By: Alpha Male
In a previous post, I used the human genome as an allegory for a financial investment (particularly a mutual fund). I suggested that a mutual fund can be represented as a combination of cash, market beta, and alpha. In conclusion, I argued that a US equity fund, for example, could also be represented by a fourth “gene”, a US dollar gene. In June 9th’s Globe & Mail, columnist Keith Damsell illustrates how this concept is already being applied to US mutual funds being offered in Canadian dollars.
(Canadian money manager) Phillips Hager & North Investment Management Ltd. launched the Currency-Hedged U.S. Equity Fund and the Currency-Hedged Overseas Equity Fund. Clients of the Vancouver fund company were leery of the over-heated Canadian equity market and wanted to invest overseas but wanted to mitigate currency risk, said PH&N president John Montalbano.
John Montalbano, financial geneticist, aims to use new technologies to turn off what he views as a potentially dangerous gene without damaging the rest of his fund’s genome. Which begs the question, why stop at hedging currency? Why not hedge out other factors that drive fund performance. Like, say, the equity market itself?
Arguably, market beta is a more dominant driver of individual security performance (and therefore fund performance) than currency alone. Take an example of Betaco, a Canadian mid-cap producer of widgets. Since Betaco serves a wide range of industries, its stock tends to be highly correlated with the overall stock market (beta: 1.0). It turns out that Betaco management spent most of last quarter asleep at the wheel and nothing really changed at the company â€“ no new clients, no law suits, no acquisitions. In fact, there was no new information at all on Betaco. But equity markets fell 5% during the quarter and so did Betaco stock.
Now picture Dollarmax. Dollarmax is a US environmental technology company that turns old tires into products for the food packaging industry. Unlike Betaco, Dollarmax stock has no correlation to equity markets. However, like Betaco management spent most of last quarter on the golf course and no new information (or even rumours) on Dollarmax hit the markets. Dollarmax stock was flat on the quarter. But the US dollar fell 5% last quarter. So Canadian holders of Dollarmax got a -5% return on their investment.
Betaco and Dollarmax stocks each fell 5% last quarter as a result of totally exogenous factors. Companies like PH&N advocate using a short position in the US dollar to hedge Dollarmax. But I ask, why not short the S&P500 to hedge Betaco?
The answer probably lies in the fact that the US dollar has a direct-drive to Dollarmax returns (from the Canadian investor’s perspective), while Betaco might only have a 0.75 correlation to equity markets (note that a beta of 1.0 does not mean a perfect correlation). A US dollar hedge on Dollarmax is a perfect hedge and is easy for the money manager to defend on a day to day basis. But an equity market hedge on Betaco may not work every day. There will be many days when the short position in the S&P500 and Betaco both fall. A Beta of 1.0 for Betaco means that, in the long run, a short position in the S&P500 will act as a (near perfect hedge). But by the time the long run roles around, however, the money manager will have no more clients left (!)
Beta is the product of the market correlation and the stock’s volatility factor (it’s volatility as a proportion of the market’s volatility. Therefore, if Betaco’s market beta of 1.0 were derived from a perfect correlation (1.0) and a volatility exactly equal to the market’s volatility, then shorting the market would be a perfect hedge. In this scenario, a money manager might find hedging against market risk to be a safer bet in the short run.
But a currency hedge is also not a perfect hedge. Shorting one US dollar against one dollar of a US security does not perfectly hedge the security against fluctuations in the value of the US dollar. The reason is that the security itself might have an underlying non-zero correlation with the US dollar. For example, the performance of the company itself might benefit from a strong US economy. So a rise in the US dollar might correlate with a rise in the fundamental value of the stock. Or, a company might ave its own exosure to currencies. For example, Canadian Tire Corporation, one of Canada’s laregst retailers, is very positively correlated to the value of the Canadian dollar. As a recent article in the Toronto Star points out, the company’s revenues are in Canadian dollars and its expenses are in foreign currencies. So it has an operational currency exposure hat would confound any attempt to overlay a simple dollar-weighted currency hedge.
To put it in hedge fund parlance, a currency hedge might be dollar neutral, but not beta-neutral. So in the quest for beta-neutrality, neither a currency hedge nor an equity market hedge is perfect. So why the comfort with a currency-hedge and not a market-hedge? For that matter, why not other hedges such as hedges against the underlying commodity, interest rates, energy prices etc.? These hedges aren’t necessarily any more risky than a currency hedge.
One might argue clients actually want to have equity market exposure (unlike currency exposure) since market beta is, by definition, positive in the long-run. This is a legitimate point. But I would argue that investors have wide-ranging appetites for market beta. So the fixed, one-size-fits-all amount of beta that is delivered by a stock (or a mutual fund) would perfectly satisfy exactly no one. Furthermore, investors who are forced to purchase equity market beta along with a mutual fund or security might be doing so at above market prices and with zero flexibility in adjusting this beta position.
Back to Keith Damsell’s article in the Globe & Mail. Apparently, financial genomics â€“ in the form of currency hedging â€“ is really catching on:
Industry sources report that a handful of fund companies are poised to launch more currency-linked products in the weeks and months to come.
But advisors seem to show resistance. One financial advisor interviewed for the story viewed currency-hedging as an active decision to invest in currencies:
It’s a double-edged swordThere is a cost to hedging something and you may miss the opportunity for a higher return. On the other hand, if you are right, you may protect some of the capital.
A friend of mine and skeptic of PH&N’s currency-hedging philosophy recently echoed this fallacy when he told me he didn’t want to play currencies by investing (long or short) in the US dollar. Instead, he opted to invest in traditional un-hedged versions of his favorite US equity funds. But I pointed out to him the irony in this argument. The reality is that he chose to play the US dollar when he bought the (un-hedged) US equity fund. The daily returns for each position in that fund are comprised of both a stock-specific component and a US dollar head-wind or tail-wind. A currency hedge would act to remove that tail-wind or head-wind caused by US dollar movements. In essenece, I guess, two wrongs make a right. But the US dollar gene within his fund (and each security) is so embedded, that it’s difficult to isolate and manipulate â€“ until now.
The easy availability and falling price of weekly (or even daily) rolling futures contracts allows money managers to remove, en masse, the US dollar tail-wind/head-wind from each security in a fund. Taken in isolation, this futures contract itself will look like a naked position and will loose money on some days and gain on others. But investors need to remember that this gain or loss on the currency hedge is just an off-set of the gain or loss from US dollar fluctuations already inherent in the portfolio of US stocks.
The growing ubiquity of currency-hedging instruments and dynamic hedging calculations are the new technologies that enable the genetic manipulation of mutual funds.
Some financial advisors seem to have adopted a simplistic, knee-jerk reaction to currency-hedging, arguing that it is dangerous, complicated process that should be taken cautiously:
Buy good, profitable businesses at attractive prices, and hold them through market and currency fluctuations, said F. Blaine Dickson, branch manager of Capri Intercity Financial in Kelowna, B.C. Small investors have enough trouble maintaining commitment to their simple investment goals, never mind trying to have them commit to watching complicated, daily changes in currency.
If I had a nickel for every time I heard a financial advisor say that investors should by good businesses at attractive prices in response to pretty much anything, I’d have my face on the US dollar! While I agree that small investors would indeed find this discussion somewhat complex, financial advisors shouldn’t use their least sophisticated clients as a guide for what is right and appropriate for investors. Besides, let’s face it, a simple hedge is no more complicated that the earnings forecast for a multi-billion dollar corporation. And small investors devour such articles in the pages of the Wall Street Journal and The Globe & Mail on a daily basis.
– Alpha Male