Managing currency exposure in Australian superannuation funds

Transcription

1 Managing currency exposure in Australian superannuation funds with Pete Gunning Chief Executive Officer Asia-Pacific, Russell Investments This Q&A summarises the key areas of currency management, including: How volatile is the Australian dollar? Does currency add uncertainty to portfolio outcomes? How have approaches to currency management changed over time? Is there an optimal hedge ratio for all investors? What makes the Australia dollar different to other currencies? Does hedging mean less risk? Why care about currency implementation? What are the risks in implementing currency exposures? We also share a case study based on our experience in managing currency exposure actively in Russell s multiasset funds in Australia. Australian superannuation funds are investing more and more assets globally in the wake of the Global Financial Crisis, introducing greater potential currency exposure to portfolios. ASFA recently invited Pete to share Russell s insights and experience in managing currency exposures, particularly from the perspective of an Australian superannuation fund. How volatile is the Australian dollar? The Australian dollar (AUD) was floated on 12 Dec 90 US cents. The AUD/ USD is now the fourth most traded currency pair, accounting for 7% of global foreign exchange (FX) turnover 1. In the 30 years since the float, the local currency has sustained long episodes of depreciation and appreciation, as shown in Figure 1. Figure 1: AUD s long episodic trends 1.6 USD per AUD Source: Bloomberg and Russell Investments Past performance is not an indicator of future performance 1 BIS Triennial Central Bank Survey of foreign exchange and derivatives market activity in April Daily AUD urnover is $364 billion USD on a net basis.

2 Over this period, the trading range for the Australian dollar has been extremely wide. Figure 2: AUD vs Purchasing Power Parity 1.10 Rolling 10-year standard deviations AUD/USD 0.50 PPP estimate 1 Std Dev Away Std Dev Away Source: Datastream, Russell Investments Over this period, the trading range for the Australian dollar has been extremely wide. Based on Russell s estimate of Purchasing Power Parity (PPP) 2, the Australian dollar has traded more than two standard deviations away from PPP (or fair value), reaching as low as 47.7 US cents in 2001 and as high as USD110.8 in 2011, as shown in Figure 2. The dollar has also experienced short term volatility, plunging more than 15% in the months after Paul Keating s Banana Republic comments 3 and falling more than 30% in mid 2008 during the Global Financial Crisis. Figure 3: Five year rolling standard deviation of different currency pairs (annualised) 18 5 year rolling annualised currency volatility Russell s PPP estimate provides a useful medium to long-term reference point about the likely direction of currency going forward. It is not designed as a short term timing tool. The PPP estimate is based on the monetary theory of exchange rates and measures how much the AUD buys relative to other currencies (in this example, the USD, by taking into account relative inflation differentials). 3 If this Government cannot get the adjustment, get manufacturing going again and a sensible economic policy, then Australia is basically done for. We will end up being a third rate economy... a banana republic. Paul Keating on national radio 14 May Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan 2014 EUR/JPY NZD/USD AUD/USD GBP/JPY USD/CHF EUR/USD USD/CAD JPY/USD GBP/USD EUR/GBP EUR/CHF Source: Reserve Bank of Australia, Datastream Figure 3 illustrates how much more volatile the AUD/USD is compared to other major currency pairs and therefore highlights, from a pure volatility standpoint, the extra attention Australian investors need to take when investing overseas. 2

3 The final portfolio outcome depends on the relative direction and size of the offshore asset and currency movements. Does currency add uncertainty to portfolio outcomes? Although everyone seems to have an opinion on whether the Australian dollar is currently over or under valued, 80% of super funds recently surveyed believe noone is able to accurately predict the value of the currency over the next 12 months 4. One thing that is agreed on - currency injects further uncertainty to global investments 5. The final portfolio outcome depends on the relative direction and size of the offshore asset and currency movements (Refer to Figure 1 which shows that these moves can be large and prolonged). There are generally four types of scenarios from an Australian investor s perspective as illustrated in Figure 4. For simplicity, this illustration focuses on the AUD/USD currency pair and uses the U.S. stock market as the offshore asset: 1. If the USD appreciates (AUD depreciates), and the US equity market rises, the effect is a double bonus as both the underlying equity investment and the value of the USD portfolio when translated back to AUD have increased. 2. If the USD depreciates (AUD appreciates), and the US equity market falls, the effect is a double whammy as both the underlying equity investment and value of portfolio when translated back to AUD have decreased. 3. If the USD appreciates, but the US equity market falls, the net effect depends on the relative size of the movements. If the currency gains are larger (smaller) than the equity decline, the net impact is positive (negative). 4. If the USD depreciates, but the US equity market rises, the net effect depends on the relative size of the movements. If the equity gains are larger (smaller) than the currency loss, the net impact is positive (negative). Figure 4: Four scenarios for final portfolio outcomes Value of Foreign Currency UP DOWN DOWN UP Stock Market Return Hedging currency exposure can remove the impact of uncertain currency movements on global investments, leaving the underlying asset as the source of uncertainty on portfolio outcomes. 4 NAB FX Superannuation survey Especially when considering a volatile home currency. 3

