Constantine Ponticos is head of currency research at Insight Investment, a firm with an international agriculture investment strategy and assets including Polish potatoes and Chilean dairy. Here he discusses currency risk, liquidity and costs when hedging for an international farmland portfolio.
Currency risk is a by-product of international investment. Alongside the return sought from an asset, investors are also effectively holding a foreign currency deposit. This is why foreign exchange exposure has been dubbed a “hidden” risk at the portfolio level.
Farmland, particularly when an investment is also operational, is inherently a global asset, which exposes investors to foreign exchange rate movements. This can be viewed as a risk to be managed, but it is also a potential source of return.
The benefit of a dynamic approach is evident when you consider the problems that can come with a strategy of either being fully hedged or unhedged.
Taking an unhedged position for farmland is often rationalised by arguing that currency returns will wash out in the fullness of time, as currency tends to revert to the mean. If investors are prepared to tolerate medium-term fluctuations, it is less costly to remain unhedged.
Advocates of fully hedging may agree that passively held currency exposure will not produce returns in the long run, but would introduce additional short- to medium-term volatility. Investors should therefore ask themselves: if they are not being adequately compensated for a risk, why be exposed to it?
Both these positions are undermined by real-world considerations. Even if exchange rates revert to fair value in the long run, the timing of acquisitions and disposals of assets may not coincide with opportune points in the cycle. This means that the currency risk may not be afforded enough time to “wash out”. Hedging, on the other hand, transforms the volatility of unrealised exchange rate returns into realised short-term cashflows that may need to be funded.
Between the fully hedged and unhedged extremes, there is a wide variety of positions. But a strategic hedging policy is specific to each portfolio and depends on the investment objectives, the composition of the portfolio and its ability to meet potentially large negative cashflows from currency hedging contracts.
An important consideration for farmland investors is liquidity. Portfolios compromising illiquid assets can be subject to acute pressure when funding currency hedges, particularly during times of heightened market stress. While liquid investments, such as stocks and bonds, can be liquidated at short notice to meet cash calls, this is not the case for land and machinery. An investor considering a permanent or semi-permanent hedge is left with two alternatives: hold more cash on the balance sheet and suffer the drag on performance, or reduce the level of hedging and see performance buffeted by moves in currency markets.
We think that employing a dynamic currency hedging strategy offers a pragmatic solution to these challenges. At their core, true dynamic strategies are fundamentally about risk management. Because of this, we avoid taking views on the direction of exchange rates.
Instead our active currency risk management strategies aim to deliver an outcome similar to the one achieved by using option overlays. That means you get both downside protection and the ability to participate in currency gains, without paying the upfront cost of purchasing an option. This approach is less capital intensive, as the requirement for a cash buffer is substantially lower compared with using forwards passively to hedge the same average exposure.
The strategy typically increases the proportion of assets being hedged in periods of base currency strength and decreases the level of hedging in periods of base currency weakness. It can limit negative cashflows to a level appropriate for the available liquidity.
By applying a sliding scale to hedging, something few investors in farmland practice, investors can get good returns from farmland and take a more flexible and dynamic approach to their portfolio.