T raditionally, the seven deadly sins are (in no particular order!) said to be Pride, Avarice, Lust, Gluttony, Envy, Anger and Sloth. How, you might well ask, could this fearsome list possibly apply to the relatively blameless field of currency management?
Well, we're not going to attempt to draw exact parallels, fun though that might be. However, there are definitely some downward steps that might be said to lead on inexorably to disappointment. Let's take a closer look at these 'sins of omission'.
The first - and most common - 'sin', is ignoring the problem. 'Currency, that's all swings and roundabouts isn't it?, or 'I'm a long-term investor - I don't need to worry about currency losses', are arguments heard all too often. Well. perhaps so - but in the long-term, as famously remarked, we're all dead. Currency movements can and do have a huge effect on portfolios: over past two years, for example, the strong dollar has broadly halved the return from international equities for US investors.
Even when one has stepped onto the virtuous path of having a currency management programme, there are still pitfalls. The first of these is not setting a clear objective. What are you trying to achieve with a currency programmeme? Added value, risk control or some combination of the two? The objective may, of course, change over time, but has to be clearly identified.
An obvious related 'sin' is not communicating the objective. There clearly isn't much point in pension fund executives knowing what they're trying to achieve if the board hasn't bought into the concept. Everyone should have a clear idea about what will constitute good performance.
Which leads us on nicely to the next one. Choosing an inappropriate benchmark can make life difficult. This is not necessarily because the choice of benchmark will have an impact on the strategy followed by the currency manager - it may , or it may not, depending on which manager you use. The key reason is that the choice of benchmark will determine how performance looks. For example, in periods of prolonged guilder strength, a Dutch investor's currency hedging programme will generally look good against an unhedged benchmark. On the other hand, it will probably underperform a fully hedged benchmark. The lesson has to be that you shouldn't choose one of these 'extreme' benchmarks unless you're prepared for this to happen.
Another potential pitfall - that of not having clear guidelines - is, of course, much easier to avoid. Is the currency manager allowed, for example, to take cross-hedging positions (which can be seen as having nothing to do with hedging actual exposures)? And can the manager use proxy currencies to stand in for less liquid ones? If so, does the client want to specify which ones are permitted, or leave it to the manager to decide? These are just a few of the issues which can and should be addressed.
Operationally, it is important to keep one's eye on the ball. Lack of concentration on information flow between the various parties is definitely a mistake. Who, for example, is to supply the information on exposures to the currency manager - the investment manager, the custodian, or you? How often is it to be updated? And will the information arrive on a timely basis? One wants to avoid, as far as possible, any significant time delays, since the currency programme should generally reflect the actual exposures held. And of course, the information should be as accurate as possible, with all the possible sources of currency exposure taken into account.
And finally, we come to the 'sin' of inadequate reporting. Good reports are key to all parties being comfortable with a currency programme. Management information - for example, providing an audit trail, and a marked-to-market valuation - is very important. But there are also other issues which should be addressed in comprehensive quarterly reports. If the currency manager is using proxy currencies, what is the effect of that decision? And what is the performance against the benchmark, broken down by individual currency? Performance attribution is rarely easy - but it has to be tackled.
These aren't, perhaps, deadly sins when ranked against the originals. Thankfully, poor reporting rarely leads to eternal damnation. But perhaps they're deadly enough, in their own way....
Kevin Bailey is managing director BoNY Overlay Associates in London