Hedging currency risk

Freelance writer Leon Kok writes that currency risk is becoming a bigger and bigger issue among investors shopping around for international funds.

Some international funds hedge currency; some don't. And don't think that massive financial institutions or fund managers are beyond getting it wrong - it's precisely what happened to Nedbank a few years back. It hedged against the rand and became horribly unstuck.

That's also why many prominent management companies such as Templeton don't explicitly hedge. Templeton is one of the oldest mutual fund companies around, having gained enormous experience in foreign investing.

John Stopford, London-based fixed interest head and chief strategist at Investec Asset Management, put it to me recently that currency strategy shouldn't merely be defensive - it should be exploited. He and his fixed interest team who manage Investec's Managed Currency Fund do just that.

Established in 1980 and currently with $200 million plus under management, it has a formidable performance record versus the SDR basket of currencies or versus the rand, including reinvested deposits.

It has used traditional investment strategies and derivatives to generate returns above cash, regardless of the market environment. In addition, the underlying assets give a cash plus or absolute return of LIBOR (London Interbank Offered Rate) plus 4%. LIBOR is an interest rate offered by a specific group of London banks for US dollar deposits of a stated maturity and is generally accepted to be the benchmark deposit rate.

"The assumption that most investors make is that currency returns tend to average out over time, which is broadly true over long enough periods", says Stopford. "What this observation misses, however, is that exchange rate movements can have a significant impact on returns for significant lengths of time. During the past three years, for example, the US dollar has been a relatively weak currency, depreciating by over 8,5% annually against the Euro.

"This medium-term divergence in performance is both a threat and an opportunity", he argues. "Unmanaged currency exposure can undermine good foreign asset allocation, but good currency decisions can ad substantially to returns. Indeed, studies conducted by leading consultants have found that active currency management has proven to be a particularly successful strategy for those who have chosen to undertake it".

Stopford explains that the characteristics that tend to lead to a currency to outperform include better than average value (taking into account inflation), above average interest rates, and positive relative price momentum. Systematic analysis of currencies to identify these features creates the ability to build overlays that will add substantial value over time.

"By actively managing this mix, investors can ultimately outperform any single currency alternative, even if one currency does better than the others for a period of time. Even the strongest currencies can be outperformed in the long run".

He says that if you buy high yield currencies as opposed to low yielding ones, over time you'll make money. Or if you buy a currency that has recently appreciated, it will trend for a while and further appreciate. Likewise, currencies that have gone down will tend to go down further. A further consequence is that over the longer-term currencies tend to mean revert.

"If you're the currency manager adding incrementally or outperforming incrementally the average currency basket, over time you'll beat the strong currencies, because they ultimately tend to mean revert.

"The managed currency approach is typically to add incrementally value to a basket of currencies every year, every month. And then over time that performance should mean that you don't only outperform the world's weakest currencies but also its strongest currencies.

Stopford says his team treats currencies just as they do stocks. "The way we approach this is that we don't try to forecast currencies - that's a mug's game. Nor do we try to identify the world's strongest currencies. But what we do is view currencies just as we'd view a share - seeking characteristics that are attractive, such as yield, value and momentum.

"We try to avoid currencies with unattractive characteristics. By applying that approach we believe that we can deliver more persistent, more stable performance for outperformance over time. It's not a question of saying that the rand is going to be X in a year's time; it's saying which of the various currencies can we choose from and would like to own on the basis of the characteristics that are apparent to us. However, we also make certain that we have a well-diversified spread of attractive currencies".

Old Mutual Unit Trust (OMUT) marketing manager, Craig Gradidge, tells me that his company is looking at providing a similar offshore fund, but it will be a lot more defensive than the Investec's Managed Currency Fund.

"OMUT is considering converting its UK-based Money Market Fund from a sterling-only fund to a multi-currency fund. However, it's not our intention to get arbitrage out of currency dealing", he says. "We wish merely to provide sound diversity".

These options perhaps have considerable merit if you believe that world equity markets amount to a bubble waiting to burst, coupled with the view that valuations in both high yield and investment grade bonds look frothy at present and don't compensate adequately for the risk you're exposed to.

Leon Kok writes for publications in the United Kingdom, the United States and Switzerland, in addition to local periodicals such as Finance Week. He writes in his personal capacity and views and comments should not be considered to be advice. If you are unsure which unit trusts to invest in please consult a financial advisor.