Mathieu: Is that not doing anything about currency risk? Is it actually taking an investment decision because you're going long that foreign currency hedge it or not? Like it or not?
Jafer: Hello and welcome to the Minds & Markets podcast. I'm your host, Jafer Naqvi. This is our first edition. And what we're hoping to accomplish this series is to take some time and dive into investment concepts that clients may benefit from hearing bit more richness and depth too. I'm very excited today for the first podcast to have with me, Matthieu Cote from our Client Portfolio Management team.
Jafer: Welcome to the show, Mathieu!
Mathieu: Thank you. Jaffer And I'm very happy to be joining you with joining you today for the first addition of minds on market and will be unpacking some information about currency hedging.
Jafer: Well, perfect. I hear you sometimes talk about synthetics, and you refer to them as the funky part of investment markets, but they can really mean a lot. A lot of people look at synthetic instruments almost being the tool or one of the tools that was at the root of the financial crisis. But describe to me what you mean by funky, because it's not always just about risk.
I think a lot of the ways you work with our clients are not on taking risk with synthetics, but actually about managing and reducing risk. So maybe from your perspective, let's unpack what synthetics and derivatives are and how do our clients on the institutional side use them?
Mathieu: Great (of) you asking that question because I would say that what I'm passionate about working in the specific space is using the toolkit of data. That's not to speculate in the market, not to increase risk and leverage, but really to better control the risk profile of a portfolio. So, we do work with a lot, for example, of large institutional clients in Canada.
It can be a large insurer, it can be a DB pension plan, and these DB plans have a fixed liability profile that comes with, you know, the fact that they have to pay out to their retirees and over a long period of time. So that liability profile is sensitive to different risk factors. You can be sensitive to interest rates, to inflation risk and the likes.
So, what the pension fund does is that they manage their assets, align with the risk profile of their liabilities. And that's where I would say derivative really comes in handy because we can use leverage to cheaply source exposure to different asset classes.
Jafer: So, topic du jour then currency hedging, and I need help with this. And so maybe for the listeners we can maybe go through a bit of a case study because there's different borrowers and lenders and different currency when you're doing a for to hedge risk. So, let's just say you're a Canadian dollar investor with U.S. equity exposure and your $100, you want to hedge and under one healthy hedge, what are the mechanics?
How does how do we actually go about synthetically hedging our currency risk back?
Mathieu: This is a situation that we do face with our clients in the Canadian landscape, increasingly so since the beginning of the year. Why is that? I would say, first of all, equity market in Canada is fairly small in terms of the global size of the equity exposure. So, the Canadian initial investor here is taking equity exposure in sizable amount outside of its home country.
When they do that, they need to sell Canadian dollars and buy the foreign currency in order to be able to gain that exposure. And I think that is underappreciated.
Jafer: So, if I say differently, if you're buying U.S. equities and you're the Canadian investor, you have to sell your Canadian dollars, get that back in USD in order to buy the U.S. stocks. True denominated right? If you sold your Canadian dollars, you own U.S. now. And that's where the current exposure comes from.
Mathieu: Correct. And now you're exposed to two risk factors. You ‘re exposed to say the S&P 500 return. You also long the U.S. dollar against the Canadian dollar, which is your home currency. So, when you calculate your total return at any given time, you're going to want to look at the return on the currency and the return on the S&P 500.
In instances where the markets say it is correcting and the currency is falling; you have increased volatility in terms of domestic local return for your foreign investment. Historically (it) hasn't really been a problem for the Canadian investor because of the recent weakness like a decade long weakness in (the) Canadian Dollar against you is the really against a basket of foreign currency. If we look at long time is recalled that what we tend to see is that negative correlation between U.S. equity and the U.S. dollar.
And if you bring that back from the lens of a Canadian investor, it means that historically you kind of had the natural hedge when investing in U.S. equities without really taking to any measure to hedge the currency risk. Because, again, you know, your currency is going to be falling basically when the U.S. equity market is also falling.
So that's mitigating the last that you would have otherwise experienced ...
Jafer: So sorry. So that because I'll get crossed ups, what you're saying is the currency part of the return for the Canadian western U.S. stocks goes in the opposite way of the market.
Mathieu: And that's coming from the fact that the U.S. dollar is the world reserve currency. So, at times of stress in the market, the U.S. market, but the global market, generally speaking, we see capital flowing into the safest asset, which is U.S. Treasuries, which is eliminated into U.S. dollar. So that relationship has been strong for a very long period of time.
But there are signs that allude to that relationship, perhaps weakening going forward.
