The effectiveness of an FX hedge has long been without a standard method of measurement. A lack of a universal measure deprives both investment managers and their end investors of a meaningful way to evaluate performance and understand the effectiveness of their process. Consequently, the absence of a comparison prevents a manager from demonstrating achievement of their investment objectives. That is about to change.
Brown Brothers Harriman has developed a simple metric that distills the effectiveness of an FX hedging program into a single score allowing comparison across funds, managers or service providers -- the FX Hedge Efficiency Score.
The FX Hedge Efficiency Score provides investors with an effective comparison of hedging programs. Most importantly, it creates a basis upon which more detailed conversations around the calibration of the hedging program can take place. It provides insight into target areas of improvement and whether those improvements may relate to timing, costs and/or operational workflows.
- The hedging program is designed to recover as much of the FX spot effect as possible. The spot effect is defined as the effect of FX from translating an investment from its value in foreign currency (local) terms to its value in investor currency terms (unhedged). The intention is not to enhance returns through active management of FX, but to minimize FX exposure.
- The goal is to achieve the above with as much certainty and consistency (minimal tracking error) as possible. The FX Hedge Efficiency Score is designed to assess these two key elements of performance: spot recovery (return) and tracking error elimination (risk).
Spot Recovery Ratio
The goal of the hedge is to recover/offset the greatest percentage of the FX spot effect as possible. The FX spot effect represents the return element of the FX Hedge Efficiency Score and is calculated (from the investor’s perspective) as:
For example, if a USD (local) asset returned 10.00% over a given period and the unhedged return of that asset to a GBP based investor over the same period was 5.00%, the spot effect is equal to -5.00%. In other words, the US Dollar depreciated by 5.00% relative to the British Pound.
Next, the performance difference between the hedged and local returns attributable to the interest rate differential (IRD) between the two currencies over the hedge period must be accounted for. To do this, we need to adjust the hedged performance up or down to account for the difference in cross border risk free interest rates. In our example, we assume an IRD for the period of 0.50%, meaning that risk free rates in the UK are 0.50% higher than in the US. This should yield a perfectly hedged return of 10.50% for GBP based investors in the absence of all other implementation factors. Such factors might include timing delays, costs, unrealized P&L of the hedge or the fact that the hedge is a reaction to past information (asset value uncertainty).
We can now measure the “spot recovery” reflected in the hedged performance by comparing the adjusted hedged return against the unhedged return:
If the hedged return was 10.25% and the IRD over the period was 0.50%, the adjusted hedged return is 9.75%. Comparing that to the unhedged return of 5.00%, implies the spot recovery was 4.75%. The hedging goal is to offset the -5.00% spot effect, therefore we are left with -0.25% attributable to other implementation related factors (relative spot performance).
The Spot Recovery Ratio can be calculated as:
To ensure equal penalty for both positive and negative relative spot performance of the hedge, we measure its absolute value (remember, the goal is not to enhance performance through active management, but to eliminate risk). In this scenario, the hedge captured all but 0.25% of the spot effect, representing a 95.00% recovery rate. The remaining spot FX exposure not recovered may be the result of any number of implementation factors as mentioned above.
Tracking Error Elimination Ratio
Tracking error is defined as the volatility of the return delta between two return series. Calculated in the same manner as typical standard deviation of any return series, it can provide a measure of the consistency of the hedging program.
To begin, calculate the tracking error of the unhedged returns relative to the local asset returns to determine the magnitude of the tracking error improvement provided through the hedging program. To do this, simply calculate the daily return differences of the unhedged relative to local asset return series. Once these returns are available, calculate the standard deviation of this series.
Next, perform the same calculation for the hedged returns relative to the local asset returns to determine the tracking error of the hedged returns. Assume the tracking error of the unhedged series is 10.00% while the tracking error of the realized hedged series is 0.10%, the tracking error reduction ratio is simply calculated as:
In our example, the hedged performance eliminated 99.00% of the tracking error resulting from FX exposure.
FX Hedge Efficiency Score
Finally, to determine the FX Hedge Efficiency Score, simply multiply the ratios:
A perfect score would result from recovering 100% of the spot effect, while eliminating 100% of the tracking error. While a flawless score is not practically achievable, the FX Hedge Efficiency Score can form a basis for peer group comparison, provider performance evaluation and program calibration.
Ultimately, managers owe it to their end investors to demonstrate the effectiveness of the products they offer. In a world of increased demand for transparency and an abundance of investment choices, offering investors a simple way to evaluate your success can open the door to new business. Whether the FX Hedge Efficiency Score highlights how well a hedging program is run or sheds light on areas of improvement, managers only stand to gain from a better understanding of their performance.