Currency strategies in a balanced portfolio

Martin Hammond, Portfolio Manager at Prescient Investment Management

A Cup of Coffee

Purchasing power parity is the seductive theory that all assets cost the same everywhere relative to one base unit of account. This means that one cup of coffee should cost $1 in the US and $1 in South Africa. This $1 cost converted into rand mean we would pay R14 for a cup of coffee. If they do not cost the same there’s an incentive for trade to bring the discrepancy back in line.

For transactions to take place, a country needs sufficient currency (or units of account) in circulation so that there is no scarcity or oversupply. When in oversupply, the value of a country’s currency declines and you end up paying more for that cup of coffee when measured in rand, but the same when measured in dollars.

Now let’s combine these two ideas. Different countries experience different levels of inflation depending on how quickly they increase their money supply relative to how fast their economy is growing. Therefore, for the argument of purchasing power parity to hold, exchange rates should adjust over time to account for differences in inflation between countries.

Currently at Prescient Investment Management (Pty) Ltd (Prescient), our long-term expectations are for US inflation of 2%, and 6% for South Africa. The 4% difference is what we expect the exchange rate to depreciate by over the long-term. As a result, any investment offshore (specifically those into US dollar) should theoretically grow by 4% from currency depreciation alone.

Currency Depreciation vs Volatility

Over the past 20 years, the inflation differential has been closer to 3%, and currency depreciation around 4%. This period included such notable events as the Tech Bubble (2001), the Great Financial Crisis (2009) and, more recently, Nenegate (2015). While the outcome has been 4% depreciation, the journey was somewhat more eventful than this number implies. As seen from the chart, the rand is prone to bouts of extreme weakness followed by sizable moves in the opposite direction - often by more than 30%. So, while holding offshore exposure will benefit an investor over time, it can also cause detrimental drawdowns if the portfolio is not rebalanced on a timely basis.

Understanding Currency Operations

Since the rand depreciates over the longer term, but is also very volatile, asset allocators approach currency risk very differently.

As a balanced fund investor, it is important to understand the fund’s strategy with regards to managing its offshore currency exposure, separately and distinct from managing offshore asset exposure. Generally, funds have the following avenues available in managing their offshore currency exposure:

Move Your Money

The first method is to simply move capital between local and offshore markets. The decision to purchase or sell currency is the same as buying or selling offshore assets. This can lead to slippage in the portfolio as assets at a reasonable value may not be available at the time that the currency is attractive to trade. Alternatively, assets might be sold at depressed prices at a time when the currency is attractive to trade.

Hedge Your Money

To avoid this situation, asset allocators split the timing of the currency trade and the asset trade. They will increase or decrease their offshore exposure using currency derivatives and then wait for an opportune time to purchase or sell the underlying offshore assets.

Lock in Your Money

Another aspect to currency hedging is that it allows for the inclusion of assets in portfolios which would otherwise have been avoided from a risk perspective. Income or conservative balanced funds, for example, cannot stomach the exchange rate volatility of offshore fixed income assets. By hedging out the exchange rate risk, a portfolio can purchase attractive and high yielding fixed interest instruments outside of the normal South African universe and eliminate exchange rate volatility to the fund.

As an example, if offshore bank paper is priced at a spread 4% above Libor (the London Inter-bank Offered Rate), by hedging that into rand the investor is earning 4% above the local money market without any currency risk. From an income fund perspective, the certainty of the performance is more important than the potential of outperformance that unhedged currency exposure might provide.

Protect your money

Prescient’s preferred method to protect a portfolio from currency downside risk is through the use of currency options. This allows the payoff profile of the currency to be changed to limit the downside while allowing partial upside participation, should the currency depreciate.

Because the purchase of currency option protection requires a premium to be paid – a cost to the portfolio -, an investor needs to be cognisant of the price and look for ways to reduce it.

As an example, at the peak of the Nenegate crisis in January 2016, with the rand trading at an exchange rate of above R16 to the dollar, option volatility was exceptionally high and the purchase of protection on the exchange rate was expensive (i.e. protecting the value of offshore assets against rand strength while still profiting from potential rand weakness). However, capping your offshore currency exchange rate to R21 to the dollar by selling options at R21 would have completely funded the cost (i.e. allowed the portfolio to profit from rand weakness up to R21 to the dollar but also protect against rand strength). This was possible purely because the price of options at R21 to the dollar was even more extreme, a function of market sentiment that the expectation that the rand would weaken even further. This strategy is shown as the red line in the chart below. This provided good upside and limited the downside, all at zero cost to the portfolio.

Implementing a currency protection strategy under current market conditions is less favourable. The blue line, also at zero cost, protects the portfolio against 10% of rand strength, but allows for a 15% gain from rand weakness before gains from further weakness are capped out. The green line balances the need for sufficient potential upside against the need for capital protection.

The above examples illustrates the need to dynamically evaluate the currency option strategy relative to market conditions and tailor the approach accordingly.

Offshore exposure in sheep’s clothing

Lastly, one other way to gain offshore exposure is in the type of local equity that a fund chooses to purchase. A significant portion of our listed market generates its revenue in dollars while costs are local. For example, resource counters sell platinum for dollars, but pay their costs in rand. Over time the devaluation of the rand will boost their revenue line as they receive the same amount of dollars, but more rand, assuming a constant dollar platinum price. The market is well aware of this and shares with large offshore sensitivity to their earnings move in line with significant moves in the exchange rate. Therefore, a portfolio can have significant embedded currency risk depending on the local equity selection over and above the offshore exposure held in the portfolio.

Conclusion

When investing in a balanced fund, take some time to understand the nature of the currency operations that the fund engages in as that will have an impact on the future upside and downside risks to fund. Currency decisions need to be taken in line with the overall risk and return objectives of the fund.