The Myths and Realities of Currency Management

Foreign exchange risk is not something that can be ignored

Originally published in the January 2015 issue

Why is foreign exchange interesting at all? Why is it worth us spending time on the subject, and why do we think that it’s going to be increasingly interesting for investors globally going forward this year and beyond?

At Millennium Global, we have now been in business for 20 years. We have been somewhat beneath the radar screen, I think, in terms of our profile, but we were founded in 1994 with the express focus on providing currency management solutions to the institutional investor community worldwide.

We currently manage about $14 billion of AUM in a variety of strategies. We seek to provide a comprehensive range of currency solutions to institutional investors, whether it be passive hedging, dynamic hedging, strategic hedging, actively managing existing risk, providing total return products, emerging market overlays, and also advisory services. We have relationships in Australia, Japan, South East Asia, the Middle East, Europe, the UK, North America and Canada. As we meet with clients around the world, we see a wide variety of needs as the underlying portfolios are different, investment objectives also differ and risk tolerance varies. Our aim is to provide very customised, bespoke solutions to all types of institutional investor.

Millennium Global has always been independent and the heart and soul of the firm has always been the provision of specialist currency management services. I think the currency management space is going to become more interesting and there is going to be more demand for the kind of products and solutions that we provide given the increasing impact of currency movements on international portfolio returns.

The last six months in FX markets have been transformational in the sense that volatility has risen back to long-term norms, having hit 40-year lows in mid-2014. The opportunity set has expanded, there has been policy differentiation in the world economy, and currency markets have begun to move substantially as a result.

Perhaps the main focus has been the appreciation of the US dollar against many trading pairs, and in particular the prospect of monetary policy tightening in the US this year, versus a stagnant European economy with the ECB now looking to begin a quantitative easing programme. That has caused a significant shift in the US dollar’s relationship with the euro. As you know, in the UK we have had the Scottish Referendum and that’s made sterling somewhat of a bagatelle ball, as there was a lot of volatility around the vote. We have had the renewed focus on the China slowdown with commodity market weakness and the dramatic collapse in the oil price. That has been significant for the commodity currencies, of course – the Australian dollar and Canadian dollar in particular. In addition, the emerging market axis has suffered greatly from the weaker China growth story and also the tightening of monetary policy in prospect from the United States – the US being the principal engine of growth in the world economy. So there has been lots going on and Millennium Global has been able to exploit these opportunities, and we have had strong performance in 2014, our best for around a decade.

2013 was an interesting year as well. We had the largest move in US dollar/yen for 35 years. Not since 1979 have we had such a large percentage change, and that was driven by a major policy adjustment by the Japanese authorities. Our belief is that, given the differences in global economic cycles and the change in policy, you are likely to see that continuing. After the financial crisis all central banks had engaged in a “race to the bottom”. All short-term interest rates went to virtually zero, and the lack of policy differentiation between countries meant that there were no imbalances to exploit through the currency markets. That has really changed.

If we look at the history a bit further, we are now just over 40 years into the regime of floating exchange rates. It was August of 1971 when President Nixon took the US dollar off the gold standard. Almost two years after that in March of 1973, the onset of floating exchange rates began.

It was one year later in 1974 that the United States passed the now famous ERISA Act (the Employees Retirement Income Security Act). That marked the beginning of international investment by US institutions. In 40 years we have had a substantial amount of flow into international investments, not just in the US, but also of course in the UK. As we sit here we have probably the biggest cross-border investment flows we have ever had – and this is increasing. You have a pool of capital in the world including pension plans, insurance, mutual funds, sovereign wealth funds, hedge funds, private equity, of well over $100 trillion, and a large proportion of that is invested in overseas assets. The need to manage currency risk in international portfolios has never been greater.

