Market Volatility Prompts a New Look at Currency Hedging
The global currency markets were hit by some of the highest volatility in years following the outbreak of the COVID-19 pandemic, shining a spotlight on how asset managers are hedging their FX exposures. Not only are managers seeking more efficient ways to mitigate slippage due to currency exposure, but they need their hedging programs to provide more granular detail to investors about how currencies are affecting their overall returns.
Additionally, regulatory requirements contained in the Markets In Financial Instruments Directive (MiFID) II in the E.U. and U.K., such as the best execution obligations require fund managers to increase scrutiny of their currency hedging programs.
While funds can manage the hedging process in house as part of their investment team, the increasing complexity in designing, implementing, monitoring and executing an optimal currency hedging program is prompting many managers to outsource the hedging process to third-party providers with subject matter experts who specialize in FX trading and hedging.Most managers have long been accustomed to hedging FX portfolio risk: when they buy a share in Swiss francs for a U.S. dollar-based fund, for example, they may wish to neutralize the possible fluctuations of the two currencies. But many managers also face additional currency risks when they market their funds to new jurisdictions in local currencies, such as a dollar-based fund marketing to Europe and Asia, which adds an additional layer of currency risk that can drive performance slippage at the share class level. All of the local investors form a share class and the manager hedges the share class investment currency against the fund's base currency so that both groups see similar returns, insofar as possible.
There are several overarching elements in putting in place a well-managed currency hedging program: designing and implementing the program, the day-to-day program management, and the program's oversight and post-trade evaluation. Here is a road map on how these steps can be achieved:
Program design and implementation
Fund managers seeking to optimize their hedging program ideally need the capability to allow for customized calibration of parameters that define the operation of the hedge. Considerations such as hedge ratio filters (the allowable variance from 100% hedged), roll schedules, settlement cycles, staggered rolls, fund holiday calendars all factor into the effectiveness of the hedge.
Hedge filters may vary depending on the investment strategy and underlying volatility of the asset classes of the fund. The challenge for hedging programs is to set the filters at a level that is not too wide nor too narrow, to try to achieve the optimal tradeoff between transaction costs and performance slippage. If filters are set too wide, there will likely be a divergence between the class and the fund's performance. Too narrow a range will force the manager to undertake more frequent rebalancing trades, which has a negative impact on the fund's performance by incurring additional transaction costs.
Designing an efficient hedging program that involves multiple investment strategies requires sophisticated analytical tools. FX specialists can design a program that takes historical performance of the base fund and a hedged reference to try to determine the sweet spot that produces the best results at the lowest transaction cost. In the case of new funds, the same analytical tools can be used to synthesize historical performance to calibrate hedging parameters.
Trade execution is also key to an efficient hedge. Managers may seek to avail of a customized trading model that aligns with the fund’s objectives and minimizes tracking error. Funds typically have options to trade through their custodian's own FX desk, or use an agency approach by utilizing a panel of outside liquidity providers to obtain competitive prices from multiple FX desks, which provides both price discovery and risk diversification. For certain FX trades, such as capital stock conversion, it may be preferred to request the WM/Reuters price, or another appropriate market benchmark, through your principal provider, for specific program trades where the performance of the class might benefit from execution at the FX valuation point of the fund.
Day-to-day program management
Fund valuations will fluctuate on a daily basis as the underlying asset prices and currencies rise and fall. Although the hedge ratio filters are set at the outset, they need to be reviewed periodically to ensure the hedging program is performing as expected. While much of this is accomplished through automation, there needs to be subject matter experts who are monitoring the day-to-day deviations from the hedge program, overseeing what is happening between the portfolio and the forward activity to ensure the fund is within the predefined ratios, and that rebalancing activity is properly calculated and instructions are being sent to the FX desks to execute timely. Flexible, detailed and client-focused reporting options for oversight and reconciliation need to be made available and, ideally, dedicated resources strategically located across multiple regions to support clients’ global needs.
Program Oversight and post-trade evaluation
In addition to transparent and detailed execution reporting as a base requirement, the post-trade evaluation should look at how the program's performance compared to the core fund's performance, for example, explaining why a euro-based investment got a 1.2% return while the same U.S.-dollar based investment returned 1%.
“Performance attribution” should detail what factors drove any performance deviation so that the fund can provide investors with a detailed explanation of the impact of market-driven factors and of the program parameters. Some FX providers offer a detailed hedge dashboard that show this data both in raw form and in graphic displays so the fund management can easily implement changes.
The oversight function will also make sure that any changes in the market or portfolio, such as shifts in asset allocation, are incorporated into the hedging strategy. Likewise, periodic review of execution, program calibration and factors impacting performance should take place.
With the increased market volatility, additional regulatory scrutiny, and the need to do more with less, more and more managers are reviewing operational functions such as Currency Hedging and re-assessing how they are managing their programs and whether or not they belong as an in-house function. As highlighted above, irrespective if the program is managed in-house or delegated to a FX specialist there are some critical aspects for managers to consider to ensure their hedging programs are well designed and managed, but also deliver appropriate levels of transparency and oversight.
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