Is there a smart way to hedge against FX exposure?

on Jul 1, 2015 in Currency, Home | 2,726 comments

In today‘s market environment, when equities valuation are high and starting to come under pressure, and yields are at record low, it is becoming crucial for foreign asset investors to consider hedging their currency exposure. Investments in foreign instruments, such as equity and fixed income, can generate substantial returns and provide a greater degree of portfolio diversification. However, they introduce an added significant risk, namely currency risk. Since currency exposure can have a significant impact on portfolio returns, investors should consider hedging this risk appropriately and methodically. While hedging instruments such as currency futures, forwards, swaps and options have always been available, their relative complexity has hindered widespread adoption by the lambda investor. A broad industry rule of thumb is that it would be more common to see a foreign currency equity portfolio left at least partly unhedged, while a fixed income portfolio would be expected to be largely hedged. But how do we go about effectively construct a currency hedging program? This is what this article is all about. The Impact of currencies should not be overlooked As a matter of fact, currency fluctuations contribute to interim risk and may substantially increase the magnitude and likelihood of drawdowns. It might be argued that the impact of currency tends to net out at zero over the long-term. In theory, it is believed that there is purchasing power parity (PPP) between two currencies, to which they will revert to over time. This would suggest the practice of currency hedging to be irrelevant over the long term. In practice however, there are a few flaws to this argument. Currencies can trade beyond their PPP for extended periods of time, and not all investors are looking to hold an investment over the long-term. Several models describe currency movements, incorporating variables such as relative purchasing power of currencies, real and nominal interest rate differentials, and trade and financial flows. While currencies tend to follow their PPP rates in the long term, empirical studies of exchange rates have shown that currency returns exhibit non-random trends and reversals. These studies have drastic implications for currency investment policy. Moreover, over the short-term, the impact of currency can actually be quite substantial. Even for longer-term investors, currency can attribute a significant amount of additional volatility and potential drawdowns. Therefore investors recognizes that the key problem they want to solve with hedging is the avoidance of large losses from foreign currency weakening (or domestic currency strengthening), which often happen suddenly over short horizons. The trade-off is ultimately between certainty around expected cash flows and the cost of that certainty. The question which remains, is it worth it? Investors often spend considerable time developing an investment policy, or strategic asset allocation, for multiple asset class portfolios. For portfolios that include foreign investments, the policy should include guidelines and a benchmark for the management of the currency exposure. Let’s dig a step further into the two types of currency hedging program. Passive versus active currency management As mentioned previously, currency exposure is an inescapable feature of investment in foreign markets. Generally speaking, there are two types of currency management strategy, static hedging program and dynamic hedging program. The decision to any of the two approaches can have a significant effect on a fund’s performance. Static strategies, referred as passive hedging, use currency hedging to reduce both upside and downside currency risk. Managers may choose to fully hedge currency exposure, removing any impact from currency fluctuations or partially hedge in order to achieve a result somewhere between that of a fully hedged portfolio and an unhedged portfolio. A static approach provides investors with better transparency rather than being at the discretion of the portfolio manager. From the practitioners point of view, a passive currency hedging policy should be mainly driven by the volatility of its currency exposure introduce to a portfolio, not by its expected return. Whereas, dynamic strategies referred as active strategies use both fundamental and/or technical approaches has the best opportunity of consistently adding value. Active currency management strategies seek to exploit certain characteristics of currency markets, and views about currency returns should dictate tactical decisions, not policy decisions. Currency markets exhibit what are considered the three essential characteristics for active management to succeed. • Observable inefficiencies that can be captured using fundamental and technical approaches • A stylized fact, for expecting those inefficiencies to persist. As an example, the recurrent presence of nonprofit maximizers such as central banks, corporate treasurers, and foreign investors with passive currency policies • Much lower transaction costs than either equity or fixed income trades These factors imply that active currency managers have a larger opportunity than equity and fixed income managers to beat a passive approach. To summarize, passive hedging leaves you fully exposed to one or the other, or sub-optimally exposed to both. Despite the fact that dynamic hedging is not widespread, there is still significant room for investors’ consideration. What are the routes for a dynamic currency programs? Investors are taking one of two routes in their dynamic currency programs, by developing systematic or so called rule based signals into their hedging programs. Some are applying those signals with optionality, and others replicate those trades synthetically with forward contracts. The signal output will indicate hedging out significantly more those currencies that are over-valued as opposed to the under-valued ones. The primary objective is not to add realized return but to provide...

