In January, the removal of the cap for the Swiss franc saw the currency rise almost 40% in a single day.
The impact on Swiss stock and bond markets was profound and immediate. The Swiss stock market sold off by 8.7% on the day after the announcement (16 January) and a further 6% the following day, while the yield on the 10-year government bond turned negative. It was a stark reminder of the caprices of the currency market and the potential effect on investment returns.
Hedge of reason
Investors had already been contending with the steep rise in the dollar, as growth in (still) the world’s largest economy leapt ahead of its developed market peers. This has been good news for those without hedging.
In contrast, those investing in Europe who had remained unhedged saw the value of their gains eroded by the weakness of the currency.
Until relatively recently, Japan remained the key area where currency significantly influenced investment returns. ‘Abenomics’ in Japan has among its goals lowering the currency and encouraging investment in the stock market. Investors without hedging therefore found themselves losing anything they gained in stock market returns in the declining currency.
Their only option to participate in climbing stock markets was to hedge the currency at the same time.
Many are predicting greater volatility in currency markets in 2015. Monetary policy between countries is diverging, with the Federal Reserve and Bank of England possibly on the cusp of raising rates and the European Central Bank having introduced monetary easing.
After years of a ‘race to the bottom’ in currency markets, some currencies – notably the dollar – are likely to retain strength, which will impact investor returns.
James Stanton from deVere Group, suggests the Swiss move in itself may prompt its own currency war. He points out that the Swiss Central Bank action was entirely unexpected, and says the enormity of the change could create turbulence in currency markets for some time.
The Swiss move appears to be a reaction to plans for quantitative easing in the eurozone. Eric Chaney, head of the research and investment strategy team at Axa Investment Managers, says: “We think the Swiss Central Bank considers the downside risk to the euro/dollar significant, with the possibility of parity reached before year-end.
“This would have damaged the attractiveness of Switzerland as a financial safe haven for savers from the wider dollar zone, had the CHF/euro peg been upheld.”
A volatile sector
There are signs that wealth managers are increasingly turning their attention to the problem, aware that currency could have a profound impact on investment returns. However, many recognise currency markets are unpredictable and that taking large positions can be fraught with danger.
Petronella West, director of private clients at Investment Quorum, says: “As the Swiss franc example showed, currency positions can turn against you very quickly. We have clients who took out euro mortgages at the height of euro weakness against sterling, and have found them cripplingly expensive subsequently.
“Currencies are under the control of central governments, whose agenda is not the same as investors. As is often said, it does not pay to fight the Fed.”
Andrew Wilson, head of investment at Towry, agrees that investors need to have a good reason for introducing any currency positions into a portfolio:
“In certain circumstances an investor may wish to buy a currency hedged share class of a mutual fund to, say, capture the return from Japanese equities but without the influence of fluctuations in the yen.”
He adds: “Usually one would needa very strong opinion to do this, as it is unlikely that an individual would know anything that the market in aggregate does not, and hence is not already priced in.
“Furthermore, there are, famously, three rules for forecasting currencies: ‘you can’t, you can’t and you can’t.’ This may ring true for anyone who was short the Swiss franc recently, for example.”
That said, despite the difficulty in predicting currency, wealth managers investing in global stock markets have to make a decision, to some extent, on behalf of their clients. West says that where it is clear what is driving the currency – such as in Japan – Investment Quorum is happy to buy a hedged version of funds.
For example, last year, it bought the Jupiter Japan Income fund on behalf of clients. The hedging of the yen has seen the fund significantly outperform this year. West was comfortable with this position because the Bank of Japan had specifically stated that it would intervene to weaken the currency.
Thin end of the hedge
Otherwise, she says wealth managers may risk ‘double-hedging’, whereby the wealth manager counter-balances the hedging taken by a fund manager.
