FOREIGN CURRENCY HEDGING: PASSIVE, ACTIVE OR DO NOTHING?

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1 FOREIGN CURRENCY HEDGING: PASSIVE, ACTIVE OR DO NOTHING? FOR PROFESSIONAL INVESTORS April 2017 Overview In this commentary, we take a look at the following topics: Investors have a variety of options and choices to help deal with foreign currency exposures in their portfolios. Hedging some or all of the foreign currency risk will decrease the risk of the portfolio. Passive hedging is not risk-free and introduces significant market timing risk. Active hedging minimizes market timing risk and reduces negative cash flows in periods in which the base currency weakens. How are active hedging decisions made? Momtchil Pojarliev, CFA, PhD Senior Portfolio Manager Currencies momtchil.pojarliev@fftw.com

2 Foreign Currency Hedging: Passive, Active or Do Nothing? - April THE CONUNDRUM FOR INTERNATIONAL INVESTING Foreign currency exposure is a by-product of international investing. When obtaining global assets exposure, investors also acquire the embedded foreign currency exposure. In effect, unhedged foreign equity portfolios can be categorized into two portfolios. Portfolio #1 consists of a locally denominated market-weighted portfolio of foreign equities. Portfolio #2 is positioned long a basket of foreign currencies against the US dollar (with the weights of the basket determined by the weights of the equities in portfolio #1). Exhibit 1 outlines the composition of the proto-typical US institutional investor portfolio. We assume that the 6 allocation to equities is divided across US equites (27.5%), non-us developed economy equity (25%) and emerging market equities (7.5%). The 32.5% allocation to non-us equities is a source of significant foreign exchange risk (portfolio #2). Schmittmann (2010) estimates that currency risk contributes up to 4 to the overall risk of an equity portfolio. EXHIBIT 1: CURRENCY EXPOSURE IN A TYPICAL INSTITUTIONAL INVESTOR 60/40 PORTFOLIO Weight FX Exposure US Equity 27.5% 0. Non US Developed Equity Emerging Equity 7.5% 7.5% US Bonds 4 0. Total % Source: Pojarliev M, R. Kasarda and Richard Levich (2014) The Impact of Currency Exposure on Institutional Investment Performance: The Good, the Bad and the Ugly The sharp increase in the value of the US dollar since mid-2014 of more than 25% has caused a big divergence in the performance of US equities and unhedged international equities due to the depreciation of foreign currencies against the US dollar. Put differently, while portfolio #1 did well, portfolio #2 experienced a 25% loss as the US dollar surged. According to some estimates, US pension funds have lost about $1 trillion between July 2014 and March 2015 attributable to the strong US dollar. The appreciation in the US dollar after the US elections has further increased the magnitude of the losses. Fortunately, investors do have a variety of options to deal with foreign currency exposures. The best option will differ from institution to institution and depend on the importance placed on negative cash flows, risk reduction versus value added and, the resources available to select and monitor active currency managers. In this paper we outline some of the choices investors have to address the foreign currency risk in their portfolios and will explain active hedging in more detail. OPTION #1: DO NOTHING, I.E. MAINTAIN UNHEDGED FOREIGN CURRENCY EXPOSURE Foreign currency return is measured as the difference in the return to an unhedged portfolio versus that portfolio position hedged back into the investor s domestic currency. Exhibit 2 plots the foreign currency return of the MSCI ACWI ex USA Index since the introduction of the euro in January 1999 until December 2016, i.e. the performance of portfolio #2. The chart illustrates that unmanaged foreign currency exposure is a source of uncompensated risk. Currency has no long-term expected return, because although it is a risk exposure, it is not an economic asset for which a long-term premium exists. From January 1999 until December 2016, the average foreign currency return has been about zero (-0.26%), but the volatility has been 6.5 and the drawdown has been as high as 29.64%. It is not a surprise that most institutional US investors fall in this category, i.e. the currency policy is to keep the foreign equity exposure unhedged. In the weak US dollar environment, from 2000 until 2011, US investors enjoyed a windfall as the foreign currency return contributed positively to the performance of international equities. So, the policy of doing nothing to address currency risk was rewarded with a positive return as portfolio #2 performed well in this decade. However, since mid-2014, the foreign currency return has fallen about 25%, causing a significant drag on performance. EXHIBIT 2: CURRENCY COMPONENT OF THE MSCI AC WORLD IMI INDEX IN US DOLLAR Do nothing? But Currency Exposure is an Uncompensated Risk Cumulative Return 3 25% 2 15% 1 5% -5% -1-15% -2 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Source: FFTW, Bloomberg Currency Component Return Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15

