Investors must be conscious about currency says Russell

Institutional investors are being urged to embrace ‘conscious currency’ by thinking of currency risks as unmanaged active portfolios, and therefore develop responses to deal separately with those risks.

Russell Investments’ director of research and communications, Ian Toner, said typical institutional investors had very large exposures to currency movements but still allowed the size and nature of this exposure to be defined by other markets.

“Institutional investors should start by thinking about currency in its own terms and seek some beta-like exposure or add some ‘active-like’ management to that exposure by hiring an active manager and telling them to outperform the benchmark,” he said.

Investors were usually in one of two camps, he said. In the first were investors who thought that the currency market was “so random that there is no point in even trying to hedge, so they have a thoroughly uncompensated position”.

The second way of thinking was that “the currency risk is describable so we can find a benchmark for currency”. Toner dismissed the argument as to whether or not currency was an asset class. “You don’t need to believe in currency as an asset class,” he said.

“Essentially, this is a sterile argument, so let’s move on. This is to stop the conversation disappearing down blind alleys about whether or not currency is an asset class. “It’s a call to action, and that action will depend on the fund. There’s not one product to fix this – we’re building a framework.”

In a nutshell, Toner said, conscious currency involved taking whatever aggregate currency exposure that a fund had, and altering the way in which cross-rate exposures were weighted. “This is a change from factors that arise from international equity, fixed interest and/or property markets – and which are not aligned with currency considerations – to a set of factors that are aligned with the currency markets themselves.”

He outlined four responses to the idea of conscious currency. First, an institutional investor had no exposure at all to currency risk and so was fully hedged. Second, an investor reduced the risk of an inherited asset class to an optimal hedge ratio, and this could lead into the third response.

Third, risk was reduced over time and replicated with a benchmark. Within this third response, there could be two paths: to track a benchmark or to reduce risk to zero. Fourth, active currency management was used to eliminate the inherited currency risk; or the investor used more passive management which replicated a benchmark.

“It’s a sterile argument as to whether currency risk is an asset class,” Toner said. “Large institutional investors are, overwhelmingly, exposed to this and so it has to be treated like other risks. The labels on the buckets are irrelevant. How likely is it that your inherited currency portfolio, out of all of the tens of thousands of possible currency portfolios happens to exactly match the neutral benchmark of the currency market?”

This new approach to understanding currency exposure has been in development with Russell for more than two years. Toner said a number of factors had led to its development:

• larger global exposures are forcing currency risks to be considered

• benchmark technology had been developed in recent years

• academic literature had unpacked some of the fundamentals of older ways of thinking

• the GFC had drawn attention to rethinking risks, especially counter-party risks, and

• investors were now more willing to think about risk.

The full Russell Research paper, Conscious Currency — A new approach to understanding currency exposure, is available at: http://www.russell.com/institutional/research_commentary/PDF/Conscious_currency_.pdf