Investment Strategies

Forex Gains Ground As Asset Class For Wealth Managers

Emma Rees Features Editor February 2, 2010

Forex Gains Ground As Asset Class For Wealth Managers

Foreign exchange is high on the agenda of many wealth managers. With weakness across many leading currencies enduring and volatility set to rise in 2010, various strategies are being employed to mitigate the impact on the value of clients’ portfolios. This is of particular concern for clients with investments outside of their base currency or with international interests.

Foreign exchange is high on the agenda of many wealth managers. With weakness across many leading currencies enduring and volatility set to rise in 2010, various strategies are being employed to mitigate the impact on the value of clients’ portfolios. This is of particular concern for clients with investments outside of their base currency or with international interests.

At the same time, forex trading is also becoming popular with individual investors as currency is increasingly viewed as an asset class in its own right.

In the last two years, currencies have had a significant impact on the performance of clients’ portfolios. For example in 2009, the MSCI World Equity Index rose by 30 per cent in dollar terms, but rose by just 15.7 per cent in sterling. In 2008, the same index fell by 40.7 per cent in dollar terms, but fell only 17.9 per cent in sterling.

“In fairness, currency movements over the last two years have been much bigger than average and such extreme movements would not be expected every year,” said Sanna-Liisa Valtanen, director, Asset Risk Consultants (ARC).

“Currency movements tend to cancel each other out over the long term, but they can have a big impact in the short term, particularly in the environment we’ve just had.” To make her point, Ms Valtanen said the difference between the sterling and dollar denominated versions of the MSCI World Index is just 20 basis points over the last decade.

Portfolio managers running long-term mandates employ strategies in accordance to their style of portfolio management. To minimise currency risk, managers tend to hold the majority of cash and fixed income instruments in the base currency of the portfolio. “If fixed income exposure is outside the base currency, it is common to see managers hedging it back”, said Ms Valtanen. “Similarly, exposure to absolute return type hedge funds, where possible, is often in the base currency to minimise foreign exchange risk.”

While some houses routinely hedge their equity exposure, most do not. “Looking at recent history, hedging has been detrimental to the performance of a sterling-based portfolio,” said Ms Valtanen.

Tom Becket, chief investment officer at PSigma Investment Management, said uncertainty regarding the impending general election and heightened fears around deficits means that significant sterling weakness might well return to be a feature of 2010. “For this reason, much of our portfolios are facing overseas. We are currently investing more equity money internationally than in the UK,” he said.

His firm has been recalibrating its portfolios towards global equity markets and companies that earn a high proportion of their earnings in currencies other than sterling. It is effecting this by buying overseas companies, along with the many companies on the UK stock market that make the better part of their profits from other parts of the world, like the US and emerging markets.

“Our favoured way of gaining exposure to such companies is through the Investec UK Special Situations, M&G Global Basics and MFS Global Equity funds,” said Mr Becket.

Newton Investment Management also favours those sectors within the UK equity market which provide overseas exposure.

"Our currency preference is skewed towards countries that have experienced less of a negative hit from the credit crunch," said Peter Hensman, global strategist. “This week's weak GDP data for the UK that showed the economy limping out of recession in the fourth quarter of 2009 reflects the weak underlying condition of the UK economy.”

Ugly contest

Mr Hensman describes the choice between currencies at present as “something of an ugly contest, rather than a beauty pageant” and acknowledges that while sterling has its flaws, it is already cheap relative to the euro, and that events in Greece and Portugal are demonstrating that many alternative currencies face challenges as well. "Our currency preference, for this reason, is skewed towards countries that have experienced less of a negative hit from the credit crunch and against this backdrop the more internationally exposed sectors within the UK equity market should fare better," Mr Hensman concludes.

While Mr Becket describes investing in overseas companies or those that make the majority of their profits overseas as relatively “blunt tools” and said a more sophisticated approach might be to buy other currencies, there is an opportunity cost to this. “Instead we are investing in global macro funds that take positive and negative views on currencies, like L&G’s Diversified Asset Return Fund. Whereas these were once only structured as hedge funds, there are now funds which use UCITS strategies. There are also emerging market currencies funds, like BarCap’s equal weighted EM currency fund,” said Mr Becket.

