The relationship between institutional investors and the idea of currency risk has been an uneasy one. For a start, there remain an overly large number of investors who are either unwilling or unable, due to the specific regulations of their fund, to consider currency risk as separate and independent from the underlying risk of their investment. Such a view is particularly prevalent among equity, although it is also present to a smaller extent with fixed income fund managers. The aim of this blog is to err on the practical, to take the ideological out of the equation and seek to demonstrate empirically and theoretically that managing currency risk can consistently boost a portfolio’s return.
On the face of it, this blog may seem targeted at only those who manage currency risk on an active basis. This is not the case. Rather, it is aimed at any institutional investor who faces in the course of their “underlying business” exposure to a foreign currency, whether or not they are in fact allowed to carry out some of the ideas and strategies presented herein. Let us start then with two core principles on the issue of currency risk:
1. Investing in a country is not the same as investing in that country’s currency.
2. Currency is not the same as cash; the incentive for currency investment is primarily capital gain rather than income.
Almost before we have started, some may view the above as controversial. In my career, I have come up against not infrequent opposition to these principles, albeit for varying reasons. The answer I have given back has always been the same:
The dynamics that drive a currency are not the same as those that drive asset markets