Conscious Currency: helping to meet the challenge of currency market risk

Ian Toner - director of research and communications, Russell Implementation Services, Russell Investments.

Currency has risks. That's a simple statement that won't surprise most investors. They understand that changes in exchange rates can have a material impact on investment returns, and that the currency markets are both volatile and difficult to predict.

What makes it worse is that exchange rates are just that - rates at which one thing of the same type can be exchanged for another. In other markets investors can think of prices in natural terms (the price of one share of IBM is a certain number of U.S. dollars), but currency markets are different -you're exchanging one currency for another. One currency "going up" is identical to the other "going down." That's a different way of thinking from the day-to-day analysis that investors do, and quite unlike the stock example, as we don't think of an investor who's buying IBM stock as someone who is "selling dollars," even though that's technically correct.

So currency risk is volatile, unpredictable, confusing, and requires that investors adopt a different way of thinking from the normal approaches for most asset classes. This problem is only likely to get worse. It seems like we may be moving towards a more unsettled world, with greater economic pressures, more complex political pressures, and challenging demography creating significant economic differences between regions and countries. At the same time great uncertainty over inflation (and deflation), with increasing focus on the money-nature of gold, and greater exposure to commodities combine to make exchange rates (often the lynchpin and transmission mechanism of all of these issues) a larger part of the picture than has been the case over the last 20 years. In retrospect the 20 years just gone appear a time of convergence and relative stability.

It's not a huge surprise then that discussions about currency are not most investors' favorite thing. It's more interesting and comfortable to spend time discussing which managers to hire or fire, or to spend time talking about long-term economic and market forecasts. Understanding the nature and behavior of funding liabilities can be complicated, but is at least based upon relatively simple concepts that most investors can grasp. When currency is actually discussed it's often in the context of trying to construct a general market view for the prospects for the investor's home currency against the aggregate of other currencies. This is, of course, an active forecasting exercise.

Most often, though, the conversation about currency falls into two categories:

• Should I hedge my currency risk?
• Should I hire an active currency manager?

I believe that addressing the currency question in this way misses the point and leads investors to think about not only their currency but their whole portfolio exposure decision-making in a sub-optimal way. Instead I would propose a different approach that we at Russell describe as Conscious Currency^TM.

To explain why I believe the current approach is less than ideal, and why I think the new approach is clearer and better, we need to look at the assumptions embedded in the standard approach to making hedging decisions. We can then try to understand the ways that currency is embedded in the tools we use today. Finally, we can discuss the basic decision that an investor needs to make, along with how that can be embedded in their portfolio structure decision-making process and, more importantly, in their portfolio.

What we assume today

The standard approach to thinking about currency risk today can be summarized as follows:

"Currency movements are random, and all come out in the wash. Because I'm a long-term investor I'll only need to worry about currency risk at extremely high levels of total portfolio exposure. As my investment time horizon shrinks, the level of currency risk that I can tolerate drops. If I'm a very short-term investor I might worry about having approximately 20 percent exposure to currency risk. If the amount of currency risk that I have is high enough to make me worry, I'll think about hedging it away - maybe moving to a 50 percent hedged position to minimize regret." This approach can be described in a simple chart (see Fig 1). A picture like this will appear in many standard investment textbooks and in presentations prepared by investment consultants and advisors discussing currency risk with their clients.

Fig 1 - For illustrative purposes only

Now the nice thing about this chart is that it provides a clear and simple approach to understanding the currency hedging question. Unfortunately this clear and simple approach turns out not to be very helpful. The standard approach depends upon two basic problems which we need to look at.

The first seems a little embarrassing, but is true nonetheless: there are effectively no long-term investors in currency market terms. The trends that we see in the currency markets (see Fig 2) can last for a long time and can be significant. There are very few investors who are prepared to suffer on the losing end of a currency movement for five, seven or 10 years without beginning to reconsider their behavior. In reality, then, while most investors aren't short-term (in the sense of changing their view every quarter) they are certainly not long-term (as they'll certainly look at annual performance, and will often make the decision to change behavior based on the results they achieve over three years).

Fig 2 - USDCAD Currency U.S./CAD Exchange Rate

The point I'm making here isn't that this relatively shorter term focus is a bad thing necessarily - it's not. When you're talking about 10- or 15-year trends it's very difficult to say you should just sit tight for all 10 or 15 years on the losing side of the trend. Regulations and prudential expectations would actually make a very long-term view on many issues challenging. In the U.S. we saw the introduction of the Pension Protection Act significantly reduce the timeframe of data that investors are allowed to use when determining whether or not to make a contribution. Manager assessment also works on shorter timeframes. Most investment managers with five years of poor returns are likely to feel very vulnerable with many of their clients.

