FX Hedging for Fund Managers: From Policy to Strategy and Implementation

FX Hedging for Fund Managers: From Policy to Strategy and Implementation

Evaluating and managing types of risk in fund management

In this post by Andrew Shortreid, SVP Global Institutional Sales at Corpay Cross-Border Solutions, he details important steps portfolio managers, members of investment committees, and fund managers can take to create effective hedging policy and optimize FX risk mitigation over time. In this piece, you’ll hear from a seasoned expert, who has worked in challenging roles in the fund and institutional space across European markets.

With the added complexity of managing FX risk related to diverse asset classes and in multiple jurisdictions where international funds operate, Shortreid’s focus on real-world examples — unique to portfolio management — provide nuanced, and high-level, takeaways.

Read to learn:

• Why hedging strategy and FX risk mitigation are important for professionals in the funds and institutional space

• How to approach FX hedging in the realm of portfolio theory:

  • Analysing portfolio structure and other elements in relation to FX exposure

  • Balancing investment risk to generate returns while mitigating underlying FX exposure that can erode gains

  • Developing and adhering to best practices for hedging at the portfolio level, the individual asset level, or the investor level

• How to recalibrate hedging strategies and evolve over time:

  • Determining fund risk appetite and calculating costs

  • Identifying the types of derivatives, hedges, and strategies a fund manager may use on an ongoing basis

• Developing an FX decision-making framework to create a hedging discipline, forming a foundation to optimize decisions and capture winning approaches far into the future

In financial markets, an element of risk is essential to generate return. The fund or portfolio manager is, in many ways, a professional risk manager, evaluating what risk — and what level of risk — is acceptable to investment committees. The manager’s role is to devise a strategy that aligns with the fund policy and risk appetite and then to implement the strategy accordingly.

In this post, we extend this concept to FX risk for international funds. A sound and disciplined FX hedging program can help the manager separate the noise from the signal, keeping the focus on the fund’s financial returns.

The importance of hedging strategy for investment funds.

When you're a professional investor managing capital on behalf of a group of global stakeholders, investors, and other institutions, you're in a role as a fiduciary for those parties. In this trusted role, the expectation is that you’re going to take a technical, thoughtful, and thorough approach to the activities you're undertaking on their behalf.

There's a specific process that you go through to communicate to these parties the types of risk that you [will] be taking with their capital, the types of returns that you expect to be able to generate for taking those risks, and how you're going to manage those risks on an ongoing basis, and monitor and report your activities back to [these parties].

The idea behind having a hedging policy for international assets is to provide investors with transparency into the ‘mental models’ and the decision-making framework that you, as a manager, are employing when you're making decisions with the fund’s capital.

Think about how well-documented everything is about a fund. Funds will have detailed written parameters around what makes a good investment for them. They will have detailed parameters around how fees are going to be charged and what expenses [will be incurred], and what service providers are going to be involved in the operating that fund management business.

So, [it’s important to have] a policy that governs what happens when investments are made in international jurisdictions, or when there's an additional set of exposures that may be outside of the traditional investment factors that one might expect. It’s best practice to have a clear, thought-out communication plan [about] what the policies are around how those assets are managed andhow those exposures are [defined] and mitigated. It’s [an important part] of the process of setting up a professional fund.

Understanding portfolio theory.

[As] a portfolio manager or a member of an investment committee, a fund, or fund management business, [you are in the professional role] of taking and managing risk. You always strive to take smart risks, to allocate capital effectively, and to make sure that you're making the best risk management decisions that you can, on an ongoing basis.

There's an idea in financial markets that there's no ability to generate return without taking some element of risk, or put more precisely, there's no ability to earn excess return without some element of risk involved. So, with respect to thinking about portfolio theory and the building blocks of return within a portfolio, you want to ensure that every investment you're executing on and every strategic decision you're making incorporates a well-considered evaluation of the returns that you're generating on a per-unit of risk basis, or the rewards that you're able to capture for taking certain risks.

When it comes to foreign exchange, there isn't a structural return premium that [you, as] a manager, can capture from being [in a] long and unhedged foreign exchange position.

