “trade crosses” in a hedging program, that is, he cannot trade EUR Vs.JPY, as all trades are referenced via U.K. Sterling.
- Greater Transparency and Clearer Attribution of Returns
Returns associated with risk reduction (passive hedging) and return enhancement (currency alpha programme) are more clearly distinguishable from one another and attributed. This improves transparency to the investor, who can clearly see whether the currency manager is able to generate returns.
- The Investor Has the Option of Appointing Multiple Currency Alpha Managers:
In the combined approach, one manager can take responsibility for managing the passive hedging programme, and then multiple currency managers can be appointed to implement currency alpha programmes which run side-by-side. A portion of the total risk budget is allocated to each manager, and this allows a greater diversification across managers and styles for the investor.
For more information on Overlay Asset Management’s active currency hedging solutions, please contact us.