Currency management plays an important role in managing investment returns. We use it to mitigate the risks of fluctuating exchange rates when investing internationally.
An offshore investment involves the purchase of an asset denominated in a foreign currency. Given the fluctuation of exchanges rates, investing in offshore assets gives rise to a risk that the value of the foreign currency being purchased will depreciate in value relative to the Australian dollar (AUD).
This is important because, as an Australian investor, we are ultimately only interested in achieving investment objectives that are expressed in Australian dollar terms.
The approach to managing currency risk differs across the industry due to a variety of reasons, including philosophical differences. Two important beliefs that underpin UniSuper’s approach to currency management are:
Currency is not an asset class in its own right, i.e. currencies do not, of themselves, generate an income stream. Unlike some other asset managers, we do not allocate capital for the purposes of currency trading as this would be akin to outright speculation. Currency risk is simply a risk associated with offshore investment that needs to be managed.
Calculation of a currency’s “fair value” is highly problematic at best over the long run, and effectively impossible over short to medium terms. This partly due to the fact that currencies do not generate an income stream in their own right. It’s also because at any point in time, different influences are impacting a currency’s direction. There are numerous, seemingly plausible, theories that attempt to quantify the fair value of a currency. Some of the more common include purchasing power parity, interest rate parity, relative terms of trade, and the like.
The problem is that no single theory has been able to adequately account for historical movements in many currencies, let alone predict future movements. The inherent unpredictability of currency movements is at least partly related to the fact that capital flows outweigh trade flows by many multiples, and the motives of capital allocators such as central banks, hedge funds, pension funds, corporates treasuries, etc. are many and varied.
Against those beliefs, we use a currency management framework where the actual hedge ratio employed differs across asset classes.
Hedging strategies per asset class
The following table summarises the different hedging strategies used for different asset classes. In determining the actual hedge ratio, various factors are taken into account including:
- the volatility of the underlying asset class,
- the liquidity of the currency being hedged, and
- in the case of listed equities, the actual level of the currency relative to historical trading ranges.
|Listed equities (Developed Markets) including Global REITs
||Discretion to adjust the hedge ratio between 0% and 100% per currency pair
UniSuper applies a minimum hedge ratio based on pre-defined levels approved by the Investment Committee.
The minimum hedge ratio is mainly determined by reference to the level at which a currency is trading relative to its historical range.
Other factors such as prevailing market conditions and liquidity considerations are also taken into account when determining the actual hedge ratio.
|Listed equities (Emerging Markets)
Currency hedging for many Emerging currencies is extremely challenging (e.g. high cost, illiquid, etc).
Currency movements tend to correlate with economy.
Volatility of the currency is far greater than the underlying asset class.
Assets include infrastructure, Private Equity & Property.
Volatility of the currency is far greater than the (reported) volatility of the underlying asset class.
Hedging strategies per investment option
Based on the above table, one could see that the hedge ratios will differ significantly across investment options, depending on the allocation to different asset classes within the investment option.
For example, the Balanced option has an allocation to global fixed interest and unlisted assets that will be 100% hedged. It also has an exposure to global listed equities that will be hedged at different levels depending on the currency involved.
As another example, if we consider US dollar (USD) based assets, the hedge ratio can vary between 0% and 100%. If the AUD was trading at its historical lows of around 0.60% the hedge ratio is likely to be close to 100%. Conversely at levels close to their historical high the hedge ratio will be close to 0%.
We do not disclose the exact hedge ratio as it literally moves by the second in line with currency movements. However, with the AUD/USD trading somewhere between 0.90 cents and parity, the hedge ratio is likely to be somewhere between 10% and 20%.
Accordingly, any portfolio holding US shares (such as all of the diversified investment options, and sector options such as Global Companies in Asia, International Shares, and Global Environmental Opportunities), will benefit from a depreciation in the Australian dollar.
Talk to UniSuper Advice on 1800 UADVICE (1800 823 842) to find out how they can help you.