She explains: “Most of our investors are sterling-based and need to be considering a sterling outcome. Too much currency fluctuation introduces a lot of risk. If you were hedged in the dollar last year, you would have lost out on much of the large return available on the S&P and Dow, but it could quite easily have gone the other way. You need to be careful on hedging on funds and be sure on the outlook for the currency.”
Wilson says the group takes account of currency when investing in any asset class, but the emphasis is on making sure clients have a spread and are not inappropriately exposed to any individual currency.
He says: “Most investors know that they should diversify by asset class and sector, and the same holds true for currency. One should not want to be entirely exposed to a single currency, especially given the levels of government debt in the developed world. Sterling, for instance, quickly lost 25% in 2007/8. Large and unforeseeable events happen far more frequently than one might think.
“The best way of hedging the volatility of currencies is to have exposure to many of them. The quickest way to increase your risk, and portfolio volatility, is to simply hedge everything back to one single currency. At Towry we have been overweight US assets for some years, not just because they were attractive, but because we also saw the dollar as ‘the last great diversifier’, which enhanced the efficacy of the position for us.”
For Towry, currency is part of the overall return, so the team does not hedge as such, but takes account of currency positioning and aims to capture the diversifying properties, even taking advantage of large moves. They might take profits in one sector and add to an underperformer, for example.
The only area where they would consistently undertake currency hedging would be in alternative strategies, where the aim is to obtain alpha, striving to capture the pure skill of the manager rather than any other type of return. In this area, a residual currency impact would be unwelcome.
Finally, Wilson believes it is acceptable to hedge currency exposure in a corporate bond fund. This is where a manager may see value in an overseas credit, but where the yield advantage could be wiped out quickly by an unfavourable currency move, which was not part of the investment thesis, and can be safely hedged away.
Art of exposure
Wealth managers take currency exposures in different ways, with relatively few using straight foreign exchange transactions. David Coombs, head of multi-asset investments at Rathbone Unit Trust Management, for example, has increased his dollar exposure though investment in US Treasuries.
Marcus Brookes, head of multimanager at Schroders, takes his exposure in a number of ways.
Notably, he has used some of the increasing range of currency ETFs that are on offer.
Last year, for example, he invested in a 2x leveraged ETF that was short the euro and long the dollar. This has made around 18% over the past 12 months. These ETFs are more readily available in the US, where there are now around 40 listed.
The most common means to hedge currency remains using hedged share classes but this has limitations.
Darius McDermott, managing director at Chelsea Financial Services, says: “We believe that quantitative easing in Europe is likely to see a weakening in the euro, so investors should really be looking to hedged share classes. However, it is very difficult to find hedged share classes for European funds – there is only a limited choice. There are a lot of hedged share classes for Japanese or US funds, but it is more difficult for other currencies.”
That said, ETF providers are increasingly recognising the problem and issuing hedged share classes, though this makes them marginally more expensive.
There are also a number of dedicated currency funds. These are not used for hedging strategies, but to deliver a return that is not correlated to standard equities. They tend to focus on exploiting differences between currencies rather than being, say, overweight the yen or euro.
Coombs has recently taken exposure to traded currency funds. He says: “There is likely to be a lot of volatility in currency markets. We want to be invested with those managers that are in a position to take advantage.”
According to Morningstar, performance between these funds varies significantly: The Swiss franc version of the GAM Star Discretionary
FX fund is up around 40% over the past year. Other strong funds were the RWC Core Plus fund, the Investec Global Strategy Fund Emerging Markets Currency Alpha fund and the GS Global Currency Portfolio, but the euro version of the Pictet Global Emerging Currencies fund dipped 17% over the same period.
Currencies are undoubtedly complex and unpredictable. Nevertheless, it can pay not to fight the machinations of central banks, and wealth managers looking at global investments may need to form a view on currency as state-sponsored manipulation of currency markets continues.
In this case, wealth managers are ensuring that currency fluctuations do not ‘get in the way’ of the real return from an individual stock market.