Passive Currency Management: policy decisions and optimal implementation


managers are today engaging a market previously dominated by specLDOLVW PDQDJHUV $GGLWLRQDOO\ the increased demand on investment managers to provide hedged strategies has given rise to a SUROLIHUDWLRQ RI QHZ KHGJHG SURGXFWV WR FRPSOLPHQW previously available unhedged investment strategies for direct investment by both institutional and retail LQYHVWRUV


This diversity of service and product alternatives SUHVHQWV LWV RZQ FKDOOHQJHV IRU LQVWLWXWLRQDO LQYHVWRUV WKDW PXVW QDYLJDWH WKLV JURZLQJ PDUNHW RI RSWLRQV %H\RQG WKH DELOLW\ WR H[HFXWH DQ ); transaction at a fair price, a successful currency KHGJLQJ SURJUDP VKRXOG RIIHU RSHUDWLRQDO HIÀFLHQF\ WUDQVSDUHQF\ SHUIRUPDQFH DWWULEXWLRQ DQG FDUHIXOO\ calibrated hedging programs tailored to investor liabilities, risk tolerances and investment KRUL]RQV ,QFUHDVLQJO\ TXDOLW\ implementation, trade operations, transparency and analytics are emerging as critical components of WKH KHGJLQJ SURJUDP


performance attribution and reporting far in excess of previously accepted practice 7KH GHFRPSRVLWLRQ RI SHUIRUPDQFH GLIIHUHQWLDOV ZLWK PDWKHPDWLFDOO\ robust tools improves the ability of investors to UHÀQH WKHLU LQYHVWPHQW SURFHVVHV DQG PLQLPL]H JDSV EHWZHHQ WKHLU UHWXUQV DQG WKRVH RI WKHLU EHQFKPDUNV ² W\SLFDOO\ GHÀQHG DV D SXEOLVKHG LQGH[ VXFK DV WKH 06&, RU WKH ORFDO UHWXUQ RI WKH DVVHW EHLQJ KHGJHG


“The decomposition of performance


differentials with mathematically


Technology is clearly important to both research and product implementation, particularly for SDVVLYH VWUDWHJLHV LQ ZKLFK WUDFNLQJ error is measured in fractions of a EDVLV SRLQW 6XEVWDQWLDO LQYHVWPHQW LQ UREXVW DQG ÁH[LEOH WHFKQRORJ\ is required to achieve operational FULWLFDO PDVV 0DQ\ PDQDJHUV continue to run and monitor VLJQLÀFDQW DVVHWV WKURXJK OHVV WKDQ DGHTXDWH VSUHDGVKHHW EDVHG V\VWHPV WKDW DOORZ IRU H[FHVVLYH operational risk, impeding fund performance and leading to higher IHHV DQG LPSOLFLW SHUIRUPDQFH GUDJ /HDGLQJ FXUUHQF\ PDQDJHUV E\ FRQWUDVW GHSOR\ SXUSRVH EXLOW WUDGLQJ applications for currency management products, SDVVLQJ RSHUDWLRQDO EHQHÀWV RQ WR FOLHQWV WKURXJK reduced errors, more competitive management fees, improved performance and greater transparency through rHSRUWLQJ


Implementation


considerations Investors today are demanding full accountability of performance slippage of hedging programs against SUHVFULEHG EHQFKPDUNV 7KLV KDV REOLJHG PDQDJHUV WR UDLVH WKH DQWH RI SURFHVV WUDQVSDUHQF\ ZLWK


14 Currency Investor | Autumn 2011


robust tools improves the ability of


LQYHVWRUV WR UHÀQH their investment processes and minimize gaps


between their returns and those of their benchmarks”


The goal of the hedge is to mitigate the currency HIIHFW DQG UHSOLFDWH WKH ORFDO UHWXUQ RI WKH DVVHW )RU H[DPSOH LI D 86 GROODU LQYHVWRU SXUFKDVHV D security denominated in euros, the goal of the hedge is to replicate the return of that security in the local PDUNHW ,Q VR GRLQJ WKHUH DUH D QXPEHU RI VRXUFHV of performance slippage to consider, including market, implementation and SRUWIROLR UHODWHG VOLSSDJH 7KHVH components are equally relevant ZKHQ HYDOXDWLQJ SHUIRUPDQFH against a published index, KRZHYHU WKLV HYDOXDWLRQ VKRXOG be considered on a relative basis EHWZHHQ WKH LPSOHPHQWHG KHGJH DQG WKH UHOHYDQW EHQFKPDUN


Market driven slippage consists of Asset Value Uncertainty – the fact that investors can only hedge WKH FXUUHQW NQRZQ YDOXH RI DVVHWV ,QYHVWRUV EHFRPH RYHU RU XQGHU hedged as time passes and asset YDOXHV FKDQJH 0DQDJHUV DUH RQO\ DEOH WR DGMXVW KHGJHV DV QHZ information becomes available, at ZKLFK SRLQW WKH KHGJH LV LQ QHHG of adjustment, suggesting the QHHG IRU UHJXODU PRQLWRULQJ 7KH


second component of market driven slippage is the ,QWHUHVW 5DWH 'LIIHUHQWLDO EHWZHHQ WKH ORFDO PDUNHW DQG WKH EDVH FXUUHQF\ RI WKH LQYHVWRU 0DQ\ LQYHVWRUV GHHP WKLV WR EH D ´FRVWµ RI KHGJLQJ ZKHQ LQ IDFW LW·V an economic condition that must exist to prevent DUELWUDJH RI ORFDO ULVN IUHH UDWHV


Implementation driven slippage relates to manager GHFLVLRQV ZLWKLQ WKH SURJUDP ,PSOHPHQWDWLRQ decisions are typically motivated by the goal of simultaneously minimizing tracking error and WUDQVDFWLRQ FRVWV 7UDQVDFWLRQ FRVWV DUH DQ REYLRXV source of performance impact; so trade minimization LV DQ LPSRUWDQW HOHPHQW RI WKH GHFLVLRQ SURFHVV %\ contrast, trading less often may lead to drift of the


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