Special Report: Currency - A dangerously underrated risk
Anthony Harrington finds that investors can easily overlook the foreign exchange risk that comes with investing outside of their own currency area
At a glance
• It is easy to forget the potentially huge losses that can result from currency risk.
• It is a complex area partly because of the number of possible currency pairs.
• The dollar behaves differently from other currencies as a result of its global status.
• Currency can be seen as an independent source of risk and return.
Diversifying internationally as a way of lessening the risk of synchronised draw-downs in equity investments has become such an ingrained strategy that it is all too easy to forget the associated currency risks that come with investing in another currency area. Yet, as many US pension funds found to their cost in 2014, if currency differentials move adversely, as they can, investors can find many years of gains from their global portfolio wiped out in a single year by a massive, foreign exchange-related loss.
This, of course, creates a dilemma. Hedging is not cheap and many pension funds are not in a position to tolerate the cash demands that can come from sustaining a hedge when it is ‘out-the-money’. To resolve this dilemma, trustees and pension fund managers need to have detailed conversations with currency specialists to try to understand something of what drives currency risk, and to get a feel for what they are facing.
As Jeppe Ladekarl, a partner at First Quadrant notes, these conversations are taking place virtually across the board. “The harsh experience meted out to US investors last year was always going to spur activity,” he says. Ladekarl sees these conversations as prompting a limited amount of action – the firm is seeing a definite increase in dynamic currency mandates crossing its desk – but, so far, for many funds, things have not progressed beyond talk. Pension funds are not noted for their speed of action and currency is a hugely complicated arena with a large number of moving parts. Many trustee boards have difficulties working out what position to take on currency risk.
“We would argue very strongly that funds need to look at currency exposure as a distinct and separate risk area. You cannot fault people for not hedging if they have done the analysis and taken an explicit decision not to hedge. But if you just assume that certain exposures are not a problem because they are hard to get your head around, then that is very bad,” he says.
Ladekarl points out that all too often the currency decision comes as an afterthought. “It is a hard problem to solve and you should not just rush past it,” he warns.
A large part of the complexity, of course, comes from the fact that investing globally brings multiple currency pairs into the equation and currency pairs behave differently depending on whether investors are repatriating cash from a high to a low-yielding currency or vice versa, or working with two currencies that are at present pretty much on a par with each other.
Precisely because it is so complex and so far-reaching in its effects, the impact of currency on global portfolios has been the subject of extensive academic research. As Van Luu, head of currency and fixed income strategy at Russell Investments, says, the factors involved are well understood. “The three key factors influencing relative currency values are ‘carry’, ‘value’ and ‘trend’, and these are widely used by active managers and also in some smart beta products to take positions,” he points out.
Carry refers to the practice of borrowing an (ultra) low-yielding currency to fund investments in a higher-yielding currency. Value concerns whether currencies are cheap or expensive according to their purchasing power, taking into account the relative performance of the economies behind currency pairs. The US and the UK are recovering faster than some other economies, for example, and that is a fairly long-lived trend. Finally, trend is self-explanatory and simply looks to see if one currency is showing a stable trend of appreciating or depreciating against another currency.
In collaboration with FTSE, Russell Indexes maintains a currency index called the Conscious Currency index (see figure), which builds on these three factors. Russell’s overall strategic approach to currency management employs a related framework which it terms Cycle-Value-Sentiment. “This is a slightly more sophisticated version of the three carry, value, trend factors. Carry corresponds to cycle, but here we look not just at the spot interest rate differentials but at longer-term yield differentials and changes in yields that anticipate future monetary policy,” he says.
The longer-term approach is necessary for those trying to incorporate the potential impact of quantitative easing (QE), for example, which is not readily captured by a naïve carry policy that just looks at one month’s interest-rate differential. “When the carry trade originated, it was never envisaged that large-scale asset purchases by central banks could be used as a monetary policy tool. The whole focus was on short-term interest rates. But, nevertheless, even the naïve version works very well. The Russell index has a Sharpe ratio of 0.8, which shows that it is doing its job,” he says.
His advice to pension funds is to begin any consideration of strategic asset allocations by viewing the expected returns under fully hedged conditions. “This does not mean that every investor should always be fully hedged when investing abroad. But you should start your analysis from a fully hedged position, then add currency risk in and see what kind of risk reward you can expect,” he says.