Benchmarking – An art or a science?

on Apr 15, 2015 in Home, Portfolio ad hoc | 1,850 comments

Benchmarking has increasingly become a de facto aspect of most investment programs today. The ubiquitous nature of benchmarks has led index providers to create indices representing just about every asset class, country, and investment style in the market today. With benchmarks covering all types of assets and investment strategies, it makes sense to choose carefully and only after deciding one’s investment goals and risk tolerance. Despite their widespread use for relative performance evaluation, benchmarks still can’t fully evaluate whether an investment program will achieve its ultimate goal: meeting investors’ objectives. Whether investors should benchmark is the easy question. More difficult ones are what to benchmark, and how. In the old days, pension funds basically had the SMI index for equities and the SBI index for bonds. The increase in complexity created a whole new set of issues for investors: how does one go about setting up a benchmark of his portfolio? For asset classes not having suitable market-based benchmarks there has been a rise in popularity of reference-rate plus margin benchmarks. Since this benchmark is not explicitly tied to market cycles, it is best used when evaluating portfolios over a long-term basis. As such, a benchmark based on an absolute target return measure may be consistent with this objective, but absolute benchmarks grow in usefulness as the length of time considered grows – and, conversely, these benchmarks are less useful in assessing short-term performance, as market noise may obscure the longer term performance trends. Reference-rate plus margin and absolute benchmarks have two major drawbacks. Firstly, they are best suited for long time horizons, thus not suitable for investors tracking on a shorter time horizon and are not risk-adjusted. As far as the benchmark suitability is concerned, suppose for instance an investor who believes that the CHF will weaken may choose to invest in securities denominated in other currencies because they will increase in value if the Swiss Franc falls. Under the circumstances, he takes an exposure on foreign holdings and is fully exposed to changes in currency values. He would appropriately use an unhedged index to reflect and track more accurately his positions. However, investors such as pension funds seeking capital preservation or to meet liabilities typically opt for indexes that hedge currency risk (fully or partially) and avoid the volatility that currency investing can bring. Despite the availability of more sophisticated indices, it is up to investors to reflect on how they use them. Benchmarks should be used with a healthy degree of skepticism and additional metrics linked not only to return objectives but also to risk elements including asset quality and development exposure, to monitor the performance. In other words, practices today span the good, the bad and the ugly. Investors, therefore, should engage with their counterpart in dialogue around the inherent advantages and drawbacks of the available benchmark methodologies relative to their investment policies and objectives. Because no true market index exists, investors should be aware of the limitations of various approaches and their possible consequences. Unfortunately, when benchmarks are not appropriately selected, they could lead to decisions that can inadvertently create increased risks. To recap, a fair and appropriate benchmark is an important tool in assessing a portfolio manager’s investment skills. The benchmark construction approach, should let investors build a benchmark that is representative of their portfolio and accounts for the different ways in which a manager can add value. However, the investors should remember the limitation of benchmarks. Whether the benefit is for an institution such as a pension fund, investment portfolios are ultimately designed to meet some future liability. Yet, taken alone, a performance comparison relative or a tracking error to a specific benchmark tells investors nothing about whether their portfolio is positioned to meet its objectives going...