Effectively, owning assets in different currencies relative to the base currency doesn't enable you to capture any incremental returns on a consistent basis. There's this idea that you're taking an uncompensated risk when you are holding these positions on an unhedged basis. [Mitigating] this volatility or eliminating these risks [is what] most managers are keen [to do] on a more granular basis. Further, the idea that the presence of a foreign exchange component in your overall return stream is akin to ‘noise’ in the financial performance of your strategy. If your underlying investment strategy has an internal rate of return of, say, 15%, but your exposure to unhedged assets in a foreign jurisdiction may add or subtract 2 or 300 basis points from that return, that could be the difference between you being in the first quartile or the fourth quartile of the management cohort. That's going to have a significant impact on your ability to raise capital in the future. So if that's a risk that you can mitigate for an attractive level of cost, then it's something that most managers would choose to do.

Creating an effective hedging policy.

The foundation of a hedging policy is having a well-understood idea of what the overall allocation and investment strategy of the fund is likely to look like on a fully deployed basis: what is the sum of the investments that are made over time? The types of investments and the types of exposures that the portfolio is likely to have; the jurisdictions; [the] time frame of the investment holding periods, asset classes, and the nature of the underlying investments that are being made.

[You’d want to think about questions like] are they going to be private equity investments that have a duration of seven to nine years? Are they private credit assets that are going to be paying international currency cash flows on a monthly basis back to the fund? Are they Venture Capital? Are they relatively binary in terms of their outcome over time?

[You’ll want to consider] all these types of things. So the starting point for your hedging program is having that detailed understanding of what the built-out portfolio [will] look like.

And then, thinking about [these ideas] from the standpoint of the composition of the capital that you're going to be raising for the fund. Are you raising from the cross-section of international investors and where are they located? What currencies are coming in and how does that mesh with the overall strategy of the fund that you’re looking to execute?

[As a portfolio manager] you’re thinking not just in terms of the underlying assets, but also where your investors [are] and how it’s being brought together at the fund level.

Defining risks to develop the hedging strategy.

You can hedge at a number of different levels within a fund. [You can hedge] at the portfolio level; the individual asset level; the investor level:

Where does it make the most sense for a fund or a manager to design the hedging policy to optimize the outcome and calibrate what makes the most sense for the business.

With the design understood, the fund can start to think about targeting: What levels make the most sense from a hedging standpoint, and what is the tolerance for risk that the manager wants to express…the tolerance for the elimination of risk? What level does the manager want to control for, from that standpoint? Is the optimal hedging ratio 50%, or 75%, or 90%? How do [these considerations] roll down within the overall strategy?

[The strategy] can be applied to any individual asset or groups of assets: If you have a mid-sized fund or a large fund, and you have foreign exchange exposures in multiple jurisdictions, you may want to hedge different rates for those assets in different currencies as well.

Maybe you need to have a 75% hedge ratio at the fund level, but within that [strategy] you might want to hedge 100% of your Euro assets and 50% of your Aussie dollar assets to get there. It’s not necessarily something that needs to be applied uniformly across the entire portfolio; [It depends] on the underlying positions, the context of the environment, and the cost required [to] hedge each of them.

There's a sensitivity analysis that is undertaken by the manager as they're going through and looking at what [might be] the best combination of activities that help [the fund] to meet the overall objective.

Adjusting hedging strategies over time.

[Your hedging strategy] is going to evolve over time. Part of the policy is to understand how much a manager will let the position move before it needs to be rebalanced. What's the tolerance for slippage? [How much] can you become over-hedged or under-hedged relative to target before it makes sense to rebalance?

Part of that is a cost exercise as well. You can have a perfect hedge that is maintained indefinitely, but it's going to be very expensive. You can have a hedge that operates more in a band, which may be more practical for a lot of strategies.

Recalibrating the hedging strategy.

Because you’re only going to be hedging the actual capital that's allocated at any given point in time as new investment decisions are made, the hedging program will [also] evolve. The idea of setting up a policy [is to] say: “Within the contract of the fully deployed portfolio, we would like it to end like this. This is the guidance that we're going to codify within the constituting documents of the fund. [That will] enable us to get access to the tools and strategies to get [to our goal], but it won't start at 100% [clarity].” It won't start with the entire hedge program rolled out.

It's something that needs to be looked at organically as those investments are made over time.

Looking at costs to achieve an outcome.

