EVERY investment in an international asset requires an equal investment in foreign currency that is often overlooked. What is unappreciated is that movements in foreign exchange markets can nullify gains or amplify losses on the underlying portfolio of international assets. The forte of the currency overlay manager is to safeguard the portfolio’s value against undesirable swings in FX rates and to exploit inefficiencies in the FX markets with the intention of increasing the portfolio return.
To understand how currency overlay managers achieve this goal, we start with one of the truisms of finance – that currency is a zero-sum game. There is strong empirical evidence to suggest that the return to currency is zero in the long run (currency here means a basket of currencies held in proportion to the equity in a typical international portfolio of equities), giving rise to a situation that is anathema to every investor: an increased exposure to risk but zero return in compensation.
While sensible investors should find the prospect of a risk that is unrewarded in the long-term unpalatable, over the shorter time horizons that are typically of concern to an investment strategy, we cannot even be sure that the effect of currency will “wash out”. An examination of annual unhedged and hedged equity returns over the last few decades shows clearly the impact that currency can have on an international equity portfolio. This impact is far from negligible – currency risk is ignored at one’s peril.
A currency overlay manager is dedicated exclusively to managing these “accidental” currency exposures generated by the asset manager – separately from, but in parallel with, the underlying manager. With separate mandates, the underlying asset manager is not disturbed by the use of an overlay manager and is free to disregard currency in the same manner as before. However, through the application of a portfolio of forward contracts or another currency derivative, the overlay manager replaces the unintentional currency bets of the underlying manager with the deliberate investment position of the currency specialist.
The beauty of this division of labour is that the combination of managers gives the best of both worlds: the best currency decisions from the currency specialist, and the best asset decisions from the asset manager. A currency overlay programme usually reduces pre-existing unmanaged currency risk, as it strategically hedges accidental exposures according to the investor’s wishes. Separate from this, active management involves taking dynamic positions in the currencies of the portfolio – long positions in currencies that are expected to appreciate, and short positions in those that are expected to depreciate.
Active currency management is attractive because although the currency markets are liquid, they are inefficient. There are not many small buyers and sellers of currency, with the bulk of FX transactions by amount done by a comparatively small number of investment managers, central banks, and large corporations; and not all participants are trying to make a return. There is also a lack of consensus on what drives currency markets.
Another reason for this inefficiency is that, historically, currency investing has been considered speculative in nature; consequently, there have been many more participants investing in traditional assets such as bonds and equities rather than currencies. There is ample evidence from both practitioners and academics that certain currency strategies can yield persistent returns over time. One such strategy is based on forward rate bias – buying higher yielding currencies by selling lower yielding currencies, and in its simplest form known as a carry trade. This is but one of the many tools at the currency manager’s disposal as he pursues his return-generating mandate for the client.