Beruflich Dokumente
Kultur Dokumente
November 2010
Acknowledgements
This paper has taken shape through multiple iterations over the
course of the last year, so the author has a wide range of current
and former colleagues and others to thank for their input,
comments and support. Of particular note (and this is of course
an incomplete list), and in alphabetical order, are Janine
Baldridge, Bob Collie, Mike DuCharme, Tom Fletcher, Steve
Fox, Grant Gardner, Greg Gilbert, John Gillies, Joe Glynn, Joe
Hoffman, John Leverett, Kelly Mainelli, Aran Murphy, John
Osborn, David Rothenberg and Mike Thomas, each of whom
contributed significantly to improving this work, and Heather and
Calista Toner, who can now have their dining room table back.
All of the quantitative work included in this paper was performed
by Bin Wang, who has been an invaluable resource from the
very early stages of this work. Any errors in the paper are the
author’s own.
SECTION I: INTRODUCTION
Most institutional investors have significant exposure to international
assets: few institutional investors hedge the currency exposure that
this entails. While institutional investors typically believe that this
currency exposure has little long-term effect, the reality is that it can
be seen as a significant concentrated bet on the behavior of their
domestic currency. In fact, for many institutional investors, this single
bet on the relative strength of their domestic currency can be seen as
the single largest unmanaged bet in their portfolio.
Despite the size and nature of this significant currency exposure, U.S.-based
investors have typically spent little time and focus on managing it while other
investors, where there is a higher propensity to hedge, tend to use relatively simple
approaches to the question of currency exposure. The techniques that U.S.
investors use point toward a conclusion that there is no need to hedge currency
exposure. Investors typically then consider whether it may be appropriate to hire an
active currency manager to provide what is described as “alpha.”
Recent thinking about the tools and concepts involved, both within Russell and in
the academic research community,1 has led Russell to begin to reconsider some of
these conclusions, and then to reconsider some of the appropriate behaviors the
1
For example (Examples include but are not limited to):
“The Beta Continuum: From Classic Beta to Bulk Beta,” Mark Anson. Journal of Portfolio
Management, Winter 2008.
“When should investors consider an alternative to passive investing?,” Geoff Warren and Don Ezra.
Russell Research Viewpoint, January 2010.
“The Carry Trade And Fundamentals: Nothing to Fear But FEER Itself,” Òscar Jordà and Alan M.
Taylor. NBER Working Paper 15518, November 2009.
“Do Professional Currency Managers Beat the Benchmark?” Momtchil Pojarliev, CFA, and Richard
M. Levich. Financial Analysts Journal, Vol. 64, No. 5, 2008.
How investors can develop a new “grammar” around currency exposure; and
This new framework has led us to question many of the traditional assumptions
about currency. The proposed implementation solution is referred to as Conscious
Currency, and may drive significantly better returns for investors.
Currency surprise
Some of the changes in exchange rates can be predicted, due to the interest rate
differential between the two countries involved. This interest rate differential is reflected
in the pricing of the currency forward curve.2 Investors do, however, face the danger of
“currency surprise”: the difference between changes in exchange rates to be expected
on the basis of the pure interest rate differential and the actual changes in exchange
rates.
This effect can be very significant. Exchange rates can trend significantly, with those
trends coming to an end suddenly. Exchange rates typically exhibit significant volatility,
and the predictive power of simple interest rate differentials appears to be fairly limited
and time-dependent.
2
Currency forward contracts can be thought of as spot transactions (so the price is set today) with delayed
delivery. The price is therefore adjusted by an amount equal to the interest rate differential today to reflect the
effect of the different interest rate environments.
The standard approach to currency exposure has been to look at the issue entirely in
the context of hedging. The investor asks a simple question: Should I hedge the
currency exposure I take on when I invest in international assets?
This simple question has traditionally been answered by use of an heuristic (or rule of
thumb) outlined in the following chart.3
High
High
Foreign Currency Exposure (%)
Consider Hedging
(Minimize Regret) Do
Do Not
Not Hedge
Hedge
(Unnecessary)
(Unnecessary)
Do
Do Not
Not Hedge
Hedge
Low
(Not
(Not material)
material)
Short
Short Long
Long
Evaluation
Evaluation Horizon
Horizon
For illustrative purposes only
This appears to outline a very simple and clear thought process. Investors should
concern themselves with hedging only when they have relatively high exposure to
currency, and then only when their evaluation horizon is relatively short-term. This
approach is quite compelling as long as the presumptions that underlie it are correct,
and as long as the terminology is correctly understood and applied.
