Are you sure that equity futures don't have currency risk?

Yesterday, I heard someone say again that equity futures don't have currency exposure. While that is often the case, it is not always true and that is an important thing to keep in mind when analysing a portfolio or developing a portfolio analytics system.

The usual reasoning is as follows. Imagine I am a GBP-based investor who buys a future on the S&P 500 that is quoted in USD. Let's assume that the the futures price of an S&P futures contract is USD 1,000 with a contract multiplier of 1000. In essence, this position is equivalent to borrowing USD 1 million and buying USD 1 million worth of the S&P 500 index. So, my net exposure to the USD is zero. As a result, the value of my portfolio in GBP is not influenced by the GBP/USD exchange rate.

Or is it? There are two reasons why this may not be true for all equity futures:

a) Changes in the futures price
First of all, the futures price of an S&P 500 futures contract may change from the level at which I bought the futures contract. The most important cause of changes in the futures price is a change in the value of the underlying, but changes in the risk-free rate, yield, and time remaining until the contract date can also influence the futures price. In any case, let's assume that the futures price changes from USD 1,000 to USD 1,100.

So how does this change my USD exposure? Well, I still owe the USD 1 million I borrowed at the start of the contract, but I now have an exposure of USD 1.1 million to the index contract. Thus, my net exposure is USD 0.1 million. And if the GBP/USD exchange rate changes, then this will influence the value of my portfolio. That is, as soon as I have an unrealised gain or loss in the futures contract, I have a currency exposure.


In practise, most risk and performance systems will capture this currency risk. Most systems will evaluate the future as a short cash position of USD 1.1 mln. and a long equity position of USD 1.1 mln.. By itself, this would be incorrect: because I gained USD 0.1 million on the contract, the net value of the position should be equal to USD 0.1 million rather than zero. However, because futures are marked-to-market, I will have received USD 0.1 million on my margin account. As long as I add this USD 0.1 million cash position on my margin account to my positions in the risk/performance system, the system will see that I have a net USD exposure of USD 0.1 million and correctly measure risk and return.

b) Currency exposure in underlying
However, many risk and performance systems assume that, just because the future is priced in USD, that both the long and the short leg are 100% exposed to the USD. That does not need to be true, however. The cash leg (which is the short leg when I buy a future) will indeed have 100% exposure to the USD, but the equity leg may have non-USD exposure. This non-USD exposure can arise in four possible ways:

i. The underlying may contain securities that are denominated in a currency other than USD. An example is a future on the MSCI World index, which contains exposures to stocks that are listed in many different currencies.

ii. The underlying may contain depository receipts that, though they are denominated in USD, their actual currency exposure is to a currency other than USD. After all, a depository receipt is equivalent to a certain number of shares in a company on which the depository receipt is issued. For example, the Gazprom ADR that is listed on the NYSE and trades in USD will track the performance of the underlying Gazprom share that is listed on the RTS that trades in RUB. Just translating RUB to USD doesn't remove the RUB exposure.

iii. In some cases, futures trade in a currency other than the base currency of their underlying. For example, there are futures listed in Singapore that trade in USD but whose underlying is an Asian equity index. This clearly leads to substantial currency risk: we borrow in USD and commit to buy the underlying in a currency other than USD.

iv. More philosophically, we may question whether the currency of risk is always equal to the currency in which an instrument is traded. After all, the currency of risk is determined by the currency risk in the cash flows generated by the instrument and most companies have cash flows that are influenced by the currencies in which they trade their inputs and outputs and the degree to which they hedge the currency risk of these input and output prices. For example, Royal Dutch Shell shares may be listed in EUR, but it is likely that the cash flows of Royal Dutch Shell contain a lot of USD risk as the main output, oil, is traded in USD.

Clearly, therefore, equity futures can have currency risk. In many cases they don't, but don't assume that this is always the case. Are you sure your risk and performance system doesn't make this assumption?

What's so special about hedge funds? Part 2

First of all, I want to thank Ignacio for his thoughtful response to my first blog entry! In his reply, Ignacio claims that hedge funds differ from traditional investment portfolios because they have more freedom to invest. I don't deny this. But, as the use of the word "more" clearly implies, this means that the difference between hedge funds and traditional investment portfolios is not a black-and-white distinction but one of different shades of grey. How much more freedom does a portfolio need to have in order to call the portfolio a hedge fund?

Is the distinction one of leverage: traditional funds don't leverage, but hedge funds do? Well, even UCITS III funds are able to leverage by up to 30% (hence the recent popularity of 30:130 funds), but few people would call them hedge funds. At what level of leverage does a fund become a hedge fund? Take your pick. My key point is that any attempt to make a distinction based on the degree of leverage is an arbitrary one. Hence, the distinction is a false one.

So how about going the ability to sell short: is a hedge fund different from a traditional fund because it can go short? The answer, once again, I fear, is negative. First, as per the argument above, UCITS III funds can also go short. Second, as I argued in my first post, though traditional long-only funds do not take short positions in an absolute sense, they do so relative to their benchmark. And that means that you can turn a traditional long-only portfolio into a portfolio with long and short positions by shorting the underlying benchmark. In other words: you get a so-called hedge fund portfolio by buying a long-only traditional fund and shorting the benchmark against which that fund is managed.

