Investors exposed to risk through currency exposures

More hedging has improved average returns, but has also exposed Australian investors to downside risks, according to a US senior portfolio manager.

Speaking on currency strategies in global equity portfolios at the Conference of Major Superannuation Funds on the Gold Coast, Katerina Alexandraki, senior portfolio manager, currency strategies group, Alliance Bernstein (USA), said global equity portfolios embed a currency exposure that exposes investors to risk.

"Not much thinking has gone into currency because it's residual," she said.

"Identifying 'optimal' hedge ratios involves the balancing of multiple and, at times, conflicting objectives," she added, including reducing the volatility of portfolios.

Alexandraki spoke of "passive hedging" strategies and said that some hedging can protect a portfolio from the very volatile movements of the Australian dollar.

"A passive half-hedge strategy leads to a small improvement in the 'Sharpe ratio' but at the cost of larger downside risks," Alexandraki said.

In balancing risk and return objectives in a passive hedging strategy, Alexandraki said in an Australian-based portfolio, risk-wary investors might prefer less than 50-50 hedge.

She also said that too much hedging doesn't necessarily lead to lower volatility, noting that the drop in the Australian dollar can help cushion the volatility of declining global equities. Alexandraki said keeping a portfolio unhedged can be good, but investors should be aware that this may "compromise the upside".

Alexandraki argued that the volatility-minimising hedge ratio is partly dependent on the correlation between base-currency returns and global equity returns.

She said we should be hedging less when there's a positive correlation between our base currency and global equity returns, adding that we're subject to correlation and equities changes.

"Correlations vary over time and are generally difficult to forecast," she said, also pointing to increased downside risks as hedge ratios increase.

Alexandraki briefly discussed "dynamic" hedging strategies, which she said can "create a true trade-off".

"A dynamic hedge strategy can materially increase the Sharpe ratio but downside risks are now larger," she said, adding that an investor's choice of strategy will reflect their risk and return priorities. "Transaction costs of hedging must also be considered.

"Australian investors face a trade-off in managing the currency exposure in their global equity portfolios. An active hedging strategy can considerably improve volatility-adjusted returns, but it exposes investors to downside risks," Alexandraki said.