The first step is identifying your target outcome. So, once that's been defined, the manager and their provider are going to try to figure out what type of strategy achieves that outcome and how much that's going to cost.

Now, the manager needs to look at that strategy and that cost, and then determine if it's acceptable for their fund to bear. [If the costs are not acceptable], then certain aspects of the target and the strategy need to be adjusted until they're in alignment with the outcome that the manager can support. Sometimes it means they hedge a smaller part of their exposure; [other times] it means that they may hedge their entire exposure, but the hedge doesn't kick in until there's a little bit of slippage from the target.

Other times it can mean there are different structures or different strategies that can be implemented, which customize the exposure at different levels. Ultimately, it's going to start with what the target is, relative to the cost, and if that cost is expensive, then [adjusting] can be an easy decision. If the cost is more difficult to achieve, then there's a bit of reworking that goes into the strategy to find the best outcome.

Implementing the hedging strategy.

Different funds are going to have different internal processes and run investment operations in ways that they feel are best for them. In some cases, [they] will have a policy that is drafted that gives the internal financial [team], or investment operations team, the ability to hedge within certain parameters and execute on those as per policy.

In other instances, it may be that the investment committee wants to approve any of the individual trades and strategies that may be implemented.

The idea behind having a policy is that it should generally identify the types of derivatives, hedges, and strategies that a fund manager may be permitted to use on an ongoing basis without requiring board approval. The idea is that hedging should eliminate risk, not introduce new aspects of risk, and so typically the hedging policy will permit the types of instruments that are designed to minimize, mitigate, eliminate, or transfer FX risks that the fund is looking to eliminate.

Approaching hedging in a changing market.

Cost can be measured across a range of strategies and asset classes, and [there are] various levers that a manager can pull to express the strategy and generate the outcomes that they're looking for.

Certain types of strategies can be inexpensive from a pure cost standpoint, but require the fund [to] allocate available liquidity to their hedging program. [One example] is a rolling short-dated series of hedges that need to be settled on a regular basis and would require additional liquidity or the liquidity reserve in order to do so. [This strategy] is typically going to be a low-cost, high-control way of hedging certain assets. [You could use this for] private debt or other income-oriented credit strategies that are generating yield and service potentially out-of-the-money contracts as they come due. This is one example of a strategy that might be appropriate and [that] gives a high degree of control. There's liquidity that's coming into the fund each month from the interest coupons that are received and so that typically makes sense.

We can see a different approach with other managers and less-liquid, longer-dated, or longer-duration type strategies [for] venture capital, real estate development, infrastructure, or private equity. In these strategies, managers like to minimize the need to either keep cash on the sidelines to service shorter-dated hedges that need to roll, or to call in capital from investors in order to purchase a one-way vanilla option.

[So you may want to think] about cost in terms of what the credit costs are to implement a strategy, but also what the consumption of liquidity [will be]. [You may want to consider] the capital intensity from a liquidity standpoint that comes into play in the strategies that a fund can implement.

[As a fund manager] you’re trying to find the optimal fit between [different] types of instruments and the level of protection [they offer]. [You’re going to want to consider] the slippage or the variability of the protection and then the liquidity and timing.

Determining and calculating costs.

Cost has many forms: pure margin cost, liquidity cost, flexibility cost, and performance cost.

[You may be thinking about] what makes the most sense [in] different circumstances and how you want to bring [it] all together [in your hedging strategy].

In a perfect world, there are no constraints, but [in reality as] a manager [you] might be bound by [costs and tenor]. You can only go out so far without additional credit charges or other things that can dampen performance.

It’s difficult to have your cake and eat it too. There's no free lunch and [creating a strategy] is a series of trade-offs, and trying to identify what that optimal set of trade-offs is for an individual manager at a specific time.

Nobody's got a crystal ball. So, if we can't see the future, all we can do is make decisions today with imperfect information about the future. Part of the manager's job is to take a thorough assessment of all those factors before implementing a strategy.

Conducting assessments to further develop hedging strategy.

[Managers are assessing] the value of the asset that they're looking to hedge and how [it will] change, over time. [They’re] thinking about it from a scientific standpoint. What's the probability that this asset is going to grow in value over time, or that we're going to receive a specific cash flow that we're expecting?

