CURRENCY MANAGEMENT
investors who are prepared to suffer on the losing enG RI D FXUUHQF\ PRYHPHQW IRU ÀYH VHYHQ RU years without beginning to reconsider their behavior. In reality, then, while most investors aren’t short-term (in the sense of changing their view every quarter) they are certainly not long-term (as they’ll certainly look at annual performance, and will often make the decision to change behavior based on the results they achieve over three years).
The point I’m making here isn’t that this relatively shorter term focus is a bad thing necessarily – it’s not. When you’re talking about 10- or 15-year trends LW·V YHU\ GLIÀFXOW WR VD\ \RX VKRXOG MXVW VLW WLJKW IRU all 10 or 15 years on the losing side of the trend. Regulations and prudential expectations would actually make a very long-term view on many issues challenging. In the U.S. we saw the introduction of WKH 3HQVLRQ 3URWHFWLRQ $FW VLJQLÀFDQWO\ reduce the timeframe of data that investors are allowed to use when determining whether or not to make a contribution. Manager assessment also works on shorter timeframes. Most LQYHVWPHQW PDQDJHUV ZLWK ÀYH \HDUV of poor returns are likely to feel very vulnerable with many of their clients.
Instead, we should recognize that most or all investors are not in the very long-term category when it comes to dealing with currency risk, and adjust our assumptions accordingly. When thinking about hedging, the idea that “it all comes out in the wash over the long-term” becomes irrelevant. Put simply – even if it all comes RXW LQ WKH ZDVK RYHU WKH ORQJ WHUP \RX GRQ·W EHQHÀW from that long-term if you’ve changed your policy in the short- to medium-term.
If we take this as our starting point the decision becomes easier to understand. The cost of running a hedge for an institutional investor (or for a fund manager managing retail money in the form of a unit trust or mutual fund) may be between eight and ten basis points per annum (based on our experience at Russell providing this type of service). With currency volatility typically running between 10 percent and 15 percent per annum based on standard market measures, the portfolio only needs to have a very small amount of exposure to make it more effective simply to eliminate that currency risk using a hedge.
So, while the chart above seems very clear and helpful, it turns out to not be of much use. There are no (or almost no) true long-term investors in the relevant terms, and once investors have any substantive exposure to currency at all, the logic of the assumptions would drive them towards fully removing that risk.
Rather than assuming that currency
exposures “fall out” of other exposures, or that currency
managers should be
assessed in a vacuum, Conscious Currency™ recognizes that
currency is a stand-
alone opportunity set, and that the decision to take on currency risk should be taken rationally and explicitly.
But what we do know is that many investors remain exposed to currency markets, and that while investors often incant the words “currency markets are totally random and all come out in the wash” they will often then spend huge amounts of time and energy trying to make forecasts for a number of those currencies. There are two possible explanations for this. Either investors are simply foolish or the assumptions underlying the current approach (and therefore the current approach itself) are wrong. In 20 years in the industry I’ve met few fools – and even fewer with real decision-making power. I think the safer
assumption is that investors are identifying a problem with the current standard approach, but simply aren’t yet at the stage of articulating the problem (or its solutions) clearly.
Instead, investors using this standard approach need to set an upper bound of currency exposure above which they’ll want to hedge. And this is where the underlying assumptions behind this chart become important: because the chart is based on a basic assumption that currency behavior is random – and so random that it’s not describable or predictably trending.
But surely risk that is so random that it can’t even EH GHVFULEHG HIIHFWLYHO\ PXVW E\ GHÀQLWLRQ EH uncompensated? The normal approach that we take to uncompensated risk is to make a simple determination of whether the cost of eliminating that risk is greater or less than the cost of exposing ourselves to it.
Currency is like high
fructose corn syrup So, we’ve established that the standard approach, which involves assuming long-term investment horizons and random currency market behavior, doesn’t make sense. To move forward let us look at WKH GLIIHUHQW ZD\V WKDW FXUUHQF\ H[SRVXUH ÀWV LQWR WKH portfolio. I sometimes think of the effect of currency in the portfolio as being rather like the effect of high fructose corn syrup in the food industry. If you spend time looking at the ingredient labels on food packaging you’ll be surprised to see how often a wide
Autumn 2011 | Currency Investor 25
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