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Michael Sager, I’m a client portfolio manager at CIBC Asset Management.
The question is to explain dynamic hedging and how it fits within passive and active currency management. Dynamic currency hedging is an approach to the management of currency risk. There’s a number of ways to think about currency risk broadly in portfolios. At one end of the spectrum, we have passive hedging and passive hedges typically consider currency as an unrewarded risk that they inherit from global investing in equities or bonds. Because it’s unrewarded, they typically simply hedge that risk away. That’s at one end of the spectrum with passive hedging. At the other end of the spectrum, active currency investors. These market participants consider currency to be an asset class offering diversifying returns. There are returns to be harvested from currency and they are very diversifying, so very attractive. Those two ends of the spectrum are very different. One seeks return, the other one seeks to minimize risk.
Dynamic hedging sits in the middle of these two ends of the spectrum. In many cases, it’s very similar to passive hedging. The intention is to minimize risk from currency by tactically adjusting the amount of currency hedging. Dynamic hedges seek to add a little return to portfolios over time. That’s really where dynamic hedging sits in a portfolio. Very similar, most of the time, to passive hedging, but with one eye on trying to add return as well as primarily minimizing risk.
We find in terms of how it’s performed, that over the long-term, dynamic hedging does not reduce risk compared to a benchmark portfolio. For a Canadian-based investor, an optimal hedge ratio, historically at least, has been to be unhedged with your currency exposure. That reflects the correlation of the Canadian dollar with global economic cycles and equities. The best benchmark for Canadian investors who have global exposure is to be unhedged.
If you then introduce a dynamic hedging strategy and currency on top of that, where sometimes you’re deviating away from that unhedged benchmark, you’re increasing your hedge ratio periodically as the Canadian dollar weakens. We find that that actually increases the risk of your portfolio. It’s not optimal to dynamically hedge, it’s much better just to stick with your original benchmark. From that perspective, a risk perspective, dynamic hedging has not delivered on its performance goals over the long-term. We also find from a return perspective that dynamic hedging does not generate positive returns that is significantly different from zero. Again, you’re introducing operational complexity and risk into portfolios and you’re not being rewarded. To us therefore, it doesn’t make sense to pursue a dynamic hedging mandate. Better still to either remain unhedged or to embrace currency as an active investment strategy that absolutely can add value to a portfolio.
Let’s now think about currency in a different way. Currency to us is not just an inherited exposure, it’s actually an opportunity. It’s an opportunity to source another diversifying stream of return in portfolios. That is active currency investing is a liquid alternative strategy that’s really beneficial to portfolios. Diversifies equity exposure, diversifies fixed income exposure, and also diversifies exposure to other often illiquid alternative asset classes and strategies. As such, it adds additional return and it also diversifies.
Let’s not just think about currency as an unrewarded inherited risk that we get when we invest in global equities, for instance. Let’s also embrace active currency investing as an investment strategy that’s very beneficial, or has been very beneficial historically, to overall investment portfolios. How do we incorporate an active currency strategy into investors portfolios? This has changed a little bit over the years. Originally when the active currency manager universe came into being 20 years ago, active currency was introduced into portfolios very much as a constrained overlay.
Currency managers were allowed to introduce additional return seeking currency risk into portfolios, but only to a very small extent limited by the size and sign of underlying equity or bond exposures. The opportunity to add value from currency management was very limited. That’s the old world. Nowadays, it’s much different. Active currency mandates or management is now typically considered as just another source of return, another risk allocation that can generate return. It’s implemented as an unfunded overlay.
It’s a very capital efficient way of sourcing additional returns because being unfunded, it doesn’t impact the underlying strategic capital allocation of portfolio. It’s implemented as an unfunded overlay, an unconstrained unfunded overlay. It’s not tied to underlying investments. Sometimes it’s managed by the hedge fund managers within a pension fund. Sometimes it’s given over to the equity managers to oversee. But it’s absolutely a risk allocation to a dedicated and skilled currency manager who is then charged with implementing long and short currency positions using that risk budget to generate a source of return. There’s no link between the risk allocated to the currency manager or the positions utilized within that risk budget and the underlying asset positions of the portfolio. It’s an unconstrained overlay allocation to a skilled, dedicated currency manager.