The problem most investors face with this chart is that these conditions do not apply.
There are three issues here:
3
This ground has been well covered in previous Russell research. Examples include the following papers:
“Currency Hedging Policy for U.S. Investors,” Greg Nordquist and Mark Castelin. Russell Practice
Note No. 87, October 2004.
“Currency Hedging Policy Formulation for Canadian Investors,” Bruce Curwood, Yoshimori Maeda
and Mary Robinson. Russell Research Commentary, October 2005.
“Revisiting the Normal Currency Hedge Ratio,” George Oberhofer and Joseph Smith. Russell
Practice Note No. 122, February 2007.
To begin, we need to restate some terms. We can then divide possible opinions about
currency into three mutually exclusive but collectively exhaustive groups.
Terminology
The core restatement relates to what a “neutral” exposure to currency is. We should
recognize that the decision to invest (on an unhedged basis) in international assets
involves the effective purchase of two portfolios: a portfolio of the underlying assets,
and a portfolio of currency exposures. These two portfolios are identical in size, and
their asset allocation policies are also identical – but those asset allocations are set
based on the nature and structure of the underlying asset market, not the currency
market.
4
And a random exposure by definition cannot be expected to be anything other than uncompensated: even an
expectation of diversification benefit requires that the behavior of the exposure be something other than random
– or there is no basis for making predictions as to likely future behavior.
5
The traditional default Russell advice to U.S. investors choosing to hedge has been to adopt a 50% hedged
policy for regret-minimization reasons. The logic behind this is exceptionally well (and clearly) laid out in the
following Russell papers:
“Managing Currency Risk in U.S. Pension Plans,” Grant Gardner. Russell Research Commentary,
January 1994.
“The Regret Syndrome in Currency Management: A Closer Look,” Grant Gardner and Thierry
Wuilloud. Russell Research Commentary, August 1994.
“Statistical Estimates of the Normal Currency Hedge Ratio: Best Practice or Best Guess?,” Grant
Gardner and Douglas Stone. Russell Research Commentary, November 1995.
Each of these ways of thinking leads to a conclusion about the most appropriate
approach to dealing with currency exposures:
1. Because neither the amount nor the nature of my currency exposure is going to
matter, I don’t need to worry about any form of hedging or management of that
currency exposure.
2. Because the extent of my currency exposure matters, I need to consider
whether to adjust that exposure through hedging. Because the nature of the
currency exposure does not matter, I don’t need to worry about changing the
weights of currencies I am exposed to in my portfolio.
3. Because both the amount of currency exposure and the nature of that exposure
matter, I need to consider not only adjusting the amount of exposure (through
hedging), but also changing the nature of that exposure (through some form of
currency management).
We propose that investors think about exposure to currency as they would think about
other key portfolio exposures. This involves a simple staged process:
Identifying and adopting a benchmark to describe and measure the neutral-bet
exposure to the currency markets. The design of this benchmark will be based on the
actual structure of the currency market, rather than on the behavior or nature of other
markets.
Using that benchmark to represent currency as part of the risk assessment and
allocation process when setting target policy allocations at the total fund level –
essentially allowing currency to compete with other possible exposure sets for
allocation.
Implementing the resulting decision through manager hiring decisions – including
possible exposures to the currency markets, either through strategies designed to
replicate the chosen benchmark, or through active strategies designed to produce that
return with additional alpha.7
This approach allows investors to treat currency exposure similarly to they way they deal
with other investment choices. They are free to choose an appropriate benchmark. They
are also free to implement the solution in a number of different ways. They will end up,
however, with a much more considered exposure to the currency markets than they
would have achieved by following any of the current standard approaches.
Most important – this approach does not involve exposing the portfolio to any new asset
class, or exposure set. It simply involves attempting to describe one element of the
current exposure set more accurately, and to control it more directly. Doing this (even
without active management) should drive better portfolio efficiency, which in turn should
be hoped to drive better risk-adjusted return.
6
Although past Russell research has demonstrated that active currency managers have the ability to generate
positive returns, this is certainly not a universal property of those managers, and is generally regarded as
challenging. Despite this, Russell continues to believe that some active currency managers can create value.
