Market volatility spurs some funds to look again at
currency hedging
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[February 06, 2018]
By Simon Jessop and Saikat Chatterjee
LONDON (Reuters) - A pick up in currency
market volatility over the last few days after years of suppression by
central banks' easy-money policies has prompted some investors to look
again at protecting against, or profiting from, sharp moves.
To hedge or not is a question that divides asset managers, with some
actively buying and selling currency exposure through derivatives to
boost or protect returns, and others refusing to spend the money,
viewing the long-term impact as neutral.
Even when they do hedge to protect earnings from overseas, many focus on
bonds rather than equities, given currencies often move inversely to the
more volatile stock market and the impact of adverse currency swings is
bigger on fixed-income assets.
But as global central banks look to tighten policy, lowering expected
market returns, the perceived risk from a currency move rises - a
leading index of implied currency volatility is up by half over the past
five weeks.

It can be justified: the dollar fell 10 percent in 2017 against the
currencies of its main trading partners while sterling rose steadily.
These moves were relatively gradual, lacking the spikes of volatility
that marked previous shifts thanks to the numbing effect of the
trillions that central banks poured into financial markets after the
2008 global crisis. But the anesthetic is being slowly withdrawn, led by
the U.S. Federal Reserve which has already raised interest rates five
times this cycle.
The $4 trillion wiped off global stocks from record highs only eight
days ago is a timely reminder that, as Rabobank analysts noted, "one-way
bets don't exist".
On top of this, major currency swings can make a big difference to the
end-of-year returns for active fund managers invested in foreign markets
as they fight to prove their skill to clients who have one eye on
cheaper, index-fund alternatives.
Sterling's 20 percent rise to a post-Brexit referendum high of $1.43 in
late January, coupled with uncertainty over future moves as Britain
negotiates to leave the European Union, has prompted others to act.
One is Janus Henderson's head of multi-asset investing, Paul O'Connor,
given the increasing portion of his portfolios invested in overseas
markets ranging from Japanese equities to U.S. corporate debt.
"As a result, we are running about a third to half of portfolios on a
hedged basis as we have a very low conviction on where sterling is
headed with many of the factors that were supportive of sterling
previously starting to look a bit tired now," O'Connor, whose funds
manage 5 billion pounds, said.
Mark Astley, CEO at Millennium Global Investors, a currency investment
manager, offers a range of hedging or profit-seeking foreign exchange
strategies to investors, more of whom were concerned about the impact of
a large currency swing.

"We are having a lot more conversations in the last 6-9 months than we
have had for a number of years before on the potential impact of a 10
percent currency move," he said.
Such a swing would have a much bigger effect on investors' returns if
they expect their portfolios to grow by zero to five percent in the post
easy-money era, rather than by 10 to 15 percent as in the recent past.
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Traders work on the floor of the New York Stock Exchange (NYSE) in
New York, U.S., January 26, 2018. REUTERS/Brendan McDermid

Any decision to hedge can translate into market flows of hundreds of millions of
dollars in the currency forwards and swap markets most often used by investors
and become a big source of strength for currencies.
(To view a graphic on FX market volume, click http://reut.rs/2BHcKqr)
RISKS
While realized volatility in foreign exchange markets has declined in recent
years as a result of the central bank policies, the market has still been hit by
sharp moves around unexpected macroeconomic events.
Among the biggest of recent years were the Swiss central bank's removal of the
franc's peg to the euro in January 2015, and sterling's plunge after the Brexit
referendum.
Before the vote, many large investors had no currency hedges in place and so
reaped windfall profits as the pound fell more than 15 percent, boosting the
value of their overseas assets in sterling terms.
Colin Hart, a multi-asset portfolio manager at BNP Paribas Asset Management,
said many UK pension funds and insurers were conscious they had enjoyed a good
run from non-sterling market exposure and were turning a little more cautious.
"The trend is to go back towards a long-term neutral level, which should be
around 65 percent hedged, and now we have got only 45 percent."
Mercer's annual asset allocation survey for 2017 - which covers more than 1,200
institutional investors holding more than $1.1 trillion - found that a majority
hedge about 40 percent of their currency risk.

"Though most pension funds don't pursue an active hedging strategy, in most
cases, they will put in place a long-term strategic hedge ratio that doesn't
change dramatically over time," said Phil Edwards, global director of strategic
research at Mercer.
Unlike hedge funds which look to boost investment returns from currency hedges,
longer-term investors such as pension funds view currency hedging as a tool to
cushion the impact of foreign exchange volatility on portfolios and therefore
have a longer-term ratio they work with.
More questions are also being raised by asset owners in the United States where
U.S. stocks plunged on Monday, with the Dow Jones average <.DJI> notching up its
biggest intraday decline in history with a nearly 1,600-point drop - making
overseas returns even more important.
"The question we are asking U.S. investors is that you had a perfect year in
2017 from your domestic equity market returns and a weaker dollar boosting the
value of your overseas assets and that can easily transform into a perfect
storm," said James Wood-Collins, CEO at Record Currency Management, which
advises nearly $60 billion in currency hedging strategies to clients.
(Reporting by Simon Jessop and Saikat Chatterjee; editing by David Stamp)
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