As asset managers and asset owners grapple with multiple industry challenges, a growing number are considering entrusting their currency management to a third party. But what factors should they consider when delegating this key function?
In a webinar hosted by Funds Europe, Andy Lemon of Northern Trust and Alex Dunegan of Lumint Corporation describe the drivers for delegating currency management, the sophisticated solution services available and how this market is expected to develop in 2020 and beyond.
Fund managers and asset owners are becoming increasingly exposed to foreign exchange (FX) risk. Geopolitical uncertainty and changes to monetary policy and interest rates are all contributing to currency fluctuations. Meanwhile, they are also looking further afield to additional markets for both asset allocation and for new investors, exposing them to broader currency risk.
Andy Lemon, Global Head of Currency Management at Northern Trust, says firms are looking closely at their FX hedging practices. With cost and regulatory pressures continuing to squeeze operational margins, many of these firms are considering the use of a third party.
“Asset managers face a perfect storm of regulatory requirements, rising operational costs and reduced fees,” says Lemon. This has led to a third wave of outsourcing where firms are looking beyond back-office processes to front-office functions, including delegating the management of currency volatility. “They are looking at what processes generate alpha or add value and which non-alpha processes could be delegated. For many firms, currency management falls into the latter category.”
There is a range of currency management trading styles and strategies when it comes to hedging currency risk. Three key approaches are portfolio overlay, share class hedging, and look-through hedging. The first, portfolio overlay, is hedging currency risk from assets in a different currency to the fund. The second is share class hedging which focuses on reducing the performance divergence between the non-base currency share classes and the base currency of the fund. The third, look-through hedging, combines elements of both portfolio overlay and share class hedging by hedging the fund’s asset currencies at a share class level.
There are also several costs involved in running your own currency management operation, from hedging and transaction costs to system upgrades to regulatory reporting and legal expenses. However, the rise in currency risk and its impact on investment is arguably the biggest reason for firms delegating currency management, says Alex Dunegan, chief executive of Lumint Corporation.
For example, alongside the aforementioned geopolitical volatility, some of the most popular indexes used by passive investors continue to add new countries and currencies to their equity benchmarks, such as Saudi Arabian stocks and China A shares, which thrusts investors into new currency exposures. “This will continue to be a risk investors want to mitigate,” says Dunegan.
A poll of listeners to the webinar showed the majority (55%) consider risk mitigation to be the biggest driver, compared to cost reduction (27%), while 18% thought these factors combined with growth aspirations and better governance and oversight were equally important.
This is not to say that all managers and asset owners are looking to delegate their currency management, says Lemon. There are, after all, competing priorities and some will feel averse to changing a legacy process because ‘that’s the way we’ve always done it’. Others will not trade FX in a volume large enough to justify outsourcing. Or, conversely, some will feel that FX trading is one of their core competencies.
But should a fund manager or asset owner decide to delegate, what factors should they consider? Dunegan says there are four key things to look for in a third party currency manager – customisation, scale, automation and transparency.
“With hundreds of customer accounts one rarely encounters two that are the same, therefore a currency manager needs the ability to customise rather than impose a one-size-fits-all currency programme. And, without automation, you are increasing the operational risk of manual processing and trade errors. For example, with mutual fund investing, it is rare that you trade a significant portion of the portfolio on any given day but with FX, the positions can be very concentrated, heightening the risk in currency management from trade errors,” says Dunegan.
“Scale is important too. If you have an international client base, you want to be able to add overseas customers without delay. Lastly, you want transparency so that asset managers and owners can effectively evaluate the performance of their currency managers,” says Dunegan.
Technology advancements have helped to make FX delegation a more feasible option for fund managers and asset owners, says Lemon. “It’s really about risk reduction and scalability. In a more complex market, you need greater governance and oversight. Technology and innovation will be key to helping reduce risk as well as generating scale through automation and managing the cost pressures.
“The emergence of machine learning and artificial intelligence will help with this. As these technologies develop, we will see greater use along with more use of automated analytics and data visualisation, especially as oversight becomes more important,” says Lemon.
A second poll in the webinar revealed that over half of respondents (54%) are considering delegation in the next 24 months while almost a third (32%) have already done so. But, says Lemon, it’s looking like we are at a tipping point. “Even the firms that have already delegated, have to ensure they have delegated to the right provider and are getting the right results.”
More competition is likely and this could lead to further price reduction, says Lemon. But fund managers and asset owners should not be swayed by providers purely offering less cost than their competitors, he warns. “For providers, it is about ensuring scale and a robust operating model. But for fund managers, it is not just about picking the lowest cost provider because any mistakes will have a large reputational impact on them.”
For fund managers and asset owners considering delegation, Lemon urges them to approach the issue with their eyes open and prepared to do the due diligence. “They should be aware of the risks involved in keeping the process in-house and know what risk management processes they have in place – how is it recorded and how effective has it been in the past?
“And should you decide to delegate, are you confident that your chosen provider can handle the process and can support your growth ambitions? If this goes wrong, it will affect your reputation. You have to look at the broad implications and not just the provider with the cheapest quote. You have to look thoroughly at the risk of delegating and the risk of keeping it in-house.”
“It is not simply about cost reduction. You will still be accountable to investors and regulators so make sure you have done enough due diligence to give comfort that the provider has enough experience and expertise to deliver,” says Lemon.
You can watch the webinar on demand on Funds Europe’s Webinars Channel.
This communication is issued and approved for distribution in the United Kingdom and European Economic Area by The Northern Trust Company, London Branch (‘TNTC’) or Northern Trust Global Services SE (‘NTGS SE’). TNTC is authorised and regulated by the Federal Reserve Board; authorised by the Prudential Regulation Authority; subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. NTGS SE is authorised by the European Central Bank and subject to the prudential supervision of the European Central Bank and the Luxembourg Commission de Surveillance du Secteur Financier.
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