Traditionally, the biggest selling point most fx managers had was the non-correlation of their strategies to traditional assets. We believe that with the appropriate strategy fx investments offer a good risk/return profile for investors. More so in our current environment where central banks have been flooding markets with large quantities of their currencies and suppressing interest rates and yields.
Look outside domestic currency
The other reason we feel investors need to be aware of the fx market is over the past few years we’ve seen how crises ranging from sub-prime in the US, to European debt can have far-reaching effects.
More than in the past investors will need to understand potential safe havens for their money outside their own currency. We’ve seen many Greek citizens (well those who can), remove deposits from their own banking sector to safeguard in Swiss bank accounts, prompting decisions by the Swiss National Bank to quell the rise of the Swiss franc.
Another consideration is the effect of quantitative easing forcing yields so low that investors are looking elsewhere such as emerging markets either via equities or bonds and forcing foreign exchange to be considered in the investment process.
We believe a greater asset allocation to fx would better suit investors than the traditional investments within domestic equities or bonds.
What about hedging currency risk?
Generally it has been thought, especially in fast growing economies, that hedging moves in the fx market results in lower overall returns. We calculate a 250bp divergence between dollar-denominated debt and emerging market debt in local currency. A strong, fast-growing, export-driven economy will tend to result in demand for such currency, if nothing else, via importers of such goods.
Manager selection key
This will cause the currency to increase, unless it’s pegged against other major currencies. What currency hedging allows an investor to do is to reduce uncertainty over potential returns from investments/assets in other countries.
We believe that if an investor is primarily interested in short-term investment within a specific country, then hedging their fx risk enables them to capture gains due to the asset class they have invested in, without being overwhelmed by potentially large currency swings due to what traders refer to as ‘noise’.
However, the reverse also stands, and an investor with a long-term horizon could benefit more from having an unhedged exposure.
Factors such as the cost of implementing the hedge and ongoing costs related to currency moves need to be factored, and this especially becomes a rather expensive and cumbersome exercise if the numbers requiring hedging are large (notice certain custodian banks having charged on average 10 pips per trade despite market liquidity being available for two to three pips).
Investors also tend to hedge during periods of extreme fear which is usually the turning point in the markets. A smart investor may also have a particularly strong view about the direction of a currency move and thus in certain circumstances may feel a hedge is worthwhile, while in other circumstances feel that it isn’t.
This can potentially generate further returns, although the double-edged sword is that a poor manager may reduce returns with bad hedging and speculating decisions.
