Currency Conundrums
European investors who own foreign stocks and shares have been forced to ride a euro roller coaster this year as Greece’s debt crisis has produced successive waves of currency volatility. When Greek Prime Minister George Papandreou announced last month that he may turn to the International Monetary Fund to alleviate the country’s fiscal problems, the euro dropped 1% against the dollar to $1.36.
With decent investment returns hard to come by at the moment, such movements can really hurt a portfolio’s bottom line. The most cautious investors are beginning to wonder whether they should try and protect themselves from such fluctuations; the more ambitious are looking at ways to take financial advantage of them.
The issue affects different investors in different ways. If you earn your money—from salary, pension or investments—in the same currency that you expect to spend it, then changes in exchange rate need not worry you. But if you are, for example, a European investor with U.S. equity holdings, or are selling a U.K. property to buy a home on the Continent, then currency movements can be expensive.
One way to protect yourself for short periods is to book an exchange rate now using a forward contract. This can be arranged through a broker and you don’t have to take delivery of the cash until you need it.
Alternatively you can buy a currency option, which—like a forward contract—allows you to exchange one currency for another on a future date.
Unlike a forward, and for a slightly higher fee, you can also fix a “worst-case rate” so that you still benefit if the rate moves in your favor.
World First, the foreign-exchange broker, recently said there had been a 57% increase in private individuals using currency options to hedge their foreign-exchange exposure over the previous 12 months.
Forward contracts and options help manage one-off, short-term currency exposure. But for continuous foreign-exchange risk—such as from a portfolio containing international equities—investors may need a longer-term solution.
Some wealth managers are suggesting clients employ currency-overlay specialists who can manage a portfolio’s exposure to currencies with the aim of, hopefully, improving its overall performance.
“Currency overlay is a two-stage process,” says Joe Prendergast, global head of private banking currency and commodity research at Credit Suisse in London. “You start by assessing everything on a fully hedged basis, as the objective in stage one is risk reduction. The second stage is about identifying potential ‘alpha’ generation [active returns above the benchmark], which means, amongst other things, deciding where you want to add currency risk.”
Returns generated by currency managers in this way are usually uncorrelated to traditional bonds and equities, a trait that has become increasingly attractive to investors recovering from the credit crisis.
Alessandro Giubbilei, deputy chief investment officer at Perreard Investments, a currency-overlay boutique in Geneva, says the strategy often involves using systematic, computer-driven models to signal the best time to take advantage of currency moves.
There are two main approaches. Some managers attempt to follow trends in the foreign-exchange markets by looking for patterns in price movements. Alternatively, they can take bets on the relative economic performance of two countries, attempting to profit from the resulting changes in the exchange rate between their currencies.
Not all wealth managers believe that the benefits in adopting these approaches merit the costs. Some advocate living with changes in exchange rates, reasoning that they often even out in the end.
For example, “We very rarely, if ever, put currency overlays or hedges onto portfolios.” says Andrew Popper, chief investment officer of private bank SG Hambros in London.
Mr. Popper argues that global equity markets provide a certain amount of self-hedging. “If you look at the recent case of the U.K., there has been a decrease in the value of sterling and an increase in the value of other currencies relative to the pound,” he says. “But U.K. companies have also performed better because of that.” Mr. Popper also believes it can be difficult to allocate and account for currency hedges in a portfolio. This can make them less tax-efficient or negate capital protection structures.
“Even if you assume that currencies are an asset class, which is questionable, by doing currency overlay you would be introducing a new asset class into the portfolio that the client hasn’t even thought about,” Mr. Popper says.
There are other ways for investors who think currency overlay is a step too far to play the foreign-exchange markets. Investment banks have started developing investible currency indexes. These can be bought directly from private banks as structured notes or passive funds.
One example is Barclays Capital’s Intelligent Carry Index, which is designed to give investors access to an investment strategy known as the carry trade. This approach—achieved with a portfolio of long and short positions in 10 currencies—is designed to replicate a strategy of borrowing money in countries with a low interest rates and investing it in countries with higher interest rates.
Another example is Deutsche Bank’s Currency Returns Index, which takes into account the three main drivers behind currency movements—the carry trade, momentum and valuation— and applies them in a systematic fashion.
Investing in these products is a step beyond protecting oneself from adverse movement in exchange rates: they give private investors a chance to get currency movements to work for them, rather than against them.