One way of adding back currency risk would be to add an index strategy, but that might not suit all funds should it involve taking large derivative positions and some funds in some jurisdictions are barred from investing in derivatives. Another approach would be to work out an appropriate hedge ratio.
Patrik Safvenblad, CIO and investment partner at Harmonic Capital Partners, points out that countering currency risk is inherently more complex for investors in some jurisdictions. As a Swedish national, he notes, it is known in advance that any crisis of any sort, be it domestic or international, is going to cause the krona to fall against the dollar. By way of contrast, for a US investor, with the dollar as the world’s deepest safe haven pool, the global stock market could be crashing, with the US economy slowing, but the dollar could still appreciate. In recent years that has made it difficult for US funds to take currency risk seriously.
“Historically, not being hedged worked in favour of US institutions. Then we had an unusual state of affairs in 2014 and US institutions got crushed. The lesson in this is that currency market cycles last around four to six years then reverse – and when they reverse against you, then you can lose everything you gained by not being hedged, and then some,” he says.
Safvenblad points out that many trustees and fund managers fail to realise that currency effects can be much stronger than the expected equity returns from a given market. This is particularly true for emerging markets. “Take the Brazilian stock market – it is well down at present but the Brazilian real has depreciated more than 30% over the same period. So if investors did not take the currency risk into account they would been hit by a double whammy and would have lost the whole benefit of diversifying internationally.”
“We have been seeing a lot of interest from funds in various hedging strategies, and there is no doubt that the interest is being driven by these wild moves that no one expected a year ago. We have a very unusual constellation of events in the currency and equity space. No one expected the European equity market to outperform the US equity market, for example, so people have been bulking up their global equity portfolios and getting into hedging discussions,” he says.
“We are seeing pension funds in general upping their game by at least one step. Those that were unhedged are moving to static hedges. Those with static hedges are moving to active hedging and those with active hedges are now moving to alpha overlays on the active hedge, so there is awareness and movement across the whole sector,” he says.
However, once funds really start to focus on the cost of hedging – 7% is not a ridiculous number for an emerging market hedge, for example – then, for quite a few funds, the whole idea of yield-seeking abroad gets called into question. “People start thinking that they could find a 4% return very easily in their domestic market by investing in high-yield corporate debt, for example, with no currency risk. Of course, if they do that, then they lose the diversification that comes from the global portfolio, so they are risking losing out with synchronised drawdowns in their domestic market,” he adds.
A far better option, he suggests, is to stay invested globally, to get the diversification, but to use active management of your hedge in order to lower the cost of hedging. Adding an active currency alpha overlay to the hedge will give the fund access to alpha that is not correlated with any other asset in the portfolio.
“We know there is sound logic to this strategy. The interaction between equity markets and exchange rates is well understood, so being intelligent about the models you use to analyse currency movements and to gear your exposure, allows you to reduce risk,” he argues.
Like currency managers everywhere, Ugo Lancioni, head of FX at Neuberger Berman, is aware that currency markets are going through an unusually volatile period. Such behaviour is not just because of monetary policy divergences between the US on the one hand, and central banks in Europe, the UK and Japan on the other. China’s recent devaluation of the renminbi was relatively modest, but still sent shock waves through the currency markets because a currency that had been seen as risk-free and stable suddenly had policy risk written all over it. However, all this volatility is creating some exciting possibilities for generating alpha from foreign exchange as an asset class.
“It has been a tough time for many currencies. Over the past year, Brazil is now down 40%, the Turkish lira is down 27% against the US dollar; Malaysia is down 24%, the Kiwi [New Zealand dollar] down 22% and the Norwegian krone down 22%, despite the fact that Norway is running a very strong current account. However, that is an opportunity in our view. What we are seeing is that some of the high-yielding currencies are starting to become attractively priced for the first time in years,” he says.
It is unusual to get attractive currency valuations and good economic conditions at the same time. The usual state of affairs is for countries to offer attractive currency valuations when their economies are failing. “The Aussie [Australian dollar] and the Kiwi in particular are now in the middle of the pack, in valuation terms, no longer being overvalued as much as 30%, so they represent an investment opportunity,” he says.
“Our position is that funds should be considering currency as an independent source of risk and return, not together with the foreign underlying assets. We can build portfolios for funds that are uncorrelated or even negatively correlated with their existing portfolios, so it can be an amazing tool for diversification,” he concludes.