Dirk Wiedmann, head of investments, Rothschild Private Banking & Trust, said low interest rates, rising public debt and worries about long-term inflation mean the currencies of most developed countries are currently unattractive.

“The US dollar has weak fundamentals and the long-term outlook is unappealing, although we are upbeat in the short term and expect the recent strong run to continue, as the dollar recovers from oversold levels,” he said. “In Europe, problems of weaker countries such as Greece are threatening to undermine the stability of the euro region as a whole."

In this environment, Rothschild is increasing its exposure to the Swiss franc as a cheap form of portfolio insurance in case of a downturn in markets. “Although we expect the modest economic recovery to continue this year, there is always a danger that markets suffer a setback, particularly after a run as strong as that of the past nine months. Any investment that allows us to offset some of the risks in a portfolio without sacrificing too much in returns is therefore very appealing,” continued Mr Wiedmann.

Swiss franc

So why choose the Swiss franc? Rothschild’s reasoning is that the Swiss currency is a natural safe haven in times of turmoil and unlike most developed countries, Switzerland’s economy looks (relatively) healthy.  With interest rates low in all major currencies, there is little opportunity cost associated with holding the low-yielding Swiss franc. In the short term, Rothschild see the main risk as the Swiss National Bank intervening in the market to weaken the franc, as part of its measures to prevent “excessive appreciation”.

“Although Switzerland wouldn’t be immune from another downturn, we would expect its currency to perform well during a crisis,” concluded Mr Wiedmann.

According to ARC, most private client portfolio managers do not use currency as an active asset class in clients’ portfolios. “Currency is not an easy asset to call in the short term,” said ARC’s Ms Valtanen. “If a manager has a very strong view, they might express it through a trade but investment in currencies as a discrete asset class has been relatively rare in the context of private client portfolios.”

Self-directed investors

By contrast, forex trading has increasingly become an asset class utilised by self-directed investors. Barclays Stockbrokers launched BARXdirect, its FX platform in April 2008 and it has proved extremely popular.

“We have seen straight-line growth in trade volume and account numbers suggesting the retail segment is a thriving area in FX,” said Paul Inkster, head of product at Barclays Stockbrokers. The firm saw record volumes in December, with currency trades up over 480 per cent on the same month in 2008. Barclays attributes this dramatic increase in interest in currencies from clients to their search for exposure to an asset class traditionally uncorrelated to equity markets to diversify their investment portfolios. 

Mr Inkster says that while the majority of clients typically trade EUR/USD and GBP/USD, there are segments of clients who trade specific and more exotic currency pairs such as AUD/JPY, indicating a rise in interest in the traditional "carry-trade", following aggressive interest rate hikes by the Royal Bank of Australia.

“As the economic landscape continues to evolve following last year's global recession we believe the retail FX market place is set to flourish,” said Mr Inkster, who notes that as various economies emerge from recession at different times and indeed at different rates, this is likely to generate further volatility for key currency pairs such as EUR/USD and GBP/USD.

The view that currency volatility will increase in 2010 seems to be pervasive. Some European countries like France and Germany are already well advanced on their journey to growth, while the US has recently returned to growth and the UK is technically only just out of recession.

These different stages of economic recovery are causing shifting patterns in key indicators such as unemployment figures, inflation projections, interest rates and the use (and decommissioning) of quantitative easing programmes.  “All these factors combine to cause fluctuations in currency markets,” said Mr Inkster.

According to PSigma’s Mr Becket, currency volatility is going to pick up massively this year. “For example, the euro hasn’t budged despite numerous problems on the periphery. On a recent trip to Japan all the meetings I attended believed that the new finance minister would talk down the yen as its strength has been a big negative for the export industry and the country as a whole,” he said.

With increased volatility in forex markets on the horizon, currency needs to be firmly on the radar of portfolio managers. Those that are unprepared may miss opportunities and find that currency swings eliminate the hard work they have otherwise put into managing clients’ investment portfolios.

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