Instead, we should recognize that most or all investors are not in the very long-term category when it comes to dealing with currency risk, and adjust our assumptions accordingly. When thinking about hedging, the idea that "it all comes out in the wash over the long-term" becomes irrelevant. Put simply - even if it all comes out in the wash over the long-term, you don't benefit from that long-term if you've changed your policy in the short- to medium-term.

Rather than assuming that currency exposures "fall out" of other exposures, or that currency managers should be assessed in a vacuum, Conscious Currency™ recognizes that currency is a stand-alone opportunity set, and that the decision to take on currency risk should be taken rationally and explicitly.

Instead, investors using this standard approach need to set an upper bound of currency exposure above which they'll want to hedge. And this is where the underlying assumptions behind this chart become important: because the chart is based on a basic assumption that currency behavior is random - and so random that it's not describable or predictably trending.

But surely risk that is so random that it can't even be described effectively must, by definition, be uncompensated? The normal approach that we take to uncompensated risk is to make a simple determination of whether the cost of eliminating that risk is greater or less than the cost of exposing ourselves to it.If we take this as our starting point the decision becomes easier to understand. The cost of running a hedge for an institutional investor (or for a fund manager managing retail money in the form of a unit trust or mutual fund) may be between eight and ten basis points per annum (based on our experience at Russell providing this type of service). With currency volatility typically running between 10 percent and 15 percent per annum based on standard market measures, the portfolio only needs to have a very small amount of exposure to make it more effective simply to eliminate that currency risk using a hedge.

So, while the chart above seems very clear and helpful, it turns out to not be of much use. There are no (or almost no) true long-term investors in the relevant terms, and once investors have any substantive exposure to currency at all, the logic of the assumptions would drive them towards fully removing that risk.

But what we do know is that many investors remain exposed to currency markets, and that while investors often incant the words "currency markets are totally random and all come out in the wash" they will often then spend huge amounts of time and energy trying to make forecasts for a number of those currencies. There are two possible explanations for this. Either investors are simply foolish or the assumptions underlying the current approach (and therefore the current approach itself) are wrong. In 20 years in the industry I've met few fools - and even fewer with real decision-making power. I think the safer assumption is that investors are identifying a problem with the current standard approach, but simply aren't yet at the stage of articulating the problem (or its solutions) clearly.

Currency is like high fructose corn syrup

So, we've established that the standard approach, which involves assuming long-term investment horizons and random currency market behavior, doesn't make sense. To move forward let us look at the different ways that currency exposure fits into the portfolio. I sometimes think of the effect of currency in the portfolio as being rather like the effect of high fructose corn syrup in the food industry. If you spend time looking at the ingredient labels on food packaging you'll be surprised to see how often a wide range of different foods contain high fructose corn syrup. I'm not concerned here whether or not this is a good idea - rather I will only call attention to the ubiquity of the ingredient. Put simply, there's high fructose corn syrup everywhere.

Currency is as ubiquitous. Often it can sound like currency isn't a major part of the investment process. Investors might say, for example, "No, I'm not invested in currency because I don't believe in active currency management" - but you then often find out that the same investor is entirely unhedged in their broader international portfolio. Needless to say that investor is well and truly invested in currency!

There are three main ways that currency affects the portfolio.

The first is the most obvious one: if the investor has hired an active currency manager, they have an exposure to currency. I call this the five percent of the five percent issue. It's likely to be a small allocation within a small allocation to alternative assets in the portfolio. Often these managers will have an absolute return target and will be expected to trade on strong opinions. There is ongoing debate over whether or not managers can add value with this type of mandate; Russell's view on that issue has been broadly that they can, although manager selection is, of course, vital. This first type of exposure, then, is certainly currency exposure, but it's typically very small relative to the total size of the fund.

The second way that currency affects the portfolio is also a fairly obvious one: investors may consider whether or not to hedge the international assets in their portfolio. What's interesting about this is that the decision is usually presented in this way - "Should I hedge the exposure I have?" The currency exposure inherited from the range of international exposures that the investor has adopted is regarded as the default starting point, and the decision whether or not to hedge is posed as a decision to alter those exposures in aggregate. So, an investor with twice the exposure to the yen than to sterling who decides to hedge will keep the relative size of these positions the same, but simply reduce the total size of their exposure to currency in aggregate. Why have these positions as the starting point for the conversation? Because that's what comes out of the modeling exercise that they complete when constructing their strategic asset allocation if they use unhedged benchmarks. We'll come back to that point in a minute, but for now, what's important is that this "should I hedge my existing exposures" is certainly an important way that currency can affect the portfolio, and typically a much larger source of currency exposure than the first way identified.

