Feature | Currency hedging
investment firm and is now in line for a £1m bonus. Ironically, prominent remain campaigner Gina Miller could
also be
accused of profiting from the falling pound. Her similarly named investment firm SCM Direct is also exposed to US dollar-denomi- nated investment funds, whose returns will receive a boost from the falling pound. Most institutional investors in the UK, who have reaped the rewards of the growing internationalisation of their portfolios, have probably recorded the same benefit. By the middle of this year, institutional investors in the UK had 15% of their portfo- lio invested in non-domestic equities, which is more than double their allocation to UK stocks, which trail far behind at 6%, according to Mercer’s latest asset allocation survey. Returns from investments in foreign cur- rencies increase in value thanks to a weaker pound. For exam- ple, while the S&P 500 has returned 48.2% in US dollar terms since July 2016, it has returned 61.8% in sterling terms, according to Quilter Investors. Even sectors which produced a loss in US dollars, such as local currency emerg- ing market stocks which reported a -6.68% decline in the past year, booked a positive return in sterling terms of around 3%, Quilter Investors’ research shows.
forex data provider New Change FX. He argues that despite growing trading vol- umes, FX continues to hold a subordinate role in portfolios. “Forex cash-flows are considered to be a back-office function, rather than a key factor in determining costs and as an asset to be sold in the mar- ketplace,” Woolmer says. “Banks, traders and brokers spend millions to ensure that they profit from this negligence.” To make his point, he uses the theoretical example of a bank’s balance sheet showing that 20% of its profits are based on forex transactions. “These profits are rarely a result of taking trading risk, but rather come directly from the pockets of the una- ware” Woolmer says.
These “pockets of the unaware” belong to the investors who, either in the absence of detailed data on transaction costs or due to
ties currency movements might offer. So far, the most popular strategy to fend of exchange rate risks is a passive currency hedge where investors hedge a set percent- age of currency risk in their portfolio, regardless of changes to currency markets. One scheme which has pursued this strategy since 2006 is the National Grid Pension
Scheme, which manages its
exchange rate risks on foreign investments by maintaining cross-currency swaps and foreign exchange forwards to offset any changes in currency movements. However, while the strategy offers the merits of cut- ting costs and reducing uncertainty, it also means that the scheme is giving up on the short-term rewards brought by the falling pound.
The key difference between active and pas- sive currency management is essentially
These profits are rarely a result of taking
trading risk, but rather come directly from the pockets of the unaware. Andrew Woolmer, New Change FX
ROOM FOR IMPROVEMENT Despite the growing volatility in forex mar- kets, institutional investors in the UK remain cautious to adopt the strategy. While the majority have hedged at least half of their foreign equity exposure against currency risks, more than a third of inves- tors have not sought to protect themselves from the exchange rate risk they are carry- ing, according to Mercer.
As investment portfolios are becoming increasingly international, efficient execu- tion mechanisms are needed to prevent unnecessary transaction costs. And there is still a lot of room for improvement, accord- ing to Andrew Woolmer, chief executive of
a lack of understanding, end up paying the costs of poor currency management, ac- cording to Woolmer, who adds that varia- tion in pricing levels can be significant. “The most competitive market participants pay transaction costs of between $2 to $10 per $1m, and $10 is considered high. How- ever, we regularly watch market partici- pants incur transaction costs of $500 per $1m,” Woolmer says. “Although Mifid II creates a certain degree of transparency, it does not explicitly require a transaction cost analysis, which obscures the problem,” he adds.
RISK FACTORS REVERSED
The falling pound has flipped around the traditional understanding of currency risk, which focussed on the adverse effects of a fall in foreign currencies. Instead, investors are increasingly looking at the opportuni-
48 | portfolio institutional | October 2019 | issue 87
the level of flexibility to adjust hedging lev- els, with active hedging strategies respond- ing more dynamically to market move- ments. Nevertheless, there are also significant similarities. In both cases, the added value lies in pooling the administra- tive services with a single external provider, which allows investors to cut back on trans- action costs whilst benefiting from a net- ting effect and lower collateral costs. So a passive currency hedge does have its merits, according to Achim Walde, senior currency manager at German private bank Metzler, who estimates that investors could save up to 50 basis points by hedging their currency risks passively.
ACTIVE OPPORTUNITIES But demand for more active approaches to currency management is growing. Adviso- ry firm Bfinance identified three trends
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