Modeling Risk for Global Low Volatility Strategies : The impact and role of base currencies

“Not taking risks one doesn't understand is often the best form of risk management.”
― Raghuram G. Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy

In today’s investing world, we use a simple definition of risk: the volatility of returns on an investment. Although simplistic, this definition allows for systematic and quantifiable measures, which could be used as a basis when comparing investment options and building investment strategies. But how do we forecast the risk of a foreign investment and does the risk modeling currency matter?

Providing an answer to this question may seem easy at first glance but has proven to be more difficult without first answering other questions, like where is the investor located and in which country is the investment being made? Or is this the only foreign investment the investor owns or are there others in the same or other countries?

The importance of risk models for low volatility strategies

Low volatility equity strategies are particularly dependent on the choice of equity risk models. There is an unlimited number of risk models that could be used to build a low volatility strategy. As a matter of fact, we don’t even need a model; any measure of volatility could be used to rank the investments and construct a low volatility portfolio. However, it can become more complicated if you consider foreign investments.

With this complexity top of mind, Yuriy Bodjov, Vice President & Director and member of the TDAM’s Quantitative Equity Team recently authored an article titled Risk Model Estimation Currency and its Impact on Global Low Volatility Funds. The paper focuses on and investigates the role of the base currency in equity risk modeling when applied to global low volatility strategies.

The case for the base currency

The article discusses the dynamics related to the choice of the base currency for modelling risk as well as how TD Asset Management (TDAM) approaches that question when making investment decisions.

Some of the highlights of the article include:

• Risk models frequently express the risk of foreign investments as being the sum of the volatility of the investment in local terms and the exchange rate volatility. The latter depends on each one of the currencies composing the pair. We could have various scenarios: currencies can move together driven by the same underlying economic conditions or commodity prices; or they can move in different directions if one of the currencies is cyclical while the other isn't.
• The Quantitative Equity Team at TDAM is building risk models for Canadian clients using the CAD as the model estimation currency. This corresponds to our investors home currency. However, we clearly understand that there are some implications of doing so and take it into account when managing global low volatility funds. We also incorporate the hedging of some of the more cyclical currencies or the currencies we hedge for tactical reasons. Historically, such a strategy has proven to be the one with the lowest overall volatility solutions.

Modeling the risk in Canadian dollars results in low volatility portfolios that are more exposed to cyclical sectors such as Energy and Materials, because the Canadian dollar itself is sensitive to commodities and moves up or down in-sync. Consequently, these sectors will likely look less risky for Canadian investors. In a global low volatility fund, having a higher proportion invested in Canadian stocks also seems to reduce the risk for Canadians. In contrast, if we model the risk in U.S. dollars, the resulting low volatility portfolio will be more exposed to sectors such as Information Technology, Health Care and Consumer Staples. Incidentally, these sectors were the best performing sectors year-to-date. Such a portfolio will also hold a larger proportion of U.S. stocks.

Striking the right balance for our clients

Using a risk model based on Canadian or U.S. dollar may lead to similar low volatility portfolio risk forecasts, but the choice of the base currency and the resulting portfolio structure can have a significant impact on the performance depending the market direction. Finding the right balance between achieving the lowest possible volatility and good performance in normal and strong markets, and still having downside protection during crisis requires skill and is indictive of the investment decisions that have to be made by our Quantitative Equity Team.

Our utmost priority is to safeguard, and grow, the invested capital of our clients; by ensuring that our investment actions are empirically sound and supported by research that reflects current market and economic facts.