The third way that currency affects the portfolio is implied above. In our industry we're often at the mercy of the way that we describe the tools that we use. When we model the world using what are called "unhedged" international benchmarks (whether they're for equity, fixed income or other asset classes) it can be easy to forget what these really represent. We will typically describe an unhedged international equity benchmark just using the phrase "international equity," assuming that the currency component of it is irrelevant. But of course that's just not correct. In reality the return of an "unhedged international equity" benchmark is the combined return of two equally sized exposures: an exposure to the foreign equity and an exposure to foreign currency.

These exposures are exactly the same size, and every piece of that equity portfolio is subject to exchange rate risk. In fact, we would be just as accurate to label these benchmarks "currency based on the equity market," "currency based on the fixed income market," "currency based on the real estate market" and so on. Now, this is important for two reasons. First, it shows the degree to which currency (like high fructose corn syrup!) is embedded in almost everything that we use to make the most basic decisions. Second, it means that currency is affecting (and distorting) our approach to the different international asset markets. Not only are we getting currency in multiple different ways in our modeling, but by doing that we're also failing to get a clear picture of the other asset classes to which we might choose to be exposed.

A different approach: Conscious Currency^TM

I believe there is a better way to address this problem. We at Russell call this approach Conscious Currency^TM. Conscious Currency™ asks of investors one simple question: do they believe that currency market behavior can be described in its own terms? By this I don't mean can they predict which way particular currency pairs (or even the currency market as a whole) will move. As an industry we're not generally very good at making those calls for the equity market, let along the currency market. No, all I'm meaning is that investors must decide whether the currency market as a whole (independent of what international assets they might hold) can be described in a benchmark.

Investors who believe that such a description is not possible should recognize the implications of what they're saying: if you can't describe a source of risk, you also can't rationally conclude that the source of risk is anything other than uncompensated. As we've seen above, this means that investors of this type should simply eliminate their exposure to currency markets altogether.

Investors who believe that these markets are describable need to select an appropriate benchmark to describe them. Note that here they don't need to believe that currency "is an asset class." That's a theoretical argument of some interest but little practical importance. All that investors need to recognize is that it's a describable source of investment volatility, to which many rational investors are currently exposed.

Having chosen a benchmark (there are multiple available from a number of providers) investors should then model the world using asset class benchmarks for international assets that are fully hedged, but should include at the same time in their modeling a possible exposure to the currency benchmark that they've chosen. This approach separates the decision to take currency risk out on its own, and also allows the international exposures to be described more accurately.

Having decided on their strategic asset allocation, investors can then appoint managers accordingly (whether active or passive) in each desired exposure grouping. Currency exposure decisions should be managed in exactly the same way. Any currency manager appointed should at least be expected to provide the currency-specific benchmark risk/return stream. However if they're being paid active management fees the expectations should be higher, and always compared to the benchmark rather than an absolute return approach.

Now, it's important to note that this approach is only just available to the institutional market. Retail investors would generally find it difficult or impossible (and certainly risky) to adopt this approach on their own and are likely best advised simply to begin to prompt their investment advisor to demand product with this idea embedded in it.

Conclusion

Why do we believe Conscious Currency^TM makes sense?

First, it treats currency risk seriously and on its own terms. Rather than assuming that currency exposures "fall out" of other exposures, or that currency managers should be assessed in a vacuum, it recognizes that currency is a stand-alone opportunity set, and that the decision to take on currency risk should be taken rationally and explicitly.

Second, it seems that it would have (at least in back tests) produced good outcomes for investors choosing to follow this approach. There isn't space in this article to describe all the testing and research we've done on this topic, but details can be found in a research piece available on the Russell Investments website:
(http://www.russell.com/institutional/investment_solutions/conscious_currency.asp).

Third, Conscious Currency^TM helps investors ensure that when they hire active currency managers they're not simply paying for expensive beta. Conscious Currency^TM provides a framework for evaluating currency managers.

Finally Conscious Currency^TM redirects the wayward thinking of the standard approach to currency, which caused decisions to invest in equity and fixed income to be distorted by embedded and unthinking exposures to currency risk. Therefore, we believe that Conscious Currency^TM brings clarity and consistency to the long-standing challenge of currency market risk.

Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.