April 2010

FOREIGN EXCHANGE: Riding the storm

With currencies set for a tumultuous time, Nick Fitzpatrick looks at how currency transactions can be made more efficient through hedging exchange rate risk and a tighter focus on dealing...
storm.jpgWhile economies try to avoid heading back to recession, currencies are set to remain unsettled. Sovereign risk in Europe, a devaluing pound and mounting pressure on China to appreciate the renminbi against the dollar are some of the factors behind currency volatility.

It is little surprise, then, that some fund houses are highlighting their abilities to minimise the currency risk that is present in international equity and bond portfolios.

Investec Asset Management, for example, recently said ‘active currency overlay’ in its Multi-Asset Protector Fund, launched in the UK last year, shielded the fund when sterling rallied by 23% against the dollar between March and July 2009. A 23% rally in sterling against the dollar could have significantly hurt sterling investors if they had cashed in dollar-based investments at the time.

Currency overlay is where fund managers use derivatives to try and hedge out foreign exchange risk that could otherwise devalue portfolios. Hedging can be either passive or active. Active overlay seeks to make extra returns from currencies as well as neutralise exchange-rate risks.

Last month AllianceBernstein introduced a euro-hedged share class to its global high yield portfolio to help euro-based investors reduce their currency risk. Using various hedging techniques to try and reduce fluctuations between the euro and the portfolio’s base currency, the goal is to provide a return more closely correlated with the portfolio currency.

Arif Husain, director of UK and European fixed income at AllianceBernstein, says: “Investors’ experience of investing in global high-yield securities can be quite different depending on their base investment currency and whether or not they have hedged that risk. For euro-based investors, the strength of the euro has meant that returns have been less compelling compared with those for a US dollar-based investor or an investor who hedged that currency risk.”

Fund managers expect fluctuating currencies to be a challenge for returns in the coming months. Referring to the Greek debt episode, Ian Edmonds, portfolio manager at the Legg Mason Western Asset Global Multi Strategy Fund, said recently: “We expect to see more currency volatility going forward than we have seen in the last decade or so for the same reasons that are causing sovereign volatility.”

A heightened awareness of sovereign risk in Europe is one reason for the recent weaknesses in the euro and sterling, say Quentin Fitzsimmons and Peter Allwright, fund managers of the Threadneedle Absolute Return Bond Fund. 

This is because concerns over Greece’s ability to service its debt have spilled over into other over-leveraged peripheral European economies such as Portugal and Spain, as well as the UK, they say.

The managers note that at the start of the year the US dollar was seen as a high-risk currency and, as a result, it was weak on the foreign exchange markets. It remains weak against a number of emerging market and commodity currencies, but there has been a turn against the euro and sterling, which are seen today as the higher risk currencies.  Fitzsimmons and Allwright believe the dollar could remain strong against the euro and the pound over the next few months.

At Insight Investment Management, Dale Thomas, head of currency, explains that the firm treats currency risk as a standalone risk alongside other factors such as duration risk. Insight typically uses foreign exchange forward contracts rather than futures or options to hedge out currency risk in its fixed income portfolios. Forwards are cheaper and more transparent, he says.

Demand from pension funds
Thomas adds that pension funds are increasingly asking for currency hedging, usually as part of a liability-driven investment (LDI) strategy, which has been a key driver of Insight’s fixed income business.

“Clients want investment managers to minimise the various risks that pension funds face and they are increasingly asking us to hedge out currency risk from synthetic equities. Often clients will have synthetic equity exposure in an LDI strategy.”

Historically, pension fund trustees have tended to panic when a currency gets weak or strong and hedge at the top or bottom of the market, Thomas says.

He believes the medium-term currency trend will see the four majors – the dollar, euro, pound and yen – weaken and for there to be a relative misvaluation of the pound against the others.

“If you look at how cheap one currency is to another it normally doesn’t matter, but at the moment sterling is as cheap as it’s ever been. As the European economy does not look like it has an advantage over the UK
you would expect the pound to recover relative to Europe.”