4 Even small (currency) exposures result in uncompensated risk. How has currency been managed historically? Figure 5: Evolution in approach to currency management over time Foreign Currency Exposure (%) High Low Consider hedging (Minimise regret) Do not hedge (Not material) Do not hedge (Unnecessary) Even small exposures result in uncompensated risk. Low cost of hedging suggests beneficial to manage currency risk 15% Short Evaluation horizon Long For illustrative purposes only Historically, the commonly used decision making framework for hedging or not has primarily focused on the investor s time horizon and amount of foreign exposure: 6 We expect the amount of foreign exposure to continue to increase in future due to diversification and globalisation. The Australian share market accounts for only 2.9% of the global market (based on MSCI All Country World Index as at 28 February 2014). Further, we expect there will be an increasing need to invest offshore to keep up with the Australian superannuation industry s growth. For example, the Australian share market is currently slightly smaller than the Australian superannuation industry ($1.5 trillion vs 1.8 trillion as at 28 February 2014 based on ASX and ASFA data), but superannuation assets are projected to grow at a much higher rate going forward relative to the domestic share market.»time» horizon. As a general rule, the longer the investor s time horizon, the less reason for hedging as it was argued that currency movements wash out in the long run. Investors with shorter time horizons were encouraged to consider hedging to minimise regret, or the risk of being wrong in hindsight. Based on this principle, investors commonly hedged 50% of their global equities allocations, because if the AUD depreciates, the regret is that investors should have been 0% hedged, while if the AUD appreciates, the regret would be that investors should have been 100% hedged. Thus a 50% strategic hedge ratio minimises the deviation from either extreme without the benefit of hindsight. Amount of foreign exposure 6. If the % exposure to foreign assets was small (e.g. below 15%), many investors did not hedge as the exposure was deemed immaterial, as shown In Figure 5. However, increasingly, even small exposures are now managed (passively or actively hedged), as investors recognise the potentially large impact of volatile currency movements especially in the short term; where investors are highly sensitive to peer risk and regret risk; and where, in a low return environment, potential additional return sources are in demand. 4

5 What is the end goal of the investor? Are they seeking to achieve an absolute level of return, a return above inflation, or peer relative measures? Is there an optimal recommended hedge ratio for all investors? Russell believes the appropriate hedge ratio for each investor depends on the investor s specific circumstances: 1. Investor objectives. What is the end goal of the investor? Are they seeking to achieve an absolute level of return, a return above inflation, or peer relative measures? A more active currency management approach will help contribute to absolute return and inflation targets, while peer-sensitive objectives may be supported by a passive hedge closely tracking peer hedging levels. Do they have foreign currency liabilities (e.g. overseas holidays or other retirement plans involving offshore purchases)? 2. Time horizon. As discussed in the previous section, all else being equal, the shorter the investor s time horizon, the more investors should consider hedging to manage the impact of potentially large and adverse currency movements on their portfolios. 3. Risk budget and tolerance. Can the investor tolerate a significant decrease in the value of their assets if currencies move adversely? Do they prefer to spend their risk budget on other fundamental return sources, e.g. equity risk premium, term, credit, illiquidity? 4. Liabilities. Which currency (or currencies) are the investor s liabilities denominated in? If their liabilities are denominated primarily in Australian dollars, they may want to fully hedge all currency exposures in their asset portfolios to match the currency exposure for their assets and liabilities and vice versa (e.g. overseas travel and imports in retirement). 5. Investor beliefs. What are the investor s beliefs about currency as a source of value-add and diversification? Do they believe the Australian dollar persistently outperforms the interest rate differential 7? 6. Peer risk and regret. How sensitive is the investor to peer risk? For example, competitive pressures on public offer super funds, where members compare short term results in league tables, may influence the hedge ratio decision and limit the deviation from the peer median. Similarly, what is the tolerance for regret risk from decision makers? 7 The Forward Rate Bias hypothesis expect currencies of higher yielding countries (AUD, NZD, MXN, BRL) to systematically experience less depreciation than the interest rate differential implies. See next section for details. 5