7
For details underlying the case for active currency management, see “Capturing Alpha through Active
Currency Overlay,” Brian Meath, Janine Baldridge and Heather Myers. Russell Research Commentary, May
2000.
While the degree of return from each strategy varies, and while views differ as to
whether returns are related to some form of currency risk premium, there seems to be
enough agreement among market participants that these three factors explain a
significant part of currency market return, and that they appear to do so on a consistent
basis to justify using them as a market proxy.
A good currency benchmark, then, is likely to use a simple, rules-based, long/short
portfolio construction methodology to build a benchmark portfolio that captures the core
behavior for each factor in a mechanistic way, but without attempting to time the relative
strength of each factor.
BENCHMARK CHOICES
Over the last few years, a number of firms have begun to construct and issue
benchmarks designed to represent the totality of the currency exposure set. Most of
these benchmarks have only limited live history, and many of them focus on a single
factor.8 We can regard the current state of currency benchmarking as being similar to
the state of international equity benchmarking 25 years ago – better than not attempting
the exercise, providing a good approximation of the answer sought, but with plenty of
room for improvement.
The focus of this paper is not on the precise methodology an investor should use to
select a particular benchmark. As long as the benchmark concerned has most of the
properties mentioned above and as long as it is designed to represent the currency
markets in aggregate, it can be regarded as an appropriate choice for our current
purposes.
8
Credit Suisse, FTSE and Deutsche Bank all provide currency benchmarks of the types discussed. Russell has
calculated internal benchmarks for manager assessment purposes for a number of years, although these are
not public.
9
Indexes are unmanaged and cannot be invested in directly.
10
The resulting portfolio will clearly exclude some of the possible currencies. This type of benchmark is trying to
capture price-change behavior by identifying factors that drive those price changes (again, because the FX
markets are quite different from the equity markets, where a full replication approach is appropriate). Little would
therefore be added (other than transaction costs) by including those currencies where there is no useful
information in the signal structure.
8.0%
Excess Return
6.0%
4.0%
2.0%
0.0%
-2.0%
-4.0%
Jun-95
Jun-97
Jun-99
Jun-01
Jun-08
Jun-94
Jun-03
Jun-05
Jun-07
Jun-96
Jun-98
Jun-00
Jun-04
Jun-06
Jun-09
Jun-92
Jun-93
Jun-02
Each of the factors involved has contributed to the return at different strengths over
different periods. The chart below plots the contributions of each factor. It is interesting
to note the important role of carry between 2000 and 2007 – and also interesting to note
the way in which the other two factors provided diversification benefit when the carry
trade failed in 2008.
DBCR Indices
As of March 2010
280
260
240
220
Basis points
200
180
160
140
120
100
80
Jun-00
Jun-99
Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06
Jun-07
Jun-08
Jun-09
Jun-90
Jun-91
Jun-92
Jun-93
Jun-94
Jun-95
Jun-96
Jun-97
Jun-98
Jun-89
What is interesting about this benchmark is the way in which it compares with other
possible exposures, both in return and (more important) in diversification terms.
In this table we compare the DBCR approach to equity and fixed income from the point
of view of a U.S. dollar–based investor. We also include the difference between the
unhedged and hedged return of international equity – the effect that has traditionally
been described as “currency risk,” but which we now can more clearly describe as the
currency effect of a particular equity portfolio (which provides little information about the
currency market, or the true nature of currency risk).
This table shows a number of important facts. First, the return stream associated with
currency has been strong over the periods concerned – during the 10-year period, in
fact, the currency return was greater than both equity and debt. Second, the volatility of
the return, while higher than that of bonds, was significantly lower than the volatility of
equity. Third, when compared against the older definition of currency risk, the DBCR
approach has not only significantly better return, but also much lower risk.
The correlation statistics are probably more important – they are certainly as interesting.
What is clear is that the DBCR has much lower correlation with bonds and equities than
did the older definition of currency risk and that it also has low correlation with that older
definition itself. This is true across both 10 and 20 years.
In summary, then, the DBCR, over the time period for which data is available, provided
access to a relatively stable return stream. This return stream appeared to be able to
provide good diversification benefits for equity and fixed income investors. This return
also appeared to be able to do a much better job at this provision than does exposure to
“currency risk” as defined using the traditional approach. More important, this behavior
was not confined to the period for which back-test data was available, but also continued
into the live data set.