How to use a volatility Call Spread as a Downside Hedge?

on Mar 22, 2015 in Derivative, Equity, Home | 2,098 comments

One way to hedge the downside risk in your portfolio over the following three months is to purchase some put options. The exchange-traded fund SPY tracks the S&P 500 index, is highly liquid and makes a nice proxy for your US equity holdings. If you purchase the adequate out-of-the-money puts on SPY to hedge against a 10% market decline for your entire portfolio, you’ll pay about 3% of portfolio value. It is only under the condition that the market slumps more than 13% (10% decline plus 3% cost for the put premiums), that you have put a floor under which the portfolio is covered. Is that actually the best strategy to play? The call spread option trading strategy on the CBOE Options Volatility Index (VIX) might be the solution. In my view, this could be an interesting indirect theme to play. Remember, if the market goes down the VIX will go up. And if the market really pukes, the VIX will roar higher. Bull call spreads can be implemented by buying an at-the-money call option while simultaneously writing a higher striking out-of-the-money call option of the same underlying and the same expiration month. By shorting the out-of-the-money call, you reduce the cost of establishing the bullish position but forgoes the chance of making a large profit in the event that the volatility skyrockets. As the market continues to shoot to all-time highs, this strategy would act as a complementary trade to your portfolio since volatility typically expands when the market sells off. Higher volatility means higher options prices as larger swings are expected. Low volatility means little is expected in the way of market movement which is why I often think of the VIX as an indicator of relative market stress. Some people call the VIX the Fear Index as volatility tends to explode in falling markets and drop in rising markets. Currently the VIX is trading at 14.07. Its 52 week range is 10.28 – 31.06 and this indicates to me that there is still a relatively high level of complacency in the market despite the global economic uncertainty and equity markets shooting to all times highs. Keep in mind that at the height of the financial panic in 2009 it touched 80. Let’s look at the VIX April contract 16-20 call spread. This spread is trading at 0.85, which seems cheap to me. A VIX at 20 or higher will more than triple your investment. That means that if the VIX is over 20 in the following month (not at all unlikely, and under the 52-week high) the spread will expire at four. So, you are risking less than one to make more than three, I consider it to be a highly favorable risk/reward ratio in this market environment. This strategy could be a way to hedge your equity portfolio against a major move lower, albeit perhaps...

Is it overvalued? Look at the PEG Ratio

on Nov 25, 2014 in Equity, Home, Portfolio ad hoc | 1,820 comments

Many investors rely on popular measures, such as price-to-book value and price-to-earnings ratios. One measure investors like to look at, especially during times of rising stock prices is the price-to-earnings to earnings-growth (PEG) ratio. The price-to-earnings (PE) ratio divides a company’s share price by its earnings per share to give a rough indication of relative value. A relatively low PE doesn’t necessarily translate to an attractive investment opportunity. For this reason, some analysts prefer the price-to-earnings to earnings-growth (PEG) ratio. Believers in the PEG ratio think that the PE by itself is of limited value. Some companies are more expensive, or have higher valuations, than others. But that higher price tag may be worthwhile if the company is growing more rapidly. The PEG ratio is a way to quantify this mindset. The PEG ratio takes a company’s PE ratio and divides it by earnings per share growth. For example, company XYZ has a share price of CHF 40 and earnings per share of CHF 4. This gives the company a PE ratio of 10. If the company’s earnings per share growth is 10%, the PEG would be 1. It’s assumed that a fairly valued company has a PEG of 1. Suppose now that the company’s earnings per share tumbles to CHF 2 and the stock price remains CHF 40. Now, the company’s PEG is 2 assuming earnings growth remains constant at 10%. This implies that the company is overvalued. In other words, investors are paying an unjustified premium given the current growth rate. There are some drawbacks to using the PEG ratio. First of all, XYZ is not going to grow at a 10% growth rate forever. The PEG ratio doesn’t suggest how long the 10% growth rate will persist or what the growth rate is likely to be 5 or 10 years from now. Also, when compared with more detailed discounted cash flow analyses, the PEG ratio tends to undervalue companies with extremely high, almost exponential growth rates. While far from perfect, the PEG ratio still helps gauging relative value. Use it...