6 The implications.. is that the correlation patterns between currency and underlying asset markets assumed for other defensive base currencies, e.g. USD do not necessarily apply from an Australian perspective. What makes the Australian dollar different from other currencies? The Australian dollar (AUD) is a risk on play. Due to Australia s historical reliance on mining and resources, the domestic currency has been highly correlated to commodity prices, emerging markets and global growth in general. Historically, the AUD has been susceptible to large shocks in the terms of trade due to volatility in global demand and prices of commodities (Australia s exports). Furthermore, the AUD/USD currency pair tends to be a popular carry trade due to historical persistence of interest rate differentials. The Forward Rate Bias (FRB) hypothesis expects currencies of high yielding countries (e.g. AUD, NZD, MXN, BRL) to systematically experience less depreciation than interest rate differentials imply, i.e. outperform. In Australia, there is some empirical evidence of the FRB over the last year period to 31/3/2014 as shown in Figure 6. However, it isn t clear whether this is episodic and time varying (due to where we are in the market cycle) or a permanent feature. The implications for portfolio management is that the correlation patterns between currency and underlying asset markets assumed for other defensive base currencies, e.g. USD, do not necessarily apply from an Australian perspective. The potential future outperformance of the AUD due to the FRB may also cloud the hedging decision for an Australian investor. Figure 6: AUD/USD outperformance (annualised forward rate bias) 3% Annualised Forward Rate Bias, AUD vs. USD 2% 1% 0% -1% -2% -3% -4% -5% -6% -7% Source: Datastream, Russell Investments 6

7 Russell believes that currency exposure should be considered at the total portfolio level, encompassing all global asset class exposures, including emerging markets, commodities and unlisted alternative investments... Does hedging mean less risk? Figure 7: Five year rolling standard deviation (annualised): hedged vs unhedged 24% Unhedged Hedged 21% 18% 15% 12% 9% 6% Source: Datastream From an AUD investor perspective hedging does not necessarily reduce risk. The answer is time and environment dependent. In the 1990s, unhedged global equities returns exhibited higher standard deviation than the equivalent hedged series, but this switched in the last two decades as shown in Figure 7. The net result is a function of the changing correlations between the currency and underlying equity market movement. For the last two decades, the AUD has primarily been a risk on play. When global equities markets rallied, the AUD appreciated, decreasing the value of the global investment in AUD terms. Conversely, when global markets fell ( risk off ), the AUD depreciated, increasing the value of the global investment in AUD terms. In both cases, the opposing direction of the currency and asset movements serves to dampen the volatility of unhedged returns when translated back to AUD, leading to the somewhat surprising result that the volatility of hedged returns can, in some cases, be higher than the volatility of unhedged returns. The result also depends on what measure of risk is used. Is risk the simple sum of asset risk and currency risk? Is risk measured as portfolio standard deviation, peer relative or liability relative deviations? Is risk measured at the asset class level or at the total portfolio level? Russell believes that currency exposure should be considered at the total portfolio level, encompassing all global asset class exposures, including emerging markets, commodities and unlisted alternative investments, as well as traditional global equities and global fixed interest. Taking a holistic view of the currency exposure for the aggregate portfolio helps identify the net currency positions that the fund is exposed to (and allows for potential netting of currency transactions). 7