What’s really interesting from an investment point of view regarding recent currency moves is the impact on internationally invested portfolios. If you take an internationally diversified developed market equity portfolio, about a quarter of that risk comes from the currency exposure. If you take an internationally invested emerging market equity portfolio, it’s about half, and if you take an internationally invested fixed income portfolio, it’s about 85%. So that’s why it matters; the amount of risk is too large to ignore. Paradoxically, in many cases, investors don’t engage with the need to manage currency risk. The reason they don’t is because typically when they invest in international equities, or when they invest in international fixed income, they are focused on the returns of those underlying assets. When they invest in Japan, and they see that the return on capital in Japan is growing and the earnings outlook is improving because of Abenomics, they are concerned about whether they buy Sony, or Hitachi or Mitsubishi Bank and so on. They tend to think less about the outlook for the Japanese yen.

Similarly if they are buying Australian bonds, they are buying them for the yield, or they are buying them because the central bank will cut rates and, therefore, there will be an appreciation of the fixed income asset. They are typically doing it less because they have a view on the Australian dollar. It’s a very different consideration, but it’s a critical one. That’s where we guide and consult with clients to help them understand that if they do invest internationally that they do have an inherent exposure to currency risk.

So what can institutional investors do about it? There are really three things you can do. The first thing you can do – and many people still do this – is to ignore it. You can make the case that, “Well it will all come out in the wash,” and as ex-Federal Reserve Chairman Greenspan famously said back in the 1990s, trying to forecast currency markets is like tossing a coin.

The second thing people do about the risk is say, “I really don’t want it, so I will get rid of it, I will hedge it away. I want my Japanese equities exposure, I want my Australian bonds exposure [in my hypothetical example] but I don’t want the currency exposure, so I will just hedge it away and then I will have no currency risk.”

The third thing you can do is to turn the problem into a virtue to say, “We have this risk, we have this volatility, how can we use this to increase our returns and reduce our risk? To overweight the exposure to currencies going up, underweight the currencies going down, we can employ a currency overlay strategy and improve the risk and return characteristics of the portfolio.

We focus very much on solution two and solution three; we help clients with the concept of how to manage and mitigate their risk (under the second category). Do you want limit it entirely?Do you want to have some residual exposure? It might be helpful to your portfolio to have some residual risk. What is you risk tolerance? How can we help you think about those issues? What currency would you like us to manage? What is your universe? What kind of volatility are you comfortable with? What kind of risk do you take and are you prepared to take?

What I would like to address are the myths and realities in foreign exchange management to expose the folly of ignoring currency risk. There are really three myths that need to be exposed to enable investors to manage currency risk in a more considered way.

The first myth is that currencies mean revert, the idea that you can’t forecast currencies, and that what goes up is going to come down again, and what goes down will eventually find a base and come up. So why do I even worry about it? I am going to buy my Japanese equities and the yen will look after itself. But if you look at the reality and the facts over the last 40 years of floating foreign exchange rates, currencies don’t mean revert, either in real or nominal terms, but significantly change value.

If you look at the intermediate perspective, there are enormous cycles over multiple years, where the impact in return terms – not just risk – is profound in a portfolio. If we examine the data, and look at the US dollar in 1974, or the yen, or the Deutsche Mark and now the euro, or Australian dollar or sterling, they haven’t mean reverted. If you look at currencies like the Italian lira, they went down and down and down, and then ceased to exist. There are multiple cycles, but there is no mean reversion. So the idea you can ignore it on that basis is a fallacy.

The second myth is that if you like the asset you will like the currency. On the surface that’s a cogent thesis. In my hypothetical situation again, if you go and buy Japanese equities, as a lot of people did in 2013, you are doing so because the return of capital in that country is increasing, the earnings growth for those companies is improving and that ought to attract international investments, and surely that’s good for the currency?

In that sense it’s a cogent thesis, but actually the relationship between markets and currencies is much more complex. In fact, the 2013 experience was the perfect case study of why that’s not true, because part of the premise around Abenomics was to depreciate the currency to try and get the Japanese economy out of deflation and to boost growth for the benefit of the corporate sector and the economy at large. What happened was that you had a symbiotic relationship between a weakening yen, which was a policy tool, through to increased earnings, particularly for exporting companies, and a reduction in deflation which helped the corporate sector overall. Then you got the Nikkei to rise. This virtuous cycle happened and as the Nikkei rose, the yen weakened; as the yen weakened the Nikkei rose more. You had this cycle of appreciation of Japanese equity assets and depreciation of currency and the correlation between the equity market and the currency was negative.

