Jonathan Marriott, Chief Investment Officer
This week, during our quarterly Investment Landscape webinar, we received a question on dollar exposure in portfolios. Commenting on individual portfolios is difficult at such a forum, but it is a question that the LGT Vestra Investment Committee has discussed at length.
Firstly, let me confess that our Investment Committee has been reluctant to express a strong directional view on currency, but we do consider the risks associated with currency moves. In 2004, Alan Greenspan, Chairman of the US Federal Reserve, said:
"The inability to anticipate changes in supply and demand for a currency is at the root of the statistically robust finding that forecasting exchange rates has a success rate no better than that of forecasting the outcome of a coin toss."
He did qualify this comment with the following:
"The exceptions to this conclusion are those few cases of successful speculation in which governments have tried and failed to support a particular exchange rate. Nonetheless, despite extensive efforts on the part of analysts, to my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin. I am aware that, of the thousands who try, some are quite successful. So are winners of coin-tossing contests. The seeming ability of a number of banking organizations to make consistent profits from foreign exchange trading likely derives not from their insight into exchange rate determination but from the revenues they derive from making markets."
Seventeen years later, I have seen little evidence that much has changed in this regard. So, the question is: without a strong directional view, how do you manage the risk from currency moves in portfolios?
Measuring currency risk in portfolios is no simple matter. At first glance, it is easy to take the currency weight from valuation looking at the currency of each asset. However, a global equity fund priced in pounds is not sterling risk – it will have equities from many different countries and, if it reflects the global index, will hold a large amount of US dollar denominated assets. Even looking through a fund to the underlying holdings does not allow you a clear picture of the currency risk. If a global company such as Nestlé is priced in Swiss Francs, its earnings are global so it can hardly be said to be Swiss Franc risk.
The UK equity market as represented by the FTSE 100 index has over 70% overseas earnings. When the pound falls, particularly against the dollar, the FTSE 100 index may rise in sterling terms. Conversely, US equities may carry non-dollar risk. The actual calculation will depend on individual company activity and any company activity hedging their cash flows. However, as a rough guide, a UK-based portfolio that is 50% UK equities with 50% overseas equities may on the surface appear to be 50% GBP risk and about 27% US dollar risk with the balance in other currencies. Some of the other currencies are fixed against the dollar so, taking into account the UK equity market sensitivity, the real figure for US dollar risk may be closer to 60%.
The volatility in currency markets over time has been close to that of equity markets and, with the exact level of risk, we generally take the currency exposure with the equity. However, in bond markets the currency exposure is clearly defined and the volatility of bonds is less than equities so here we generally prefer to hedge any foreign currency exposure. It should be noted that these are generalisations and we may hedge equities to reduce risk or take unhedged bond positions at times.
While we do not usually take a strong directional view, there are reasons to be comfortable with overseas currency exposure, particularly the dollar. Our top priority in managing portfolios over time should be to preserve the spending power of the investments. For individuals, this means matching their personal inflation rate based on their spending. It would be difficult to live in this country only spending money on things that are not impacted by fluctuations in the value of the pound. We are dependent on imported goods and many commodities, such as oil, are priced in dollars. From this point of view, some diversity makes sense. When looking at the portfolio risk, it should also be noted that at times of stress when equities fall, the dollar has acted as a safe haven and risen giving some protection to portfolios. The US dollar remains the major reserve currency and is most widely used in trade.
Overall, we try and avoid currency speculation, but inevitably carry currency exposure in portfolios. Measuring the currency risk in a portfolio is not an exact science, but we assess the risks within the portfolio. In portfolios, a spread of currency risk is accepted and we are more comfortable with US dollar risk than other currencies.
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