Jafer: And that's what happened (inaudible) where we saw the U.S. market fall. And what's uncommon is we also saw the U.S. dollar depreciate versus the Canadian dollar. So, it's a bit of a double whammy.
Mathieu: And it was a surprise for a lot of Canadian investors when I look at their end of month performance and they see that 18% drawdown, that in domestic terms was maybe 25, 30%. Right. So that draws a lot of attention to the currency hedging topic.
Jafer: So maybe if we dive more into topic, I do want to explore a little bit on kind of the dynamics of why that traditional relationship may be at risk going forward. And some are suggesting your paper on how investors can tackle it. But I sort of go back to the mechanics of it because I think it's important in terms of understanding the costs when I'm putting a currency hedge on interest rate differentials, there's different parties borrowing and different currencies.
Can we just walk through the mechanics of how the hedging process actually works?
Mathieu: Absolutely. Once awareness comes and an investor realizes that not doing anything about currency risk is actually taking an investment decision because you're going long that foreign currency hedge it or not like it or not. So that localization is made. Now what do we look at in order to decide, you know, how much we are going to hedge, how are we going to hedge, what's going to be the process?
What are the key metrics of factors that has to be taken into consideration to better decide what is the optimal hedging policy or strategy. So, there's four key items that we have to think of. The first one is the cost of hedging. Hedging is not free. That's then going to be the volatility of both the currency, foreign currency and the foreign asset you're investing in. Thirdly.
There's going to be a correlation profile between that foreign asset and the currency. And fourthly I want to understand the dynamic or observe what the dynamic of that correlation profile has been expected to be going forward. Are there, for example, any mean reversion property between your asset and your currency? Putting all that together, if we dive deeper into the cost side of things, we've seen a lot of disparity in the central bank interest rate policy lately and that drives differential in the interest rate between different countries and that's a main driver of the aging costs when using future are forward.
Why is that? Because a mechanic for hedging currency risks using a simple forward is that we're going to be borrowing into foreign currency in order to sell that currency and buy back the home currency.
Jafer: So said differently, you're the key investor in this scenario. You've sold key dollars to buy U.S. dollars to buy U.S. stocks. And now what you're going to do is you're going to borrow U.S. dollars. You have to pay U.S. interest rates for that. Correct. Because you're going to sell those forwards to me.
Mathieu: Exactly. You love the price at which you can sell that currency. That's your hedge. The cost of that is borrowing in the foreign currency. What's you selling now? You're going to invest at a risk-free rate in your home market. So, you're going to be earning that short term gain in interest rates. So, when the differential which you are borrowing against which you're going to be investing in is positive, you're going to be experiencing, and it gets if carry for take a step back.
Before I look into the costs, we should question ourselves, should we be hedging or not? And the main consideration that helps us make that decision is to look at volatility. So, we have different asset classes, fixed income equity, fixed income, much lower volatility than equity. That means that at times, you know, you can have your currency volatility that is much higher than your underlying instrument for an investment.
So in that case, we tend to want to hedge more than now because the risk return property of your foreign investment and are being dominated by the volatility profile of the currency and most portfolio managers, they don't have the of you or as much knowledge on the currency market as they do about the expectation in terms of return and risk is for the following asset.
So, the specialty of an equity manager is knowing foreign equity. Adding too much noise around that knowledge is kind of diluting if you want the expected return of the investment. So, for a lower volatility asset, we're going to want to charge more for higher volatility assets. Now we're going to want to look at further consideration.
Jafer: And so, I think that kind of gets to why this discussion is on the equity side. So, if I'm hearing you correctly, bonds for the most part, investors tend to hedge that out because you can't absorb the currency volatility with fixed income. Interesting that long run for Canadian investors be invest in U.S. equities if you're unhedged, you're saying it actually reduced the risk.
But now are in this world where those dynamics may be uncertain, we don't know what's going on with the U.S. Monetary and fiscal policy is going to be independence going forward. Does that put a risk to the US dollar? And then at the same time, we're observing the holdings in U.S. equities for a lot of Canadian equity investors is also at a record high in terms of how big U.S. equities are in in benchmarks, in terms of how much equities investors are holding.
Maybe walk us through this strategic concept. You had in the paper and how can investors cut through the noise and put a game plan in place that's not reactive to currency hedging, but proactive?
Mathieu: So, we did look historically at a different hedging strategy for A Canadian investor investing in U.S. equities. We look at perfectly hedging the notional exposure. We look at not hedging at all. And then we look at why would say it's called a dynamic, more tactical way of managing the currency hedges and one of the main advantageous of that more dynamic approach.
