Savvy investors understand that one of the biggest risk factors in their portfolio is their domestic currency. This is particularly important in the UK where the equity market is dominated by foreign companies, the value of whose overseas operations declines when sterling strengthens.
“This domestic country risk is very hard to manage, given that one’s personal wealth is usually highly dependent on the domestic economy,” he says. “Anyone holding significant foreign assets around the time of the EU referendum realized the benefits of currency diversification and would have benefited from a significant bounce in foreign currency values.”
Currency moves can overwhelm the underlying assets, which can be particularly acute in the case of a bond portfolio given the lower average volatility of bond prices relative to equities. Currency planning is less important for equity portfolios, but if managed properly can still significantly improve their risk efficiency.
According to Nick Peters, portfolio manager multi asset at Fidelity International, currencies can be a fertile hunting ground for investment ideas, particularly over the past few years when asset classes have been more closely correlated and often been the primary outlet for differences across economies.
Old Mutual Global Investors’ fixed income portfolios use currencies as a potential source of return, only holding active currency risk when desired and hedging out all other currency exposures into the base currency or benchmark positions.
“We classify currency markets as an asset class alongside corporate bonds, emerging markets and government bonds in our multi-sector fixed income portfolios,” says Mark Nash, head of global bonds and manager of the Old Mutual Strategic Absolute Return Bond Fund.
The firm views FX as an important source of active returns in the future, postulating that as the global economy recovers from the financial crisis, volatility in FX markets will rise as correlations in economic fundamentals start to break down between economic areas.
“Growth inflation and monetary policy converged to extreme levels post the global financial crisis as the shock to the global economy was so great and widespread,” adds Nash. “As reflation traction builds and the global economy gains momentum, this should change and economies and monetary policies will diverge once again. This should increase opportunity for investors to create value in FX in global macro funds.”
Darbyshire suggests a complete ‘normalization’ of sterling would knock about two years’ worth of expected returns from a balanced, multi-asset portfolio with few options around for recovering that sort of loss. For this reason he is only running a small allocation to foreign currencies and (specifically to address the risk of a sudden normalization in sterling) holding call options on the GBP/USD exchange rate, which would produce a significant positive return in the event of a sudden lurch upwards in the UK currency.
Experts have previously told Euromoney that fund managers may be dramatically underestimating the level of risk they are taking, and Peters accepts that many investment managers simply ignore currency risk with a view that it will come out in the wash over the long run. One of the reasons for this is that hedging can entail costs, as well as being an imprecise exercise.
Long-only equity managers quite often fit this profile since their currency bets may be implicit in the country bets they are taking and the volatility of the currencies is often thought of as secondary to the volatility of the country bets or stock specifics.
|Ray Uy, Invesco|
However, Ray Uy, head of macro research and currency portfolio management at Invesco Fixed Income, says analysis incorporating the features of the local currency exposures, asset markets and how these risks correlate to the base currency and interact during periods of volatility are standard components of any decent currency management risk framework.
“Additionally, our approach incorporates a schedule of daily stress tests and scenario analysis that calculates the impact on portfolios of a range of adverse market conditions, which include currency fluctuations,” he says.
Uy observes that his firm’s active portfolio management process renders events such as the surprise outcome of this year's UK general election ‘business as usual’ items.
“The acuteness of the market reaction to Brexit and Trump’s election victory rendered most strategies useless in terms of managing portfolios around those specific outcomes,” he adds. “We believe it is more important to focus on strategic macro portfolio exposures over individual events.”