Specialist currency hedging firms, like Record Treasury Management in the UK, have promoted the benefits of currency hedging in recent years. Record was founded by Neil Record, a former Bank of England economist, in 1983 and now manages around $35.7bn (€26.5bns), for clients in the UK, Europe and North America.

Not all fund managers always see currency hedging as a necessity, however. The UK-listed JP Morgan Brazil Investment Trust, launched in March, will aim to have 25 to 50 equity holdings with no hedging of currency exposure.

Claire Simmonds, client portfolio manager for emerging markets at JP Morgan Asset Management (JPMAM), said this was because the managers were confident enough that growth from the portfolio will be substantial enough to not hedge Brazil’s real.

“We do not hedge currencies across any emerging market portfolio, partly because it is still very expensive, especially if you get it wrong.

“We incorporate our view of currencies in the overall expected return.”

She adds that over the longer term, JPMAM expects the Brazilian real to trend towards fair value and that investors in the Brazil trust should take at least a five-year view.

Nick Beecroft, a senior foreign exchange consultant for Saxo Bank, says the current environment should entail a large amount of currency hedging by fund managers. However, he is slightly sympathetic towards fund managers that do not hedge currencies as long as they have strong reasons for it.

“High-interest-rate currencies like the Brazilian real cost more to sell for forward delivery,” he says.

“So if the underlying equities are volatile and a manager believes equities will rise 30% while exchange rates rise by just 5%, then there may be a case for not hedging.”

Emerging market currencies are expected to gain in value relative to developed currencies, partly as global investors buy currency to support their increased equity and bond investments in the emerging world. A number of managers, including Investec and Record, have or plan emerging market currency funds to benefit from this.

Vital trades
As investors take more risk through greater overseas allocations, foreign exchange trades will inevitably increase, perhaps driving the currency market, which is already the largest financial market globally, to new heights. Much of the currency market is driven by transactions vital to business and economic life rather than by investment managers and traders looking for returns out of currency movements. Currency funds seek to benefit from rising and falling relative prices between currency pairs.

But the biggest beneficiaries are the brokers and a lazy eye on them can erode gains.

The London office of Russell Investments, a US multi-manager, estimates that poor foreign exchange transactions can cost investment managers 18 to 24 basis points. Russell’s own global equities funds and those of its clients saved $50m in the five years to November 30, 2009, due to a currency service it offers as part of an investment implementation service.

Basis points lost to brokers or because of macro-based currency swings have been overlooked by many investors in the past. However, driven by pension fund sponsors, things may be changing. Ian Battye, managing director for implementation services at Russell Investments, says that a recent seminar Russell hosted for US pension fund clients attracted 50 participants. 

“Fifty public pension funds logged in to our webcast. I don’t think there would have been that number a couple of years ago,” he says.

So what has changed? Battye feels greater regulatory pressure for better pension fund governance in the US was behind the enthusiastic turnout.

“The increased interest was probably more to do with compliance and governance factors because a lot of US pension plans have to deliver best execution,” he says.

In Europe, the Markets in Financial Instruments Directive (Mifid) compels investors to obtain best execution, but Battye says he is surprised that Mifid has not given the same momentum to foreign exchange as it has to equities.

However, Roy Saadon, cofounder of Traiana, a post-trade processing firm, says Mifid did make some fund managers aware that when they trade cross-border they could be giving some of the return away in currency broker fees.

“We see a lot of asset managers now opening foreign exchange desks to seek alpha. They are starting to look at EMS [execution management systems] for foreign exchange or extending their equity EMS to currencies for best execution.”

A development like this would certainly be timely as currencies become a vessel for all the economic uncertainties pervading markets. For example, on 1 March sterling dipped below the important psychological level of $1.50 after concerns around UK debt levels.

Mark O’Sullivan, director of dealing at Currencies Direct, says: “The markets need convincing that UK debt can be reduced.

“But as the pound drops, the currency markets appear to have run out of patience. Sterling could be staring over the edge of the abyss.”

©2010 funds europe

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