Liquid Alternatives, the new Eldorado for active managers?

on Jun 14, 2014 in Derivative, Fixed Income, Home, Portfolio ad hoc | 2,133 comments

Thanks to the unconventional measures of central banks and the march of index investing strategies, we are in fact seeing the rise of a new, more aggressive version of active management. Investment managers are launching investment products that give them more flexibility to roam around financial markets in search of alpha. The question is whether end investors will ultimately benefit from this phenomenon. So, what are exactly Liquid Alternatives? Liquid Alternatives are complex and opaque investment wrappers that require a bit of caution. They are packaged into a fund, covering a wide-ranging category of assets, while using a hedge fund strategy. Unlike most traditional funds, they can go short, use leverage and derivatives. The rise of Liquid Alternatives opens up a vast new market and come at a convenient time for asset managers. Now with bonds looking fairly expensive and equities unstably climbing higher, asset managers are looking for an alternative that could hold its value in dangerous waters. This is where Liquid Alternatives come into play. The risk is that unconstrained funds are not being pitched correctly. They are marketed as uncorrelated assets that increase diversification or act as insurance protection. Faced with a universe of styles and possible strategies, investors ought to be doing their due diligence in a similar fashion as a hedge fund. Consider for instance, fixed income where, after three decades of declining interest rates, the normalization of monetary policy may be a headwind for returns for the coming years. In this respect, PIMCO is pursuing a push for so-called unconstrained bond funds. In practice, the funds are sold as a conservative choice, a prudent alternative to a core bond fund that might no longer be able to preserve capital. It consists of placing bets across a wider spectrum of the fixed income market, such as emerging markets, junk debt, credit derivatives, and taking bets on the direction of interest rates. Retail investors are only catching up with what is happening among institutional investors. This process will lead to more volatility in markets, and be consequently ready to tighten the seat belt. Their record is not long enough to know whether they could get credit for diversification benefits. Don’t forget to do your homework before...

Swiss negative rates as soon as June 19th, 2014?

on May 30, 2014 in Currency, Economy, Home | 8,626 comments

Some traders are still skeptical that Mr. Draghi will make much of a move at all, then any meaningful action by the ECB president could further hurt the EUR. But we should watch out for local repercussions. The Swiss National Bank will not want to see the EUR below its CHF 1.20 minimum exchange rate target, so if that level is challenged, the SNB could introduce its own negative rates at the June 19th meeting. Cutting its deposit rate below zero is potentially a more powerful policy for the SNB to weaken its currency than for the ECB. Credit Suisse Group as mentioned in the past that it would begin charging other banks interest on CHF deposits. UBS, the country’s biggest lender by assets, also said it would charge fees on certain deposit accounts to discourage bank clients from parking cash. However, any measures have been implemented to date. A strong lending growth also entails risks for financial stability. In the past, excessive growth in lending has often been the cause of later difficulties in the banking sector. Swiss real estate is feeling the effects of the SNB’s long policy of low interest rates with prices for owner-occupied apartments growing at an average rate of 6 percent per year since 2008, which could be a source of concerned. If a central bank imposes a scenario of negative interest rates on excess reserves to the banking system, the cost of the interest will be ultimately passed along to deposit-holders (i.e. their saving customers), whether through fees or negative interest rates. Under normal conditions, depositors may be willing to pay a small fee for the convenience and security of keeping their money in the bank rather than as cash at home. However, at some point, if negative interest rates become high enough, bank depositors may elect to take their cash out of the system. For example, a credit card holder may choose to make a large upfront payment on a credit card and then run down the balance rather than the usual practice of making purchases first and payments later. In any case, the actions by the world’s central banks, the FED, that were used to avoid The Great Depression Part 2 are now coming home to roost. By using untried and untested measures to avoid what was a banking system-created crisis in the first place, central banks have backed themselves into a policy corner from which extrication may be painful. We need look no further than the current situation in Switzerland; even though it is small by world standards, the Swiss economy is showing how the impact of unconventional monetary policy can have wide-ranging and unexpected results. In my opinion, Swiss authorities should consider introducing temporary negative interest rates to discourage foreign investors from holding CHF in the event the currency begins to appreciate again and preserve its competitiveness. My conclusion is that the likelihood of a negative interest rate being imposed by the ECB is near zero. It is not going to happen. However, a bold move from Mr. Draghi could eventually trigger local repercussion and force the SNB into action...

