Comparison: Passive vs. Active vs. Passive + Alpha combined approach
| Passive Hedge | Active Hedge | Passive Hedge + Currency Alpha Program | |
|---|---|---|---|
| Objective | Risk reduction | Risk Management: replaces random risk with managed risk | Return generation: Separates currency risk from the underlying portfolio and generates excess return by actively taking currency exposures. |
| Return | Client receives local market returns (for a 100% hedged portfolio) less the cost of the hedging programme (transaction costs, manager fees and interest rate differential between risk currencies and base currency). | Client receives partially hedged returns on the underlying portfolio. The hedge ratio is increased on currencies the currency manager expects to depreciate, to protect the investor, and the hedge ratio is reduced on currencies the currency manager expects to appreciate, to allow the investor to participate in foreign currency appreciation. | Client receives the local market returns (for a 100% hedged portfolio), less hedging costs (transaction costs, manager fees and interest rate differential between risk currencies and base currency), plus the returns earned on the currency alpha programme. |
| Risk | Removes all currency risk (if hedged 100%), but the investor forgoes the possibility of participating in any appreciation of foreign currencies. | The currency manager cannot increase exposure to any currency, beyond what exists in the underlying portfolio. But the worst case is that the manager’s forecasts are incorrect and appreciating currencies are overhedged, whilst depreciating currencies are underhedged. In that scenario, the active hedging programme will generate a negative return, and total portfolio return will be inferior to leaving the portfolio completely unhedged. | Removes all currency risk from the underlying portfolio (if 100% hedged), but there is a risk that the currency alpha programme may produce negative returns. |
| Number of currencies on which the manager can take positions | Limited to the number of currencies to which the underlying portfolio has exposure. | Limited to the number of currencies to which the underlying portfolio has exposure. | Can be unlimited, or limited according to constraints set by the investor (e.g., developed market currencies only, or liquid currencies only). |
| Benchmark | Any positive fixed percentage. E.g., a portfolio can be 50% hedged, 75% hedged or 100% hedged. | Any positive fixed percentage. E.g., the benchmark hedge ratio can be set at 0% hedged, 50% hedged, 75% hedged or 100% hedged. The currency manager then varies the actual hedge ratio around the benchmark. | The passive hedge programme is usually benchmarked at a 100% hedge ratio. The currency alpha programme is an absolute return programme and is generally benchmarked against zero if unfunded, or a cash interest rate if funded. |
| Minimum hedge ratio for any given currency | The minimum hedge ratio is generally set equal to the benchmark hedge ratio less some small tolerance level. E.g., 95% hedged – 5%, so the minimum threshold for the passive hedge = 90%. If it falls below this, the hedge must be increased. | At least 0%. The least the manager can do is to leave a currency exposure from the underlying portfolio unhedged. The manager cannot increase exposure to a currency beyond what exists in the underlying portfolio. And the manager cannot create exposure to currencies which the underlying to which the portfolio does not have exposure. | Client determined. The maximum short position on any currency can be constrained by the investor. |
| Maximum hedge ratio for any given currency | The maximum hedge ratio is generally set equal to the benchmark hedge ratio plus some small tolerance level. E.g., 95% hedged + 5%, so the maximum threshold for the passive hedge = 100%. If it increases above this level, the hedge must be decreased. | At most 100%. The most the manager can do is completely hedge currency exposure from the underlying portfolio. The manager cannot decrease exposure to a currency beyond what already exists in the underlying portfolio. And the manager cannot take short positions on currencies to which the underlying portfolio does not have exposure. | Client determined. The maximum long position on any currency can be constrained by the investor. |
| Funded or Unfunded | Unfunded. Cash is left invested in the underlying portfolio of equities, bonds, etc. | Unfunded. Cash is left invested in the underlying portfolio of equities, bonds, etc. | Unfunded or funded. Cash can be left invested in the underlying portfolio of equities, bonds, etc. Or a small amount of cash can be invested into a currency alpha fund. |
| Cashflows generated by the programme |
Cashflows are generated only at the maturity of FX forward contracts – generally monthly or quarterly. Positive cashflows are contributed back to the investor’s portfolio. Negative cashflows must be met from the investor’s cash reserves or by liquidating other investments. When foreign currencies appreciate, the underlying portfolio will produce a positive return and the passive hedging programme will generate a negative return. Net return at portfolio level will at least partially offset each other, but the negative cashflows on the currency hedging programme still need to be met, despite the fact that the currency gains on the underlying portfolio may not have been ‘realised’. |
Cashflows are generated only at the maturity of FX forward contracts – generally monthly or quarterly. Positive cashflows are contributed back to the investor’s portfolio. Negative cashflows must be met from the investor’s cash reserves or by liquidating other investments. Both positive and negative cashflows generated by high hedge ratios can be significant. |
Cashflows are generated only at the maturity of FX forward contracts – generally monthly or quarterly. Positive cashflows are contributed back to the investor’s portfolio. Negative cashflows must be met from the investor’s cash reserves or by liquidating other investments. It is possible to net cashflows from the passive hedging programme and the currency alpha programme against each other. |