To see this, consider a benchmark portfolio that consists of 3 stocks: 50% is invested in stock A, 30% in stock B, and 20% in stock C. Now imagine that the traditional long-only portfolio manager likes stock A, is neutral about stock B, and doesn't like stock C. So the portfolio manager could construct a portfolio that looks as follows: 60% in stock A, 30% in stock B, and 20% in stock C. So the alpha of the traditional portfolio manager would be generated by a 10% overweight of stock A and a 10% underweight of stock B.

Now let's short the benchmark. In that case, we end up with a portfolio consisting of 10% in stock A, 0% in stock B, -10% in stock C, and 100% in cash. By this simple action, we now have created a portfolio that aims to outperform cash by taking long and short positions in various stocks, i.e. something that is typically called a hedge fund.

Note that the performance relative to their respective benchmarks will be the same for both portfolios: the outperformance of the long-only portfolio relative to its benchmark will be equal to 10% times the return of stock A plus -10% times the return of stock B. Similarly, the outperformance of the hedge fund relative to its benchmark (cash) will be equal to 10% times the return of stock A plus -10% times the return of stock B.

So what's the difference? Both the traditional manager and the so-called hedge fund manager create "alpha" using identical relative positions. The only difference is that, when you buy the traditional fund, your return will be equal to the return of the equity benchmark (beta) plus the alpha, whereas buying the hedge fund will give you a return equal to the risk-free rate (cash) plus the same alpha. There is no reason to pick one of these managers over the other: they have the same skill. The only reason to pick one over the other is if you prefer to have exposure to cash or equity.

Once again, I recognise that what we call "hedge fund managers" typically have more freedom to take positions (they can take more leverage, take larger short positions, etc.), but these differences are differences of degree. Of course, the more freedom you have as a manager, the more opportunity there is to add alpha if you have skill. But both these so-called "hedge fund managers" and the traditional managers use the same investment strategies to try and deliver this alpha. And therefore, if you don't have skill as a traditional manager (and empirical evidence shows that the average manager doesn't have any skill), then it is unlikely that you will have skill as a "hedge fund" manager.

And that's why I am suspicious of the hype surrounding hedge funds. If you weren't able to deliver alpha in a long-only portfolio, then simply repackaging the product as a hedge fund by taking the long-only portfolio and shorting the benchmark isn't going to deliver the alpha either. Of course, not all investors understand this. And many will be wooed by your new packaging. But it remains a case of "old wine in new barrels" and any attempt to sell this same old wine at a higher fee level to unsuspecting clients is questionable to say the least.

What's so special about hedge funds?

The recent proclamation of hedge fund standards by the Hedge Fund Standards Board (HFSB, see http://www.hfsb.org/), an organisation sponsored by a group of 14 large London-based hedge fund managers, made me think about the question again: what is so special about hedge funds?

These Hedge Fund Standards cover three broad areas: a) disclosure of information (investment policy and risks, commercial policy, incl. fees and expenses, and performance to investors and counterparties), b) valuation, and c) risk management. While one could argue about the quality of these standards - and I will do so in a separate post - , perhaps the most important question to which these standards give rise is: why in the world are these standards specific to hedge funds? There is nothing in these standards that cannot or should not be applied to any investment portfolio. What is so special about hedge funds?

From a purely investment-technical perspective, the answer is of course "nothing". Indeed, the standards don't even define the term "hedge fund". I can only interpret this as an implicit admission by the authors that it is impossible to unambiguously define a hedge fund. The difference between "hedge funds" and "traditional" investment portfolios is equivalent to the difference between shades of grey. While "hedge funds" may have differentiated themselves in their early days from "traditional" portfolios in terms of the use of leverage, derivatives, short positions, and illiquid instruments, these days all of those techniques are used by so-called "traditional" portfolios as well. And while investor protection laws used to limit these strategies to professional investors, regulatory liberalisation, such as UCITS III, have made these strategies available to retail investors as well.

But hedge funds deliver absolute returns, rather than returns relative to some benchmark, you might argue. Wrong again. Not only are there many hedge funds that fail to maintain market-neutrality by taking market-directional bets, but the whole concept of an "absolute return" is nothing but a thinly veiled attempt to lure investors by trying to make them believe that it is possible to earn above-normal positive returns without downside risk. There is no free lunch. Just as "traditional" funds aim to outperform a particular benchmark but risk underperforming that benchmark, so "hedge funds" aim to deliver a target return above the risk-free rate at the risk of delivering a return below the risk-free rate. In that sense, a market-neutral hedge fund is a traditional portfolio that is managed relative to the risk-free rate at the risk of underperforming that risk-free rate. Conceptually, a hedge fund is nothing but a "traditional" fund with the addition of a short position in the underlying benchmark and the proceeds invested in cash. Of course, the underlying benchmark may be more risky than cash, but presumably it also has a higher return.

So if hedge funds and traditional funds are different shades of grey in terms of investment objective and strategies, then perhaps the only difference that remains in that hedge funds not only earn 1-2% of assets in management fees, but also charge around 20% of the upside. The only way to get away with charging such significantly higher fees, is, of course, to differentiate your fund from those other funds. Lacking any significant differences other than the fees charged, what better way to differentiate than to use the power of language and invent "hedge funds" as something different from "traditional" funds.

Once again, the HFSB standards in and of themselves provide a valuable set of principles to which all investment managers should be held. But rather than adopting one set of standards for "traditional" managers and another for "hedge fund" managers, let's integrate these standards with the standards of organisations such as the long-standing CFA Institute (http://www.cfainstitute.org/) so that we can compare all managers on a level playing field. And if we can abolish the term "hedge fund", one of the most misleading terms in the investment industry, at the same time, all the better.