Take the period from 1 October 2012 to 31 of December 2013: that’s 15 months – one year and one quarter. In that period the Japanese equity market (as measured by the Nikkei 225) rose by 83.6%. It was the home run trade of 2013. If you were a US dollar-based investor and you made that choice, you were a hero, but if you didn’t hedge the currency back into the dollar, you only made 37%. You lost more than half of your return by one bad decision, so all those decisions around whether you did buy Mitsubishi Bank, or whether you did buy Toyota, were more than half offset by one bad decision. So it’s a complete fallacy to argue that if you like the asset, you like the currency.

It’s not always the case that the correlation between the two is negative; sometimes it can be very positive. Take the example of Japan again. In the 1980s, you had a very strong economy and equity market because of the productivity miracle in Japan. As a result foreigners were investing heavily in Japan and the yen was strong.

As a consequence of the yen’s strength, the Bank of Japan decided to reduce interest rates because monetary policy was tightening with the yen’s strength. As interest rates were reduced, the equity market rose due to easier monetary conditions. As that happened, more capital came into the country as investment opportunities increased and the yen was strong. The Bank of Japan then cut rates again and so the cycle continued. So you had this symbiosis where you had a very strong equity market and a very strong currency for very understandable economic and financial reasons. So my point here is that it depends on the financial and economic regime, it depends on the environment. It is possible that when you buy the asset, the currency does go up but, as we have seen, this does not happen all the time, and the beauty and complexity of markets means that you cannot make that statement; it is a fallacy. The lessons of the last couple of years have highlighted that issue.

The third fallacy, the third myth, which is why investors should not be ignoring currency, is that you can’t make money out of investing in currency markets. The fallacy here is the belief that foreign exchange markets are the most efficient markets in the world. The reason they should be the most efficient markets in the world is because they are the deepest and most liquid, they have got the greatest volume, and they are arguably the most transparent. Now it is true to say that they are transactionally the most efficient markets in the world. They have the least cost, there are no commissions, they have the finest spreads. So yes, it is true they are transactionally the most efficient but they are not the most efficient market from the perspective of the Efficient Markets Hypothesis, which says that markets are random; you can’t make money out of markets.

The reason I think is that in foreign exchange not all participants are profit maximisers. So there are distortions and inefficiencies as a result. If all of us trade US equities or manage UK equities, we are all doing it for one reason: to make a profit, to buy the best companies, to ignore the worst companies. Everybody out there that participates in the equity markets is doing that. In foreign exchange markets, that’s not the case. There are corporations out there that are worried about their payables and receivables. They are exchanging currency all day long in the currency market with no profit motive per se, but to manage payables and receivables. There are central banks that are trading the markets frequently, but they are not doing it to make money. They have got monetary policy objectives they are trying to satisfy and managing their reserve base has nothing to do with making money per se.

So, despite the fact that it is transactionally efficient, it is not efficient from the perspective of the so-called Efficient Markets Hypothesis, and the evidence is clear that currency investment managers such as Millennium Global and our peers – over time – have made positive returns from investing in currency markets. This disproves the third myth. Consequently, in the same way that investors engage with portfolio managers because they want to help them seek returns in equities or fixed income or property or real estate or hedge funds or private equity, they should engage also with currency managers to manage risk and/or generate returns.

It is our mission to dispel the myths surrounding currency management and to illustrate to investors that ignoring your currency risk is a very dangerous thing to do. The 2013 Japan example is a prime illustration of this.

I think this whole investment arena is one with which clients will increasingly engage. Certainly the proportion of return that currency is now providing relative to the total return that investors have on international assets is high. Last year was again a good case in point, when a lot of US investors were losing enormous amounts of money on their internationally invested portfolios as the vast majority were unhegded. So we are seeing a much greater interest from clients wanting to try and understand how they should think about the problem, what solutions they should consider, and how they can get a properly managed currency programme within a portfolio, rather than ignoring it as many have done in the past.