Conscious Currency™: helping to meet the challenge of currency market risk
range of different foods contain high fructose corn syrup. I’m not concerned here whether or not this is a good idea – rather I will only call attention to the ubiquity of the ingredient. Put simply, there’s high fructose corn syrup everywhere.
Currency is as ubiquitous. Often it can sound like currency isn’t a major part of the investment process. Investors might say, for example, “No, I’m not invested in currency because I don’t believe in active FXUUHQF\ PDQDJHPHQWµ ² EXW \RX WKHQ RIWHQ ÀQG RXW that the same investor is entirely unhedged in their broader international portfolio. Needless to say that investor is well and truly invested in currency!
There are three main ways that currency affects the portfolio.
7KH ÀUVW LV WKH PRVW REYLRXV RQH LI WKH investor has hired an active currency manager, they have an exposure WR FXUUHQF\ , FDOO WKLV WKH ÀYH SHUFHQW RI WKH ÀYH SHUFHQW issue. It’s likely to be a small allocation within a small allocation to alternative assets in the portfolio. Often these managers will have an absolute return target and will be expected to trade on strong opinions. There is ongoing debate over whether or not managers can add value with this type of mandate; Russell’s view on that issue has been broadly that they can, although manager selection is, RI FRXUVH YLWDO 7KLV ÀUVW W\SH of exposure, then, is certainly currency exposure, but it’s typically very small relative to the total size of the fund.
The second way that currency affects the portfolio LV DOVR D IDLUO\ REYLRXV RQH LQYHVWRUV PD\ FRQVLGHU whether or not to hedge the international assets in their portfolio. What’s interesting about this is that the decision is usually presented in this way – “Should I hedge the exposure I have?” The currency exposure inherited from the range of international exposures that the investor has adopted is regarded as the default starting point, and the decision whether or not to hedge is posed as a decision to alter those exposures in aggregate. So, an investor with twice the exposure to the yen than to sterling who decides to hedge will keep the relative size
26 Currency Investor | Autumn 2011
of these positions the same, but simply reduce the total size of their exposure to currency in aggregate. Why have these positions as the starting point for the conversation? Because that’s what comes out of the modeling exercise that they complete when constructing their strategic asset allocation if they use unhedged benchmarks. We’ll come back to that point in a minute, but for now, what’s important is that this “should I hedge my existing exposures” is certainly an important way that currency can affect the portfolio, and typically a much larger source of FXUUHQF\ H[SRVXUH WKDQ WKH ÀUVW ZD\ LGHQWLÀHG
The third way that currency affects the portfolio is implied above. In our industry we’re often at the mercy of the way that we describe the tools that we use. When we model the world using what are called “unhedged” international benchmarks ZKHWKHU WKH\·UH IRU HTXLW\ À[HG income or other asset classes) it can be easy to forget what these really represent. We will typically describe an unhedged international equity benchmark just using the phrase “international equity,” assuming that the currency component of it is irrelevant. But of
course that’s just not correct. In reality the return of an
“unhedged international equity”
benchmark is the combined return RI WZR HTXDOO\ VL]HG H[SRVXUHV DQ exposure to the foreign equity and an exposure to foreign currency.
These exposures are exactly the same size, and every piece of that equity portfolio is subject to exchange rate
risk. In fact, we would be just as accurate to label these benchmarks “currency based on the equity market,” ´FXUUHQF\ EDVHG RQ WKH À[HG LQFRPH PDUNHW µ “currency based on the real estate market” and so on. Now, this is important for two reasons. First, it shows the degree to which currency (like high fructose corn syrup!) is embedded in almost everything that we use to make the most basic decisions. Second, it means that currency is affecting (and distorting) our approach to the different international asset markets. Not only are we getting currency in multiple different ways in our modeling, but by doing that we’re also failing to get a clear picture of the other asset classes to which we might choose to be exposed.
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