And in a nutshell, what this is doing is that we spoke about the cyclicality of the Canadian dollar, the Aussie dollar. You know, these are like resource-oriented economies that tend to have a lot of cyclicality in the value of their currencies. So, this currency will tend to mean revert against the U.S. dollar, and that's over a long period of time.
And that means reversion if it's stable enough. And we're confident that it will (inaudible) in the future is something that we can act on. So, we're going to want, for example, when the U.S. dollar is strong against the Canadian dollar to hedge more. And then now the other end of the spectrum, when a Canadian Dollar is at close to parity against the U.S. dollar and priorities as high as the Canadian dollar has been against the U.S. dollar over the past 50 year(s), we're going to want to go lighter on our currency, hedge exposure.
And then as the value of the U.S. dollar is mean-reverting from, say, 150 at the high back to 140, 30 and lower, we're going to be lowering that hedge exposure and monetizing the mean reversion. One great thing about that approach is that it's kind of mitigating the negative carry of putting on the hedge in the first place that we discussed.
Jafer: It sounds like investors should be more concerned with where the US CAD relationship is relative to history. Is the U.S. dollar expensive? More than what is the cost of the hedge? And I think what you're also seeing in this approach is it's not an all or nothing that it's about managing the risk. And the answer can be somewhere, somewhere in the middle.
Mathieu: Correct. And another large benefit of that, a more dynamic approach in the context of the uncertainty that certain market participants have with respect to the U.S. dollar as world reserve currency going forward. So, it could be a relationship that's not going to be as strong as it has been historically. I think you alluded to the US deficit to the rate cut cycle in the U.S. that's about to has already started the accumulated deficit, the bond market being a little bit wobbly could lead into a situation where that flight to quality and that natural hedge experience by the Canadian investor in U.S. equity is weaker.
In that environment, you're probably going to want to hedge more to manage the risk of that so-called coalition relationship breaking down. And this dynamic hedging strategy is kind of giving you some of that because when the U.S. dollar is strong, you are actually at close to fully hedged. Right? So now if you do experience a drawdown at that point in time and the U.S. dollar is not acting the way it's expected, you manage and you had yourself against that.
Jafer: So, in that framework, just general guidance, what would be an appropriate hedge ratio for a Canadian investor today just given where we are in that long term cycle?
Mathieu: Again, we don't want to speak to client(s). We don't know where the market is going forward, but we do look at historical data, and we add that the conclusion that we can get from analyzing that data with the current market environment. So, what we see is that we don't really need to hedge U.S. equity exposure for Canadian because of the natural hedge property of U.S. equity and currency.
But going forward with the balance of risk shifting, it's probably advisable to hedge more then.
Jafer: So, starting the process might be different for everybody, but still.
Mathieu: Look at your portfolio. What is your view as well about the US economy going forward? We don't think the U.S. economy is not going to be one of the world's top economies going forward. You know, this is not where we are, but I think they are legitimate concern about the strength of the U.S. dollar as a world reserve currency going forward.
Jafer: And you made a good point in the past. What you said is not hedging is also a decision that you're making. And so, you have to be comfortable with where everything is with the amount of unhedged risk you have. So maybe flipping the question on its head a little bit as well.
Mathieu: That's correct. And I think you're being told that starting the process, you know, we covered four key points that help you to begin that conversation or that analysis. We talk about costs. We talk about volatility of your foreign investment asset in your portfolio, the cohesion profile, the mean reversion properties. And I would say one more, you know, is the current market environment and the global macro environment.
Jafer: It sounds like taking that strategic approach though, is the way to do it because it's systematic and repeatable over time.
Mathieu: Correct? Being strategical, being thoughtful, taking that risk into consideration. If you're not hedging the risk, do it with the knowledge you've taken an educated decision based on analysis. That is not something that you deem necessary for you to do given your risk aversion, given your portfolio construction and consulting as well, being a bit more tactical as well. You know, if your investment horizon is shorter or bleak and you should be doing more, why?
Because the long-term property of your historical relationship will not easily show over a short investment horizon. For a longer-term horizon, it can be more strategical but take into consideration the fluctuation that means aversion in order to determine whether combining a more long-term strategic approach with some dynamic tactical shift over time could be adding value to your current sharing strategy within your portfolio.
Reality.
Jafer: Well, Mathieu, thank you. A lot to unpack in currency hedging, not the simplest topic to tackle in our first podcast, but one I know is very important to our clients and investors. So again, I want to thank you for joining us in unpacking the world of currency hedging and walking us through some of the thoughts that have come up the team.
I look forward to joining all the listeners again for our next episode of Minds and Markets.
Mathieu: Thank you, Jaffer. It was pleasure to be with you today.
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