Managing currency exposure

Investing internationally introduces an extra layer of risk to any portfolio: namely currency risk. A foreign currency’s performance can significantly affect the return on a portfolio and we shall use Wall Street as an example. In 2007, the S&P 500 index rose 3.7% in local currency terms (USD) as shown in the accompanying graph. If, however, you were a sterling investor, your return would have been slightly lower at 2% due to the weakness of the dollar versus the sterling. However, the euro has been one of the strongest major currencies this year, climbing over 10% against the dollar, and therefore a euro based investor long of the S&P 500 index would have lost nearly 6.5% in euro (currency) terms.

Thus, there are two layers of risk in any foreign investment: the underlying asset holding and the equivalent amount of foreign currency. The foreign currency exposure can be managed using currency forward contracts or options, which effectively convert unhedged returns into hedged returns and in so doing, remove part or all of any currency risk.

To hedge or not to hedge

The majority of ‘relative’ equity funds generally do not participate in currency hedging. The main reason behind this is that the performance of the standard equity fund is usually measured relative to an appropriate benchmark in a particular currency and, hence, a tracking error risk would be introduced if currency hedging were to be adopted. It may be argued, however, that for ‘absolute return’ managers it is vital to control currency risk, as it would be futile, after achieving respectable returns from investing internationally, only to have a large amount of your gains diminished from adverse currency movements. Therefore, one could argue that if currency hedging were to be adopted and managed efficiently, this could not only enhance the returns of a globally invested portfolio but also reduce the risk.

Ashburton’s currency methodology

Ashburton have always taken an active approach to currency management for our absolute return focused funds (Asset Management and more recently our Advanced Portfolio Funds). In doing so, we not only look to reduce the aforementioned risks associated with ‘adverse’ currency movements but treat currencies as a separate asset class and continually look for opportunities to make profits from the foreign exchange market. In order for us to achieve this, we utilise various quantitative and qualitative factors to construct a comprehensive framework which, in turn, provides a more rigorous and disciplined approach to our currency management. These factors are briefly outlined below.

Momentum/trend: Over the short- to medium-term, currencies have strong trending characteristics but are shown to be mean reverting over the very long-term. It is these trending patterns and turning points over the short- to medium-term that we attempt to identify and exploit using technical analysis.

Interest rate differentials: This is an important factor for currency management, for example, when domestic interest rates are low by comparison to foreign rates, the forward price is higher than the spot price and is said to be at a ‘premium’ and expensive to hedge (Japanese investor hedging sterling back to yen). Correspondingly, when domestic interest rates are high, the reverse is true and the forward price is lower than the spot price and is said to be at a ‘discount’ and therefore cheap to hedge (UK investor hedging yen back to sterling). This essentially is what the so called ‘carry trade’ is based upon and involves selling a low yielding currency (yen) and buying a higher yielding one (New Zealand dollar) and has been very much in vogue over the last few years amongst currency speculators.

The yield curve: The shape of the yield curve for any economy has been shown to have an effect on the behaviour of the currency. An inverted yield curve (when short-term interest rates are higher than long-term interest rates) is often associated with a stronger currency as investors are gaining from the higher interest rates over the short-term.

Valuation analysis: We identify if a currency is either cheap or expensive (in relation to other currencies) from its current account position and deviation from its global purchasing power. It is noteworthy to mention that when one’s domestic currency is strong it is very difficult to make additional gains from foreign currencies and vice versa. Hence, it is no surprise that the majority of dollarbased funds in 2007 out-performed their sterling and euro-based counterparts (which own identical assets) due to the weakness of the dollar.

Key Points

• Investing internationally introduces an extra layer of risk to any portfolio. A foreign currency’s performance can significantly affect the return on a portfolio.
• Foreign currency exposure can be managed using currency forward contracts or options, which effectively convert unhedged returns into hedged returns, removing part or all of any currency risk.
• If currency hedging were to be adopted and managed efficiently, this could not only enhance the returns of a globally invested portfolio but also reduce the risk.

In Summary

It is evident that active currency management has an important role in investment management. Most conventional ‘relative’ equity funds take the decision not to hedge and are content to run with any adverse or beneficial currency movements. It may be argued, however, that through judicious use of currency hedging and by treating currencies as an asset class in their own right, an ‘absolute return’ fund may have its returns bolstered and volatility reduced. This is exactly what we are continually striving to achieve for our absolute return focused funds at Ashburton.

By Luke Gale (pictured right), Ashburton