Passive Currency Hedging
The objective of a passive currency hedge is risk reduction. It is designed to reduce or remove currency risk from an internationally invested portfolio.
The investor can choose to remove 50%, 75%, 100% or for that matter, any fixed percentage of a portfolio’s currency exposure through a hedging programme. The currency hedge manager is then tasked with monitoring the portfolio’s currency exposures as they evolve over time, and ensuring that the hedge ratio is maintained close to the target level, whilst reducing operational risk and minimising transaction cost drag.
The end result for the investor should be:
- Local market returns from the underlying assets, less the cost of the hedging programme (transaction costs, interest rate differential between foreign currencies and the base currency, and management fees associated with the hedging programme).
- Lower portfolio volatility is achieved by reducing or removing currency risk. The investor is partially or fully protected from currency volatility and foreign currency depreciation, but gives up the opportunity to participate in foreign currency appreciation.
What to look for in a passive currency hedge manager?
Passive currency hedging programmes are fairly straightforward to implement from an investment perspective. The currency manager only needs to implement hedges at the fixed hedge ratios agreed with the investor, and his views on currency markets should not matter. However, strong skills are still required to manage trades appropriately to minimise the turnover and transaction cost drag of the passive hedging programme, and to minimise errors and operational risk. Access to institutional or interbank FX prices can help reduce the impact of transaction costs in the hedging programme. Systems and processes designed to meet the needs of currency hedging can also reduce the risk of operational errors in a hedging programme.
This list is by no means exhaustive, but these are the factors that we would advise investors to consider when selecting a passive currency hedge manager:
1. Execution of FX Trades
- Ability to trade with multiple counterparties, to ensure best execution
- Experience trading on FX markets, enabling the manager to find and assess liquidity, and balance the trade-off between matching the target hedge ratio whilst minimising turnover
- A manager that trades sufficient size in the market that he is able to access institutional or interbank pricing from counterparties
2. Investment and Operational Processes
- Automated process to reduce operational risk
- Investment process should encompass multiple control mechanisms (checks and balances) to minimise errors
- Separation of front office functions (trade execution), middle and back office functions (accounting, performance analysis, trade confirmations), and custody/valuation
- Flexible processes and systems which can be adapted to each client’s needs
3. Transparent Performance Monitoring
- The hedged portfolio’s performance should be compared to a benchmark which is calculated by a third party, or uses third party prices and a pre-agreed calculation methodology
- Benchmarking enables the investor to monitor tracking error and delivers transparency on actual transaction costs associated with a hedging programme
4. Competitive fees
- Take into account any potential transaction costs, transaction fees or other costs in addition to the management fee
- Beware of low management fee quotes where the hedge manager may be generating revenues in less obvious ways, like executing trades in-house at unfavourable rates
For more information on Overlay Asset Management’s passive currency hedging solutions, please contact us.