Most investors acknowledge that currency can be a large source of risk and return in a portfolio and therefore seek to manage it in some way or another. Passive currency hedging is widely implemented by asset owners to fully or partially neutralise currency exposures. With passive hedging, the currency hedge ratio remains constant – say at 50% – regardless of market conditions, such as currency valuations, economic developments and sentiment.

Many Australian superannuation funds vary their currency hedge ratios over time though, in response to changing market conditions, for example looking at a Purchasing Power Parity (PPP) - based Value signal. This is often referred to as ‘tilting', whereby the hedge ratio is increased when the AUD is cheap and decreased as the Australian Dollar (AUD) becomes expensive. As we see below, tilting achieves an inferior risk/return outcome when compared with a multi-factor approach, which considers more than one market signal. We believe this is because exchange rates often overshoot their PPP fair value significantly, and can stay there for prolonged periods of time. This is especially true for currencies like the AUD that is typically correlated with the prices of commodities.

Dynamically adjusting the hedging ratio to consider not only PPP (valuation), but also carry (forward rates) and trend (or momentum) provides a more robust way of considering several signals that should be accounted for when making hedging decisions. Carry is important for the AUD due to the prominence of the forward rate bias for the currency, which sees hedged exposures do better over time. Trend is also important to account for the volatility of currencies that stay at valuation extremes for extended periods of time.

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