3 Foreign Currency Hedging: Passive, Active or Do Nothing? - April Doing nothing is always the easiest choice, but from a risk/return perspective it is the worst available option. Some institutional investors defer the currency decisions to their international equity managers, but international equity managers will rarely make currency investing decisions. As Exhibit 2 demonstrates, doing nothing means to continue taking uncompensated risk. This option is only best for institutions, which hold relatively small foreign currency exposure (less than 1). Coming up with the right currency policy would require resources (acquiring internal or external currency expertise, due diligence costs, etc.), which could be allocated elsewhere when exposure to foreign currencies is small. CHOICE #2: PASSIVE HEDGING Hedging some or all of the foreign currency risk will decrease the risk of the portfolio. Pojarliev et al. (2014) illustrate that by hedging foreign currency exposures, the typical US investor could reduce the volatility of the portfolio. The higher the hedge ratios, the lower the volatility and the decline in volatility is substantial, ranging between 1.17% and 3.18% depending on the time period. Therefore, some institutions use a passive 5 hedge ratio to reduce the volatility of their portfolio. Yet, passive hedging creates its own problems, from generating negative cash flow when the foreign currency is appreciating to subtracting return due to hedging costs. First, there is no theoretical justification for the 5 hedge number. Why not 4 or 6 instead? A 5 hedge ratio is only justified as a minimum regret hedge ratio, i.e. better than 10 (fully hedged) when the US dollar is weakening and better than (unhedged) when the US dollar is strengthening. Second, there is no reason to have the same hedge ratio for all foreign currencies in the portfolio. Some currencies, like the Swiss franc, act as safe havens and provide diversification benefits. The Swiss franc will typically appreciate during periods of equity market crashes; which would argue for lower or no hedge ratio for exposure to Swiss equities when the goal is to reduce the volatility of the portfolio. Other currencies exhibit high correlations to global equity markets, like the Canadian dollar, and require higher hedge ratios. Third, and most importantly, the word passive is misleading in the sense that it implies no risk. In theory, an institution, which has a $1billion allocation to foreign equities, will reduce the volatility of the portfolio by implementing a passive hedge of 5. In practice, when the currency policy is changed from unhedged to passively hedge 5, the investor would be buying $500 million in the market against a basket of foreign currencies. This introduces a big market timing risk. If the US dollar weakens after the change is implemented, the investor will suffer substantial hedging costs when the forward currency hedging contracts settle. Exhibit 3 illustrates that between 2000 and 2011, the cumulative negative cash flow would have been as high as 4, forcing investors to sell international assets in order to cover the losses on the currency forwards. So in our example, the investor will have to pay $200 million during this period. The passive 5 hedge ratio would have lowered the volatility but at the expense of $200 million! Indeed, when experiencing this significant negative cash flow, some US institutional investors who used passive hedging, liquidated their passive hedging program at the worst possible time, as the US dollar bottomed in 2011 after locking in significant losses on the short foreign currency forwards. EXHIBIT 3: DRAWDOWNS IN US DOLLAR Passive Hedged: Significant Negative Cash Flows Drawdown -5% -1-15% -2-25% -3-35% -4-45% Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Source: FFTW, Bloomberg U.S. Dollar Index (DXY) CHOICE #3: ACTIVE HEDGING One way to address the market timing risk of implementing a passive hedging program is to delegate the timing of hedging the foreign currencies to a currency manager. The active hedging program seeks to reduce the risk of the foreign currency exposure, but varies the hedge ratios for the different currencies based on views to avoid negative cash flow and to generate positive returns. In the following sections we will demystify active hedging. Does active hedging apply to all foreign currencies? The starting point of an active hedging program is to establish the foreign currency exposures of the investor. Every month end, the currency manager will obtain the exposures to foreign currencies from the custodian. Exhibit 4 is an example of the typical exposures to foreign currencies.