While the nature and process of this modeling exercise will depend upon the particular
investor, there are a number of ways by which we can gain some insight into the
possible benefits an investor might harvest from taking this newer approach to currency
risk.
There are two questions we might hope to answer by conducting further analysis:
Does this new specification of currency risk improve the description of the total
opportunity set available to the investor?
If so, does this opportunity set improvement occur in such a way that the investor
might be able to harvest benefits from a simple portfolio management process?
7.50
7.00
6.50
6.00
R eturn %
5.50
5.00
4.50
4.00
1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00
Risk (St. Dev.) %
For illustrative purposes only. As you move from left to right on the graph - increasing risk - there are
investments that can offer higher return potential. However, as with any type of portfolio structuring,
attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.
There is a clear result from this exercise. Over the 10-year period concerned, there is a
significant improvement in the efficient frontier caused by adoption of the Conscious
Currency approach. For example, at the 6% return level, the adoption of this proposed
approach reduces risk at the total portfolio level to nearly half that of an unhedged
portfolio. This is a fairly dramatic effect – we will see shortly whether this is harvestable.
This result is for U.S.-based investors over one particular time period (10 years ending
2009). However, when similar analysis is performed for investors based in other
domestic currencies, we find similar results, although the scale of the improvement
varies. This is also true as to time periods – analysis shows that over short periods,
there are times when the effect of the Conscious Currency approach does not produce
an improved frontier, but that over longer time spans, the effect becomes increasingly
stronger and more dominant.11
We therefore have good evidence that the proposed approach may provide benefits for
the investor.12 It remains to be seen whether investors would be able to harvest this
benefit by use of a reasonable portfolio.
11
Details of some of these analyses are included as an appendix to this paper. Results of this type of analysis
will, of necessity, be both time-period-dependent and also highly dependent upon the benchmarks chosen to
represent the different possible investment opportunities.
12
It is important to note here that we are restricting the discussion to the asset side of the investor’s behavior.
The way the asset side interacts with the liability issues that the investor is facing is, of course, key – but is
essentially independent of the current discussion.
3.5
3.25
Return (Annualized, %)
2.75
2.5
Unhedged
Hedged
2.25
Conscious
Currency
2
7 8 9 10 11
Risk (Standard Deviation, %) The direction of the arrows represents
increasing international exposure
13
Further analysis of this effect, for investors in different domestic base currencies, can be found in the
appendix to this paper. Again, the normal time period and data consistency caveats apply; at the least, these
results demonstrate an interesting behavior set.
14
Structurally, this is not dissimilar to a portable alpha approach, but the nature of the exercise is quite different
– rather than attempting to harvest alpha from one beta source, investors are instead gaining efficient structural
exposure to a type of beta to which they are today inefficiently exposed.
8
Return (Annualized %)
7.5
6.5
5.5
5
1 2 3 4 5 6 7 8
Risk (Standard Deviation %)
Unhedged Hedged Conscious Currency
7
Return (Annualized %)
2
5 5.5 6 6.5 7 7.5 8 8.5
Risk (Standard Deviation %)
Unhedged Hedged Conscious Currency
6.4
6.2
6
5.8
5.6
5.4
5.2
5
1 1.2 1.4 1.6 1.8 2
Risk (Standard Deviation %)
Unhedged Hedged Conscious Currency
5
Return (Annualized %)
4.5
3.5
2.5
2
6 7 8 9 10
7
Return (Annualized %)
6.5
5.5
4.5
4
1 1.5 2 2.5 3
3
Return (Annualized %)
2.5
1.5
0.5
8 9 10 11 12
11
10
Return (Annualized %)
5
1 2 3 4 5 6 7 8 9
Risk (Standard Deviation %)
Unhedged Hedged Concscious Currency
7.75
Return (Annualized %)
7.5
7.25
6.75
6.5
7.5 8 8.5 9 9.5
Risk (Standard Deviation %)
Unhedged Hedged Conscious Currency
4
Return (Annualized %)
3.5
2.5
1.5
1
0 1 2 3 4 5 6
-2E-15
-0.25
-0.5
-0.75
Risk (Standard Deviation %)
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