8 The choice of approach depends on whether investors are primarily seeking to manage the uncertainty around currency exposures, use currency as a diversifier and additional source of return, or a combination of both. How can investors manage the impact (and/or take advantage) of currency movements? There are a number of ways to manage the currency exposures in investment portfolios: 8 1. Appoint a currency overlay manager to implement a passive hedge ratio across your total overseas exposure 2. Actively adjusting the hedge ratio at pre defined market levels, e.g. using a disciplined strategic tilting process or delegating this to an overlay manager 3. Gain passive exposure to currency indices 9 4. Employ specialist active currency managers to add value over passive currency indices The choice of approach depends on whether investors are primarily seeking to manage the uncertainty around currency exposures (#1), or use currency as a diversifier and additional source of return (#3 & #4) or a combination of both (#2). These approaches can be implemented by: superannuation funds themselves if there are sufficient resources available to implement currency decisions; a third-party agency or manager can implement the currency exposures; or a provider, as part of a total outsourced solution. 8 In addition to simply using a defined split of hedged or un hedged share classes within a pooled fund structure. 9 Currency indices attempt to capture the systematic risk premiums (currency beta) potentially available in currency investing. The indices also enable investors to distinguish between the risk/return produced with and without active management insight (i.e. separate alpha and beta). 8

9 Case study of active currency management In Russell s experience, currency movements can be rapid, volatile and large; currencies tend to follow trends for long periods of time, only to change course without much warning. This is why Russell follows a disciplined and rigorous process to identify unsustainable market extremes determining candidates for tilting, as well as assessing the triggers for entering/exiting a position. We have actively managed the currency exposures in Russell s multi-asset funds in Australia since 2008, by dynamically adjusting (or tilting) the hedge ratio, with 50% being the default strategic position. Figure 8 shows how the currency exposure has been actively managed over time in the last 12 months for the Russell Pooled Superannuation Trust Balanced Opportunities Option, based on Russell s portfolio manager insights and strategist views. Factors contributing to our active currency management include: speculation and official announcements surrounding the Fed tapering; the Reserve Bank of Australia s stance on interest rates and the state of the local economy; market sentiment; outlook for carry trades. Actively managing the portfolio s currency exposure added 1.4% to excess returns during the calendar year 2013 (on a gross basis). Figure 8: Example of active currency exposures over time Hedge Ratio 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% AUD/USD Spot % 5 Apr Apr Apr Apr 13 3 May May May May May 13 7 Jun Jun Jun Jun 13 5 Jul Jul Jul Jul 13 2 Aug 13 9 Aug Aug Aug Aug 13 6 Sep Sep Sep Sep 13 4 Oct Oct Oct Oct 13 1 Nov 13 8 Nov Nov Nov Nov 13 6 Dec Dec Dec Dec 13 3 Jan Jan Jan Jan Jan 14 6 Feb Feb Feb Feb Unhedged Hedged AUD/USD Spot Price For illustrative purposes only - Russell Pooled Superannuation Trust Russell Balanced Opportunities Option 9

10 In relative terms, there is a larger range of costs incurred for currency transactions than many other investment activities... Why care about currency implementation? Once the hedge ratio is defined, and a tilting governance structure is established (where applicable), the currency exposure needs to be actually implemented, e.g. an agency or third-party manager needs to be instructed to buy and sell the appropriate equity futures and manage this exposure going forward. This can be implemented through a hedged commingled fund or a currency hedging overlay program, which encompasses all overseas exposures in one portfolio rather than each asset class individually. Figure 9 compares the relative costs of different investment activities, as well as demonstrating the range of different outcomes from different providers. Foreign exchange can have a significant impact on the overall costs for an investment portfolio. In relative terms, there is a larger range of costs incurred for currency transactions than many other investment activities (after equity trading). Based on Russell s experience in transacting currency, the following data illustrates further how foreign exchange costs can vary widely across providers: Inattention to FX transactions can be costly, with the difference between providers ranging by over 20 basis points of the portfolio value. Russell s FX trading service can reduce those costs, sometimes by more than 75%, through netting and matching, and select counterparty trading The average manager / fund paid 9.7 basis ponits in trading costs from Russell s costs were 90% lower than the average. Figure 9: Comparison of different costs for different investment activities 25% of funds with lowest charges Median of all funds 25% of funds with highest charges Investment management Administration Equity trading Foreign exchange Custody Source: John Authers, The Pension Gap, Financial Times, page 7, 28 May