4 Foreign Currency Hedging: Passive, Active or Do Nothing? - April EXHIBIT 4: NON-US DOLLAR EQUITY PORTFOLIO CURRENCY EXPOSURES Euro 20.9% British Pound 13.4% Euro-bloc 44.3% Swiss Franc 6. Swedish Krona 2.3% Danish Krone 1.2% 74.5% Norwegian Krone 0.6% Yen-bloc 17.8% Japanese Yen 17.8% Canadian Dollar 7. Dollar-bloc 12.4% Australian Dollar 5.2% New Zealand Dollar 0.2% Hong Kong Dollar 7.1% South Korean Won 3.6% Taiwan Dollar 3. Indian Rupee 2.1% Asia 19. Singapore Dollar 1. Malaysian Ringgit 0.6% Indonesian Rupiah 0.6% Thai Baht 0.6% Philippines Peso 0.3% South African Rand 1.6% Russian Ruble 0.6% 25.5% Israeli Shekel 0.5% Turkish Lira 0.3% CEEMEA 3.7% Polish Zloty 0.2% Qatari Riyal 0.2% UAE Dirham 0.2% Hungarian Forint 0.1% Egyptian Pound 0.1% Czech Koruna 0. Brazilian Real 1.6% LATAM 2.8% Mexican Peso 0.8% Chilean Peso 0.3% Colombian Peso 0.1% Source: FFTW G10 Emerging Markets As Exhibit 4 illustrates, the typical US institutional investor has exposures to more than 30 currencies, but about 5 of this currency risk is concentrated in only three currencies: Euro (20.9%), British pound (13.4%) and Japanese yen (17.8%). Traditionally, some of the passive hedging programs have been therefore implemented only against euro, pound, and yen, or only against the developed market (G10) currencies. However, disregarding all emerging market (EM) currencies ignores 25% of the foreign exchange exposure and focusing only on euro, pound, and yen neglects 5 of the foreign currency exposure. It is sensible however to simplify the hedging problem, but the differentiation between G10 currencies and EM currencies is misleading. From a risk management perspective, what matters is the magnitude of exposures in the portfolio. For example, the exposure to the New Zealand dollar is only 0.2% and therefore less important than the exposure to South Korean won (3.6%). Exhibit 5 plots the impact of the foreign currency exposure for all currencies and for currencies with allocations greater than 1%, illustrating that excluding currency exposures under 1% has had a negligible effect. Therefore, we typically recommend the active hedging mandate to cover only foreign currency exposures in excess of 1%. EXHIBIT 5: SIMPLIFYING THE CURRENCY EXPOSURES Cumulative Return 3 25% 2 15% 1 5% -5% -1-15% -2 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Source: FFTW, Bloomberg Dec-03 Dec-04 Currency Component Return Currency Component Return Excluding Allocations Under 1% Dec-05 Dec-06 Dec-07 Dec-08 How are the active hedging decisions made? An innovative approach to active hedging is to take the hedging signals from an unconstrained absolute return currency program and apply them to the constrained hedging mandate. Exhibit 6 illustrates this approach. Panel A plots the active positions for the major currencies (Euro, yen and pound relative to the US dollar) as taken from a fully unconstrained absolute return currency program since inception of the unconstrained currency alpha program (October 2006) until the end of 2016, or slightly over 10 years. Panel B translates these exposures for an active hedging mandate with an unhedged benchmark. The differences between Panel A and Panel B illustrate the objectives of the mandate. In Panel A, in 2007, the euro exposure was positive, with exposures as high as Conversely, in Panel B, the euro exposure is zero. In an unconstrained absolute return currency alpha mandate (Panel A), a manager could go Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 3 ACM refers to Tobias Adrian, Richard Crump, and Emanuel Moench

