What is Currency Overlay?
Currency overlay is an outsourced FX management program to a firm that specializes in foreign exchange markets. These overlay managers typically service institutional portfolios with exposure to foreign currencies and are used to separate the currency risk from the rest of the portfolio management decisions. This allows the portfolio manager to focus on adding alpha from investing in global assets without having to factor FX implications into their asset allocation or selection decisions. The larger the portfolio, the greater the need for an overlay manager due to the number of dedicated resources it would take to manage the FX aspect alone.
Passive overlay is normally a hedge on 100% of the total FX exposure that ensures there are no FX losses (or gains) as a result of the investment in foreign assets. This is achieved using forwards, options, futures, and other derivative contracts that lock in the FX rate for a predetermined amount of time. Once the contracts expire, a new deal has to be entered to maintain the hedge. This style does not attempt to profit from favourable FX moves.
Passive overlay may be preferable when a fund manager launches a hedged share class in the domestic currency of a global asset fund. Doing so removes FX risk from the portfolio equation, but also removes potential diversification and return benefits of multi-currency exposure. As such, the costs of passive overlay are much lower than an active or dynamic overlay.
When an investor enters into a subscription with the fund, the overlay manager immediately converts to the fund’s domestic currency. They then hedge out the base currency for a certain period using futures, forwards and swaps, and would continue to roll out hedges upon expiry. The gains and losses on the expired contracts show up in the fund P/L, which affects the fund NAV.
While passive management is common when managing traditional assets, it is less prevalent in FX management. Even passively managed global equity or fixed income funds often take an active approach to the FX component because there is a significant risk that a passive approach results in portfolio drag. An active strategy provides the best opportunity for the overlay manager to add value to a fund’s overall returns, and the FX market has all of the critical ingredients for active management: Low transaction costs and exploitable market inefficiencies.
Since FX returns tend to have very low or even negative correlations to major asset classes, the active overlay has the additional benefit of adding to portfolio diversification. Even if the overlay strategy has slightly negative returns, it can still benefit the portfolio by reducing overall volatility and boosting the fund’s Sharpe ratio. Of course, the potential value of this program largely depends on the portfolio’s domestic currency.
Active Overlay Styles
Most funds employ active overlay managers to limit downside FX risks while maintaining maximum exposure to the upside. Active overlay falls into two broad categories:
Active FX managers use fundamental, technical, quantitative, or other techniques to add alpha to fund by predicting FX market directions. Managers in this category use a combination of spot, forwards, futures, options, and swaps to execute their strategy. An active manager can hedge or even take on risk to capitalize on potential market moves. They are often structured as a hedge fund, and funds looking to employ the overlay would allocate capital to the active overlay fund. The active overlay fund is then managed externally and can have management fees between 10-20%. Active overlay can use either a discretionary or a systematic approach that uses fundamental, quantitative, or technical factors to deliver excess returns regardless of market conditions. The most common signals are:
Dynamic managers take a more reactive approach and take trend-following positions based on market moves (without trying to predict them). Managers who use this style of management usually stick with spot and forward transactions to capitalize on their low transaction costs. Dynamic overlay is a systematic approach that uses fundamental, quantitative, or technical factors as signals of when to adjust the hedge ratio up or down (but does not go unhedged or take on additional risk). The most common signals are similar to those in active overlay (above) but have a more significant emphasis on trend direction. Whether the rate is moving significantly and consistently in a particular direction over a given period impacts the hedge ratio decision due to the reactive nature of dynamic overlay. The dynamic overlay strategy can be managed internally or externally and can have management fees between 5-20%.
Costs of Hedging
Forward contracts and cross-currency swaps are the most commonly used instrument in currency overlay thanks to their relatively low costs and liquidity. The costs comprise of broker spreads, forward points, counterparty risk, opportunity costs of margin. Options can also be used to allow for protection and participation, but a premium must be paid on top of the above four costs.