Appetite for smart beta rising?

on Mar 30, 2014 in Home, Portfolio ad hoc | 2,192 comments

An increasing number of investors are moving away from traditional market capitalisation-based indices to alternative strategies, known as smart beta, in search of better returns. Alpha generation, within hedge fund investing has now been shown to be no more than having an exposure to common risk factors. The difficult part is identifying where you get paid as an investor. A paradigm shift is taking place in fund management. For years we have all been indoctrinated in the idea that fund management could either be passive and track an index, or be active and try to beat that index. There is now, however, a greater willingness to steer a middle path that is often described as alternative or smart beta. There is a spectrum of approaches that can be considered alternative beta. Some will be familiar to many investors, including style returns such as value, quality and momentum. Other strategies will be some of the alternative index approaches that have become popular over the past two years. These would include minimum variance strategies that try to achieve the lowest possible volatility, maximum diversification and so-called fundamental indices that weight stocks by accounting measures rather than market cap. State Street Global Advisors has seen a sharp rise in assets under management, in what it describes as smart beta, to more innovative, alternative methods of index construction. More than 40 per cent of investors have already adopted alternative weighting schemes. In fact, the reason behind the new indices for the vast majority of investors is probably the superiority of their performance compared with traditional cap-weighted indices. Everyone agrees that while cap-weighted indices are the best representation of the market, they do not necessarily constitute an efficient benchmark that can be used as a reference for an informed investor’s strategic allocation. However, by moving away from the consensus, investors will be questioned on the relevance of the new model chosen and the evaluation of the robustness of the past performance. Index providers are also experiencing rising demand for alternative or fundamental approaches in which stocks are weighted by metrics such as book value, dividends and sales, or minimum variance where portfolios are designed to reduce volatility. The MSCI smart beta indices turnover varies between 20 per cent, for minimum volatility and value-weighted, to 25 per cent for equally weighted and risk-weighted. MSCI cap-weighted indices average turnover of about 5 per cent. The modest turnovers achieved by MSCI, however, are achieved because it rebalances both cap-weighted and strategy indices only every six months. The appetite for customized or bespoke indices is clearly on the rise. For investors who have decided to move away from market cap, there is still much to...

Is the mint ratio relevant?

on Jun 27, 2013 in Commodity, Home, Precious metals | 2,070 comments

The mint ratio simply defined as the gold/silver ratio, is an indication of how many ounces of silver are equal in price value to one ounce of gold. In other words, how many ounces of silver would it take to buy one ounce of gold. Throughout history, governments have artificially set the gold/silver ratio for purposes of stabilizing the value of their gold and silver currency. In essence the mint ratio has been a government-established rate of exchange between gold and silver. Only when a nation establishes an official exchange rate, the market ratio is normally very close to the mint ratio in that nation because of the potential for arbitrage. For example, if Switzerland uses a 17:1 mint ratio and the UK has a 14:1 mint ratio, an investor can trade her gold for silver coins in the UK and trade her silver for gold coins in Switzerland, although he has to take the risk of transporting the precious metals safely. This bimetallist monetary system has been for instance practiced by the US government roughly from 1790 to 1870, which set by law the value of a unit of currency at a specific weight of a specific purity of metal. Of course, in doing so government is interfering with the workings of the free market and I do not expect that governments will revert to this outdated system anytime soon. I personally wouldn’t use the relationship between silver and gold prices to determine whether the price for one of these metals is likely to increase or not. But knowing its definition could be useful for your financial...