Currency Strategist Van Luu of Russell Investments shows how thoughtful management of currency risks and opportunities can help investors reach their objectives despite the low return environment
Currency risk is often viewed as a by-product of the broader investment strategies that an investor has employed, rather than an asset class in its own right. In the low-return environment, Russell Investments think that there are several ways to manage currency risks and make the most of the return opportunity:
- Reduce unrewarded risk with static currency hedging
- Manage currency risk smartly with dynamic currency hedging
- Seek additional returns with currency factor strategies
- Employ cost-efficient implementation
Reduce unrewarded risk with static currency hedging
If your portfolio contains unhedged international assets then you are automatically taking on exchange rate risk without being paid for it, i.e. unrewarded risk. This currency exposure is only a by-product of the asset position, not a clearly articulated currency investment from which you expect to earn returns.
Currency hedging using forward exchange contracts is a good way of reducing unrewarded risk. In a static currency hedging program, the currency hedge percentage remains constant (at 50%, for example). When compared to an unhedged position, static hedging often reduces unrewarded risk without giving up expected return. As we can see in chart 1, the unhedged portfolio has an embedded risk of 15%, whereas the 50% statically hedged portfolio has 14.4% risk.
Manage currency risk smartly with dynamic currency hedging
Unlike static currency hedging, dynamic currency hedging percentages can vary on a regular basis. This is because the hedging percentage is altered as market circumstances change. Successful dynamic hedging therefore, can circumnavigate unexpected and large negative cash flows, reduce portfolio risk and raise the return from international equity investing. Take for instance the Brexit referendum on 23 June 2016. Statically hedged investors mostly generated large negative cash flows as the pound weakened before (and especially) after the referendum.
Using Russell Investments' dynamic hedging model strategy in chart 2, we can see that investors would have suffered much less than their statically hedged peers. We use signals from so-called currency factors (explained below), which picked up on the weaker pound trend in 2016 and kept hedge percentages below 20% throughout.
Seek additional returns with currency factor strategies
Currencies can be exploited as an intentional return source, just in the way traditional asset classes can be. At Russell Investments, we believe that there are three main drivers of currency returns to consider (which we call 'factors'): Carry, Value and Trend. These three factors can be used in the dynamic hedging of currency risks in investor portfolios. They can also be used to dictate return-seeking currency strategies that are not tied to the investor's underlying asset allocation.
A flexible return-seeking currency strategy that considers all three currency factors at the same time is key because each one offers strong risk adjusted returns with low correlation to traditional asset classes.
Employ cost efficient implementation
Investors have long suffered and battled with high costs in foreign exchange (FX) transactions. As such, currency hedging and return-seeking currency strategies hugely benefit from cost-efficient implementation, whether that's through an electronic trading platform, or via an experienced implementation partner. Both work to find liquidity and reduce transaction costs, while implementation partners also to develop bespoke client services to manage risk.
Every basis point counts
In this low return world, don't ignore currency, because every basis point counts. There are numerous ways that Russell Investments can help investors to increase overall net returns by making the most of currency and minimising trading costs.
Van Luu is head of currency and fixed income strategy at Russell Investments
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Unless otherwise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate. Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.
Any reference to returns linked to currencies may increase or decrease as a result of currency fluctuations.
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