Are Indexes a Better Way to Manage Currency?

Coverage of the 2014 Investment Innovation Conference

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story_images_dollars-funnelInvestors spend considerable time and effort developing strategies to manage currency risk. A typical solution is to hedge that risk using passive or active currency strategies; however, both approaches have their shortcomings. Passive hedging can minimize foreign exchange risk but misses out on currency returns. Active hedging can anticipate and profit from currency moves but recent performance has been poor, particularly on a net-of-fee basis.1 Some investors are now seeking to combine less complex risk-management approaches with return enhancing features—all at a reasonable cost.

While standard passive hedging approaches can be useful for managing risk, currency exposure can help manage overall portfolio risk and potentially generate returns.

Three main factors contribute to currency returns:

• Carry is the tendency of higher interest rate currencies to appreciate more relative to lower interest rate currencies.

• Value is designed to benefit from under- or over-valued currencies compared to some macroeconomic factor.

• Trend is buying or selling currencies based on recent performance.

Some indexes have been constructed based on these three factors, and investors are now using them in innovative ways. For example, some investors replace the currency exposure associated with their international investments with one based on the indexes. That can be beneficial because an international portfolio includes an active, but unintended, bet that the currency exposure created based on securities in another asset class will contribute to the performance of the portfolio. Some investors are uncomfortable with this uncertainty but are interested in the benefits associated with currency. Using an index based on factors that are responsible for currency returns means investors have a better chance to enhance a portfolio’s return.

Besides replacing the incidental currency exposure with an intentional one, currency indexes can be used in other ways as well, including:

Managing fixed income risks. The low interest rate environment has had negative consequences for some bond portfolios, diminishing the ability of the portfolios to cope with rising interest rates. Because currency indexes based on the value or trend factors are often negatively—sometimes strongly—correlated with fixed income investments, an exposure to one or more of these indexes could help cushion a fixed income portfolio should interest rates rise.

Reducing equity risks. Many mainstream equity benchmarks and portfolios are positively correlated with carry. That’s because in the run-up to the global financial crisis and continuing today, carry has become part of a “risk-on” strategy, increasing its correlation with other risky assets. Eliminating or reducing carry-producing currencies from an international portfolio can decrease the portfolio’s risk. Transforming that carry exposure to a currency index based on value or trend can reduce portfolio risk and provide welcome stability when markets are stressed.

Absolute return. Some investors see an opportunity to benefit from the factors that drive currency returns and may invest in one or more of the currency indexes. A key feature of the indexes is flexibility in combining them in ways to meet investment objectives. An investor convinced that the greater returns from a carry strategy outweigh the risks of a significant downturn, could overweight carry (compared to the carry component in a currency benchmark) while still including underweight contributions from value and trend indexes to help reduce potential carry drawdowns.

Michael DuCharme is Head, Currency Strategy, Russell Investments

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