Pitfalls of dynamic currency hedging

Currency investors may be wondering how to manage risk, as the Canadian dollar slips and the U.S. dollar benefits from a flight to safety during the Covid-19 crisis.

Listen to the full podcast on AdvisorToGo, powered by CIBC.

A recent CIBC foreign exchange monthly outlook report predicted a “rocky road” for the Canadian dollar in the near term. While the loonie may stay “relatively flat” to mid-March levels (the U.S. dollar at around CAD$1.45) if there’s evidence of Covid-19 cases cresting and a bottoming in oil by June, the Canadian dollar could see a post-recession recovery to 1.40 by the end of the year, the report said.

The U.S. dollar has gained during the Covid-19 crisis, but may be vulnerable to losing some of it if the number of cases in the country continues to climb, the authors said.

As a risk management strategy, currency is an “opportunity to source another diversifying stream of return in portfolios,” says Michael Sager, vice-president and client portfolio manager, institutional asset management at CIBC Asset Management.

Dynamic currency hedging is one approach to managing risk, he said in a March 16 interview, but not his preferred strategy.

“Passive hedges typically consider currency as an unrewarded risk that they inherit from global investing in equities or bonds,” he said. “And because it’s unrewarded, they typically simply hedge that risk away.”

Meanwhile, active currency investing focuses on diversifying returns, said Sager, who manages the CIBC Multi-Asset Absolute Return Strategy.

“Those two ends of the spectrum are very different. One seeks return, the other one  seeks to minimize risk.”

Dynamic hedging is in between active and passive strategies: it minimizes risk by adjusting the amount of currency hedging, and also seeks to add return over time, he said.

However, Sager said the long-term performance of dynamic hedging has not reduced risk compared to the benchmark.

“For a Canadian-based investor, an optimal hedge ratio, historically at least, has been to be unhedged with your currency exposure,” he said.

“And that reflects the correlation of the Canadian dollar with global economic cycles, and equities. So the best benchmark for Canadian investors who have global exposure is to be unhedged.”

A dynamic hedging strategy may increase the hedge ratio as the Canadian dollar weakens, he said.

“We find that actually increases the risk of your portfolio,” he said. “It’s not optimal to dynamically hedge. It’s much better just to stick with your original benchmark.”

Sager also said dynamic hedging may not be worth it from a returns perspective. The strategy introduces “operational complexity and risk into portfolios” without a reward.

“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.”

Sager prefers to look at currency as an opportunity rather than just an inherited exposure. Currency can diversify equity and fixed-income exposure, as well any exposure to illiquid alternative asset classes and strategies, he said.

An active currency mandate is now often considered as another risk allocation that can generate return, he said, and is implemented as an unfunded overlay.

“It’s a very capital efficient way of sourcing returns because, being unfunded, it doesn’t impact the underlying strategic capital allocation of portfolios,” he said.

The active currency mandate is overseen by a dedicated currency manager who is “charged with implementing long and short currency positions using that risk budget to generate a source of return,” Sager said.

“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.”

This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.