11 ... it is important to ensure that the manager or institution conducting foreign exchange trades... is the best agent to conduct the role... What are the risks in implementing currency exposures? In addition to costs, there are risks involved in implementing currency exposures and transactions which also need to be managed: Operational risk Trading processes without transparency and oversight can incur human errors, leading to misunderstandings and miscalculations. Counterparty and settlement risk Trading counterparties might not be able to fulfil their obligations after a trade is made. Furthermore, headline risk means negative news about a counterparty can rapidly affect other parties willingness to trade. Avoid fraud and unnecessary expenses Recent negative publicity has increased awareness and transparency on implementation issues such as fixing, collusion, manipulation and high charges. Russell believes industry best practice to manage these risks is achieved through: Transparency and accountability in trading and reporting Every trade is timestamped to track information on each trade. There is full disclosure/fully visible commission on services after netting transactions. Improved governance helps prevent counterparty and settlement risks This includes having a strong, independent credit team to review, approve and monitor all counterparties; centralised trading; consideration of multiple counterparties to ensure bids are competitive; reducing the operational workload and risks associated with FX trade settlement (e.g. using Continuous Linked Settlement the industry program for eliminating settlement risks in FX transactions). The agency model Acting as agent rather than principal helps ensure interests are always aligned with the client s and the agent is incentivised to find the best execution/ terms for every FX trade. This helps achieve lower currency transaction costs and more holistic risk oversight. It is important to ensure that the manager or institution conducting foreign exchange trades on your behalf is the best agent to conduct the role, in the same way a best of breed equities manager is selected. CONCLUSION Investing globally incurs currency risk. Russell believes currency exposures need to be managed at the total portfolio level. Russell recommends investors first determine the most appropriate long-term strategic currency approach, and then consider active management to take advantage of opportunities and manage risks as they emerge. Finally, investors should implement currency exposures carefully to avoid cost leakage. 11

12 Russell Investments At Russell Investments, we believe all investors require a rate of return at a level of risk they can accept and commit to for the long term. We re a global asset manager with a unique set of capabilities essential to managing your total portfolio and to meeting your desired outcome. We integrate these capabilities to give all our clients what we believe is the highest probability of reaching their goals. CAPITAL MARKETS INSIGHTS MANAGER RESEARCH INDEXES PORTFOLIO IMPLEMENTATION PORTFOLIO CONSTRUCTION Capital Markets Insights Our capital markets insights help determine the exposures your portfolio needs to best achieve your goals. Portfolio Construction We believe you need world-class capabilities in strategic asset allocation. Manager Research & Indexes We achieve those exposures through best-of-breed active managers and customised smart beta or passive exposures. For more information, please contact: Dan Birch Senior Business Development Manager Russell Investments dbirch@russell.com Portfolio Implementation To keep your portfolio on track requires a purpose-built, trading capability in which the broker s objectives are aligned with yours. Russell has traded more $500 billion in currency transactions in Russell has been recognized by aicio as a leader in foreign exchange, winning the 2011 Industry innovation award winner Foreign Exchange. 10 Russell helps clients manage foreign exchange trading costs and risks in international portfolios by: Executing foreign exchange trades as a pure agent, not a principal, providing transparent execution Developing strategies to hedge currency risk through passive currency overlays & FX exposure management Analysing foreign exchange trades to assess costs and identify effective solutions. Russell s transactions cost analysis can recommend more stream-lined, straight forward solutions to reduce costs and risks. 10 No awards were given out in 2012 or Issued by Russell Investment Management Ltd ABN , AFS Licence This document provides general information for wholesale investors only and has not been prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation and needs. This information has been compiled from sources considered to be reliable, but is not guaranteed. Past performance is not a reliable indicator of future performance. Returns are gross of fees and expenses. Any potential investor should consider the latest Product Disclosure Statement (PDS) in deciding whether to acquire, or to continue to hold, an investment in any Russell product. The PDS can be obtained by visiting or by phoning (02) RIM is part of Russell Investments (Russell). Russell or its associates, officers or employees may have interests in the financial products referred to in this information by acting in various roles including broker or adviser, and may receive fees, brokerage or commissions for acting in these capacities. In addition, Russell or its associates, officers or employees may buy or sell the financial products as principal or agent. Copyright 2014 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. R_MKT_QA_Currency_V1FF_1404 April 2014