High FX costs drag on returns

Higher than expected foreign exchange transaction costs can result in a long-term return drag on a portfolio of up to 2 per cent over 40 years according to new research by Russell Investments, which urges investors to review and measure foreign exchange costs.

The results of the analysis suggest that investors can not assume that foreign exchange trades are being executed efficiently, Ian Toner, head of commission management and currency implementation at Russell Investments said.

“It should be unacceptable to investors and managers when far more foreign exchange transactions are being executed at prices close to the worst price of the day than at prices close to the best.”

He said investors need to analyse the actual trades conducted on their behalf to be sure their FX trades are receiving the right level of attention.

“One course of action for investors to ensure efficient FX execution is to publicly state that the associated costs will be reviewed and measured. Losing 2 per cent of your total fund value at the end of a 40-year period simply because of poor-quality FX execution isn’t just a rounding error,” he said.

Russell analysed 40,000 foreign exchange trades by funds managers with custodians and other counterparties between January 2008 and December 2009 on institutional assets of about $19 billion.

The research found that the average cost of each transaction, defined as the shortfall from the midpoint between the bid and offer prices, came to about 9 basis points, considerably higher than the range of 1 to 3 basis points which is the average cost in the foreign exchange market for the most traded developed market currencies.

Russell analyses shows the cost of foreign exchange transactions has not fallen in the past five years, with this latest research nearly identical to the findings of similar research conducted by the consultant in 2004 on about 36,000 trades.

The research found investors should focus on execution quality, counterparty selection and conflict management in attempting to understand the costs associated with FX execution.

It also identified four features of the foreign exchange market which could potentially lead to unnecessarily high costs: it is a specialist competency, a bundled service mix; and the lack of market structure.

To access the research click here