5 Foreign Currency Hedging: Passive, Active or Do Nothing? - April long euro in the portfolio relative to the benchmark because the objective is to generate absolute returns. For the active hedging mandate, the client already owns about 2 of unhedged euro exposure embedded in his foreign equity allocation, so it is not sensible to buy even more euros and increase this exposure. Furthermore, the manager can only sell (hedge) foreign currency up to the amount embedded in the foreign equities portfolio. So, during the period from May to September 2014, when the absolute return currency alpha program was running a short euro position, between 6 to 8, the active hedging mandate could only sell (hedge) the euros in the portfolio. The short euro position in this case is limited to about 2. This example demonstrates that every trade in the active hedging mandate is either a risk reduction trade (hedging foreign currency exposure) or a trade to limit cash drawdowns, i.e. in periods when foreign currencies are expected to appreciate and hedges need to be lifted. EXHIBIT 6: INNOVATIVE ACTIVE HEDGING APPROACH Panel A: Portfolio Exposures for FFTW Currency Alpha %NAV Exposure %NAV Exposure Source: FFTW, Bloomberg Euro Exposure Japanese Yen Exposure British Pound Exposure Panel B: Hypothetical Portfolio Exposures for the Active Hedging Mandate Euro Exposure Japanese Yen Exposure British Pound Exposure What is the impact of active hedging on the portfolio? In Exhibit 7, Panel A plots the hypothetical returns of the active hedging mandate simulated by using the foreign currency exposures in Exhibit 4 and taking real historical exposures from FFTW s absolute return currency program. Panel B illustrates the impact on the equity portfolio by plotting the cumulative performance of the MSCI ACWI ex US Index with and without active hedging. Panel A shows that active hedging is meeting its objective. During the period from 2007 until 2011, active hedging generated no return. But the US dollar was weak in this period (see Exhibit 2) and the investor already owns unhedged foreign currency exposure, so the net result from foreign currencies is positive: active hedging is not detracting from the portfolio and unhedged foreign currencies are appreciating. In contrast, a passive hedging program would have caused large negative cash flows from 2007 until 2011 as investors had to cover losses on the forward hedges. In the recent period of sharp US dollar appreciation (after mid 2014), active hedging is acting as an insurance policy, proving positive return in the period of depreciating foreign currencies. Panel B is showing the impact on the equity portfolio. Until mid-2012 (when the US dollar was 3 weaker against the Japanese Yen), there is no impact from active hedging. Active hedging would have added no value, but also caused no harm. In contrast, passive hedging would have detracted significantly from the total portfolio return during this period. After mid-2012, an equity portfolio with active hedging outperforms an equity portfolio with no active hedging. Over the full period from 2007 until 2016, active hedging would have more than doubled the annualized return of the equity portfolio, from 0.95% to 2.29% and at the same time decreased the volatility of the portfolio from 19.28% to 18.35%. Passive hedging would have decreased the volatility of the portfolio, but the impact on the return would be completely time dependent and about zero over the very long term. EXHIBIT 7: IMPACT OF ACTIVE HEDGING ON NON-US EQUITY PORTFOLIO Panel A: Return of Hypothetical Hedging Mandate Cumulative Return 16% 12% 8% 4% Active Hedging Return -4% Jan-07 Aug-07 Mar-08 Oct-08 May-09 Jul-10 Feb-11 Sep-11 Apr-12 Nov-12 Jun-13 Jan-14 Aug-14 Mar-15 Oct-15 May-16 Source: FFTW

6 Foreign Currency Hedging: Passive, Active or Do Nothing? - April EXHIBIT 7: IMPACT OF ACTIVE HEDGING ON NON-US EQUITY PORTFOLIO Panel B: Impact of Active Hedging on Equity Portfolio Cumulative Return Source: FFTW MSCI ACWI ex US IMI Net Dividends Total Return Active Hedging + MSCI ACWI ex US IMI Net Return EXHIBIT 8: HYPOTHETICAL HEDGING MANDATE QUARTERLY CASHFLOWS %NAV 4% 3% 2% 1% -1% -2% Jan-07 Aug-07 Source: FFTW Active Hedging Cashflows Mar-08 Oct-08 May-09 Jul-10 Feb-11 Sep-11 Apr-12 Nov-12 Jun-13 Jan-14 Aug-14 Mar-15 Oct-15 May-16 How to implement an active hedging program? Active hedging is implemented as an unfunded (notional amount) with some minimal (2%) cash requirements for collateral exchange. So for example, if an