If the portfolio is exposed to minor or exotic currencies, the costs of the overlay program can rise dramatically. There may be some currencies that are impossible to hedge due to thin or restrictive markets. In this case, the overlay manager may elect to proxy hedge using an appropriate basket of liquid currencies to reduce costs. The downside to this approach is the resulting tracking error, so it should be weighed against the costs of hedging the underlying FX directly.
Selecting a Benchmark and Target Hedge Ratio
The FX benchmark should be determined at the same time as the total portfolio benchmark and should compare the costs of the overlay program with the benefits. While overlay programs can reduce overall portfolio volatility, the benefits must outweigh the transaction costs, opportunity costs, and cash flow volatility that potentially come with it. If the portfolio has 10-25% exposure to foreign currencies, the benchmark hedge is typically going to be around 50% of total exposure. This is the safe play for portfolio managers who do not have a convincing FX market view, and the performance of this benchmark falls in between 100% hedged, and 0% hedged portfolios. A 100% benchmark is typically reserved for when the majority of assets are in a foreign currency, the foretasted FX returns are negative, or the portfolio’s mandate/risk tolerance warrants it.
A critical factor in the target hedge ratio decision is the sensitivity to transaction costs and negative cash flows. Significant losses or margin calls would require cash payments to settle or maintain the position, respectively. The higher the ratio, the greater the chance of incurring a negative cash flow. Tolerance or sensitivity intervals also have a significant impact, as lower tolerances to benchmark deviations result in higher costs from the increased rebalancing. Finally, the assets within the portfolio also impact the target hedge ratio. Fixed-income assets are more susceptible to increased volatility from FX moves, so bond portfolios usually have higher hedge ratios than their equity counterparts (all else being equal).
The decisions of overlay managers are often evaluated on the currency surprise factor, which is the difference between the forward rate on decision day compared to the spot rate on the forward settlement date but excluding the effect of interest rate differentials on the two currencies.
Evaluating the performance between two or more overlay managers can be tricky since their services are usually custom-tailored for each portfolio. One area that is easier to compare is pricing on trade execution. Overlay managers who advertise low management fees tend to have higher transaction costs from their FX vendors, which end up negatively affecting overall performance. When evaluating potential overlay managers, the ability to obtain fair and transparent pricing from the vendor should be a significant factor for clients.
When Does Overlay Make Sense?
Depending on the time horizon and currencies in play, the impact of FX on the portfolio can be quite drastic. In economic theory, purchasing power parity (PPP) is the equilibrium or ‘fair value” rate between currencies. While currencies do tend to be close to PPP rates over long periods, the market rate can deviate significantly from this rate in the short term.
The costs of running an internal FX program are quite high, and not all fund managers have the expertise or appetite to do so. When fund managers are unable to add value to their FX program that exceeds the trading and opportunity costs, they are better off outsourcing this function to a team of specialists. Institutional portfolio managers typically use the 10-15% mark as the minimum exposure for international assets before the FX portion has significant effects on portfolio volatility. If the portfolio is above the threshold, the fund puts an FX policy in place and manage the currency as they would any other asset class. The policy should include:
Demand for Overlay Managers is Increasing Steadily
Today most overlay programs are more focused on customizing products, services, and processes than the actual market outlook, as clients look for a 360 solution to their foreign exchange programs. Generating alpha from FX has also been rising in popularity among multi-asset and multi-strategy funds where FX is included in equity, bonds, commodities and other assets designed for absolute return. The rebound in demand for CTAs (after falling for a few years) has also helped active FX rise to prominence, as investors look to diversify their traditional portfolios. Part of the reason for the resurgence in demand for active FX management is that yield remains at historical lows, so overlay popularity among institutional investors has never been higher. Overlay managers have become a necessity as portfolio hedging for asset managers and investors continues to become more prevalent, and new active and passive hedging products are seeing increased demand.
Written by: Gianluca Privitera, CIM®