From record global investment flows to macroeconomic imbalances, rising fiscal deficits and sovereign risk, and galloping currency volatility, today’s institutional investors and asset managers are vitally interested in the management of currency risk. In this Q&A, Jay Moore, managing director of Currency Management at State Street Associates, the independent investment research arm of State Street Global Markets, addresses some of investors’ key concerns about currency management in the current financial environment.
Q. How should currency management be considered within the context of overall portfolio risk management?
A. Just as with any portfolio exposure, currency risk introduces both volatility and the potential for diversification. Investors need to determine the appropriate strategic hedging policy to minimize the uncompensated risk related to international asset allocations. They also need to think carefully about the short-term impacts on performance that currency fluctuations may introduce. The appropriate hedging policy is one that is long term in nature with the goal of portfolio risk reduction. This strategic hedging policy provides a sound basis around which various tactical views can be applied for the purposes of return enhancement.
Market conditions over the past few years have given rise to a new norm of elevated currency volatility which makes clear the importance of good decision making with respect to hedging policies, both in the long and short term.
Q. Do most investors begin their work with currency management by focusing on mitigating risk and then later come to consider currency as an asset class in its own right?
A. By definition, a passive (strategic) currency hedging policy stands on risk management without any return expectation. But investors seem to want the cash inflows derived from hedging depreciating currencies while avoiding the cash outflows from the alternative. When you have a forward hedge that results in a cash outflow (losses), there must be an offsetting gain. But many investors rarely acknowledge the offsetting gains of the underlying assets and measure their hedging decisions solely through cash flows. This implicit investor preference suggests there is a need for active currency management.
Q. Passive currency hedging is a fairly straightforward process. How can investors distinguish between currency managers for this type of mandate?
A. Due to the common misconception that passive overlay strategies are easily implemented, investors often draw this distinction based primarily on the basis of fees. Every currency manager is responsible for implementation of the passive program and is accountable for its operational risk. But to be truly successful, currency managers must have more — and that’s where transparency comes in as a differentiator. This means providing clients with insight into the importance of the various implementation decisions (contract tenor, rebalance frequency, trading filters, proxy currencies, etc.). A good manager should provide guidance on these decisions and also be able to measure their effectiveness through performance attribution and reporting tools.
Q. Is currency risk occupying a greater proportion of investor risk budgets?
A. Absolutely. As ever-greater proportions of assets are deployed beyond the currency areas in which funds are denominated, logic dictates that the proportional risk of currency allocations increases. Currency risk has long been accepted as an important element of risk within fixed income portfolios where it’s easy to appreciate its relative contribution to the volatility of the strategy. By contrast, most international equity managers have ignored currencies as their relative contribution to risk was deemed minimal. In recent years, equity risk premiums have decreased while currency volatility has been on the rise. Equity managers now understand that currency swings can make or break performance in any given year, so they are increasingly embracing currency management as a core element of their strategies.
To read more about currency management, please read State Street’s most current Vision paper, “Currency Management in a Volatile Market.”
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