investor has $1 billion unhedged foreign equity exposure, they will need only $20 million in cash to start a $1 billion notional active hedging mandate. The currency manager will then obtain the foreign currency exposures each month end from the custodian and implement active hedges. Active hedges are typically executed with 3 months forwards, which are rolled about two weeks prior expiry so that the projected cash flow will be known two weeks in advance. Exhibit 8 plots the hypothetical cash flows based on the actual historical exposures of FFTW s absolute return currency alpha program and assuming foreign currency exposures as in Exhibit 4. We estimate that the highest quarterly need is 1.5%, i.e. below the initial 2% cash margin. The worst cumulative negative cash flow would amount to 3.5% of the portfolio, far less than for a passive hedge. Note that cumulative negative cash flow from passive hedging was as high as 4 (see Exhibit 3). Over time the active hedging has added value so the program becomes self-funded. CONCLUSIONS Institutional investor portfolios typically hold a significant allocation of foreign currency denominated assets. Left unmanaged, this currency exposure functions like a buy-and-hold strategy which receives little or no risk premium and adds unwanted volatility to portfolio returns. Currency risk has long bedevilled investors, with many opinions and recommendations as to whether investors should ever hedge their currency exposure (see Pojarliev and Levich 2014). But simply passive hedging foreign currencies, creates its own problems and introduces significant market timing risk. Active hedging is an alternative to passive hedging seeking to avoid this risk, and reduce negative cash flows in periods in which the base currency weakens. REFERENCES Pojarliev, M., R. M. Levich and R. M. Kasarda The Impact of Currency Exposure on Institutional Investment Performance: The Good, the Bad, and the Ugly, Working Paper Pojarliev, M and R. M. Levich (2014) The Role of Currency in Institutional Portfolios, Risk Books. Schmittmann J Currency Hedging for International Portfolios, IMF Working Paper

7 Foreign Currency Hedging: Passive, Active or Do Nothing? - April BIOGRAPHY Momtchil Pojarliev, PhD, CFA Senior Portfolio Manager, Currencies Momtchil is a Senior Portfolio Manager on the Currencies team at FFTW where he focuses on generating alpha for portfolios as well as contributing to the investment process, both in the judgment and quantitative styles. Momtchil also contributes to the growth and development of FFTW s currency alpha strategy as a stand-alone product. He joined FFTW, a subsidiary of BNP Paribas Investment Partners, in 2013 and is based in New York. Prior to joining us, Momtchil was a Director and Senior Portfolio Manager at Hathersage Capital Management, responsible for both investments as well as business development for foreign exchange portfolios. Prior to that, he was Head of Currencies for Hermes Fund Managers and Senior FX Portfolio Manager at Pictet Asset Management. He began his investment career at Invesco Asset Management, first as a Senior Economist and then as a Senior FX Portfolio Manager. Momtchil has 15 years of investment experience. He holds an MSc in Finance from Vienna University of Economics and Business Administration, and a PhD in Financial Econometrics from University of Basel. He is a CFA Charterholder. Momtchil has advised various asset management firms, including PIMCO and Goldman Sachs Asset Management, in the area of currency return analytics. He has published extensively in finance and investment journals, including the Journal of Portfolio Management and the Financial Analysts Journal. Most recently, Momtchil has co-edited the book The Role of Currency in Institutional Portfolios, published by Risk Books. He is a member of The Economic Club of New York and the Swiss Society for Financial Market Research. He recently served on the Editorial Board of the Financial Analysts Journal ( ).

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