[The portfolio manager] is thinking about how much is this going to cost me today versus in the future, and their hedging policy is designed to allow for some discretion, oftentimes within a band, between a minimum and maximum level.

[Within the band] it may be that there's some opportunistic or event-driven factors that are going to impact the level of hedging, but it shouldn't impact whether [ the manager is] going to hedge. It could be the difference between saying, we typically have 75%, but based on X, Y, and Z market factors at current exchange rates, we now think a 90% hedge ratio is appropriate for this asset or group of assets. [The portfolio manager] could also look at future investment plans and how the portfolio may be changing over time.

Developing discipline in setting and adjusting hedging strategy.

As a professional money manager, you have a circle of competence, and you create a fund that leverages the edge that you have in that specific area. It comes down to you doing what you've set out [to do], and what you’ve communicated to your investors and team, that you're going to be doing. [You need] consistency and the discipline to follow an approach.

A strategy, a set of rules, is critical for investors and investment managers because [this] is going to lead to repeatable outcomes.

It's important from an investor standpoint that when you're looking at allocating to a strategy or manager, you want their past success to be repeatable in the future or at least [be] representative of what they can do in the future. Oftentimes, [this] comes down to having a repeatable investment process, a discipline.

When there's drift from [the discipline], then you lose the ability to attach your results directly back to decisions and decisions made within that particular framework. The most critical thing about professionally managing capital is that you want [to reduce] the guesswork involved.

This is a mathematical undertaking. [You want to] repeat [a] process [that is] the sum total of all of knowledge from a group of very smart people, which is activated and leveraged in a specific way to generate repeatable results over a long period of time. [When you do this] you compound capital for investors. This is the ethos of sophisticated alternative investing: It's not guesswork or discretionary. [You want it to be] codified, so the hedging program is [repeatable] and [operating with well-defined guidelines].

You need to have a model and a framework [that you can] show. [You need to] demonstrate why you've made all these decisions, but you will not be told what decisions [need] to be made.

The same thing [is at play] with the hedging policy. It’s going to provide you with the groundwork and evidence in the framework [that you are able] to make these decisions, but it will never tell you exactly what [the structure will be], [the exact trade], or the timing. [You still have] reliance on [that] group of smart people who are professionally focused on ensuring good outcomes.

You want [portfolio managers] to have the right framework to allow them to arrive at a decision that helps them optimize for their [specific] objectives.

Active versus passive strategies for achieving outcomes.

There’s an idea that when you’re being active in your currency calls, even within [a] range, [it] can be difficult to do and a source of significant frustration, relative to funds that stick with a consistently applied view and accept the outcomes of that from a policy standpoint.

Investment managers are paid to make decisions on the underlying capital, and not to actively trade things like currency.

It’s left to a manager's discretion if they want to acquire an asset in one jurisdiction or another, or fund a loan in one region versus another. Oftentimes, they have the ability to do that. But once they overlay that with trying to actively manage currency, it's going to require an allocation of resources that they may not have or an allocation of mindshare that their investors may not want them to be focused on. So, outside of large funds that have specific currency management teams, it's not seen as an activity that generates a positive ROI for its investors.

It’s difficult to generate consistent alpha or even [just] consistent returns [in general]. From actively managing the currency as an overlay [for] your strategy, it's not going to be how a fund manager is going to propel themselves forward in a competitive marketplace.

In conclusion.

With the complexity and expectations that come with working in the funds and institutional space, your approach to identifying and mitigating FX exposure requires parsing many considerations to produce results consistently over time. Operating as a fiduciary for stakeholders and across jurisdictions, creating a decision-making framework and hedging strategy is necessarily complex, but can result in a more disciplined, mathematical approach to FX exposure mitigation. This rigor can improve confidence in your judgment and lead to more opportunities in the long run.

Click here to listen to the companion podcast.

About Corpay Institutional

Corpay Cross-Border’s Institutional team supports practitioners across the spectrum of the international funds and institutional sector, providing a portfolio of foreign exchange, global payments and currency risk management solutions tailored to their unique needs.

The team operates from institutional FX desks based in London, Toronto, and Sydney, with local professionals working with institutional customers from branches in Jersey, Madrid, Dublin, Rome, Los Angeles, New York, Singapore, and other key financial hubs around the world.