Mitigating hidden FX risk in global portfolios

By Kellen Jibb, Market Services Solutions, RBC Investor Services

Asset owners and managers are facing significant challenges as they seek to generate alpha, expand offerings or strategies, and manage risk in their global investment portfolios. At the same time, volatile equity and fixed income markets, ongoing uncertainty surrounding central bank decisions, widening geopolitical conflicts and consequential elections are testing the resolve of even the most ardent owners and managers.

FX volatility can seriously impact a fund’s performance

In the context of this demanding environment, foreign exchange (FX) volatility can have serious implications for a fund’s performance, especially in the pension space where payouts to beneficiaries are an ongoing requirement. Factors outside individual security performance, including global exchange rates, have the potential to diminish returns and introduce additional risk to a global portfolio. Currency hedging strategies provide the opportunity to maintain exposure to global investments while mitigating the uncertainty of foreign exchange rates.


Understanding currency hedging

In any fund with investments domiciled outside the home currency, depreciation of the foreign currency against the base currency has the potential to reduce total returns, regardless of the underlying asset’s performance. Currency hedging uses a rolling series of foreign exchange swaps and forwards to mitigate the impact of currency price fluctuations. Properly executed, a currency hedge will generate positive positions to counteract declines in foreign currency rates. This enables asset owners and managers to focus on security selection rather than the unpredictable USD 7.5 trillion daily FX market.1

Once a manager decides to hedge foreign currency exposure, a variety of execution options are available. Some managers will adopt active currency hedging, taking a particular view on the future direction of currency movement and hedging their exposure, while also attempting to generate alpha. Others will employ a passive approach, using a set of regimented parameters to hedge some or all global exposure on a regular basis.

Hedging strategies are as individual as investment strategies

Hedging strategies are as individual as investment strategies. Certain managers combine elements of passive and active currency hedges. Some prefer exposure to security fundamentals only and opt to hedge the currency exposure of their entire global portfolio. Other managers, especially those in the “buy-and-hold” equity space, take the view that exchange rates will ultimately revert to their mean values over a long period of time and decide not to hedge their portfolios whatsoever. Hedging may not be for everyone but there are multiple paths to execution for those who adopt this approach.

Implementing a hedging strategy

Implementation of a hedging strategy varies across asset classes, risk tolerance and investor type. Asset managers, particularly fixed income managers whose returns tend to be more consistent but lower, will usually hedge their entire portfolios as currency fluctuations can have an outsized effect on returns. These managers will often look to have FX traders execute their positions at points advantageous to the funds.

Implementation varies across asset classes, risk tolerance and investor type

Additionally, some asset managers will offer hedged share classes to investors in various base currencies, marketing their most successful strategies to investors in currencies that are different from the main funds. This is an increasingly important offering, especially when a fund includes investors in a base currency such as CAD but is holding positions in global securities. Since hedged share classes are generally structured and must be fully hedged, there is often little to no portfolio manager or trader input. For such strategies, outsourcing to a dedicated currency manager is often the preferred option.

Asset owners, on the other hand, tend to employ different strategies. With beneficiaries to pay and stringent risk requirements to consider, many choose to hedge most or all of their global portfolios. Pension plans typically delegate security selection to third-party portfolio managers but retain autonomy over foreign exposure hedging. This is done at the top of the house where investment committees will call for the hedging of certain foreign exposures. Given these “rules-based” hedging approaches, partnering with a trusted FX dealer through an outsourced currency hedging solution, also known as a currency overlay, is also an effective option.

Choosing a hedging partner

Once the choice is made to hedge and the preferred strategy is agreed, the final decision involves finding the right partner to help implement the solution. Whether opting for a direct trading counterparty to provide competitive pricing and rapid execution, or an outsourced solution to implement a passive overlay scheme, it is critical to obtain an experienced, dedicated currency hedging partner. Selecting a partner with market expertise and dynamic technology is the logical first step, especially when considering an outsourced solution. The ability to scale up and accommodate asset growth is another key consideration.

Selecting a provider that can implement multiple strategies is key

Opting for a partner that provides multiple solutions—including full outsourcing, a hybrid model or as a direct counterparty—enables asset managers and owners to adopt a customized approach that fits their requirements. There is no one-size-fits-all solution to currency hedging and choosing a provider capable of implementing multiple strategies is key. This also allows managers to connect with a single point of contact, a single source of reporting and a single fee agreement for their FX requirements. Finding a partner that has experience and natural advantages in hedge settlements is the final piece of the puzzle. Currency hedges are often large notional sums and ensuring accurate, timely settlement limits the risk involved when dealing currency swaps and forwards.

Managing global investment risk

Reward is not without risk. Global investment strategies are becoming critical vehicles for asset owners and managers to maximize returns and diversify their portfolios. However, investing in a market outside the home base introduces the highly uncertain factor of exchange rate volatility. Choosing an effective FX hedging strategy that fits the underlying investor risk tolerance and partnering with a dedicated service provider will help owners and managers mitigate risk, opening up their portfolios to new markets and opportunities.

This article first appeared in the April 2024 edition of The Observer newsletter, a publication of the Association of Canadian Pension Management.

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1 Bloomberg News, March 11, 2024