Hedging Wisely: A Non-expert's Guide to Expertly Hedging Currency Risk
Chapter Three: The Many Faces of Currency Risk
Where there’s exposure, there’s risk.
What is currency risk and how does it affect the average Investor? Currency risk exists whenever an Investor buys into a fund whose gains and returns are calculated in a currency other than his investment currency. This is every investment with the exception of investments made in the US into funds that are entirely US based. Those do exist but they represent a small portion of investment dollars. Instead, to the vast majority of American Investors, your money isn’t invested in US currency, it’s invested in the equivalent value to the currency of the fund or funds you are buying into. Simply put: where settlement currency does not equal fund currency, there is currency exposure, which means currency risk.
More specifically, wherever there is exposure to currency fluctuations, there is a risk that the result of that exchange will not be favorable. It doesn’t matter what your investment is. Where there is exposure, there is risk. And risk, for the vast majority of Investors, is something to be avoided or at least managed in such a way that it’s likely to limit the potential for unfavorable results.
To be thorough in my explanation, I submit there are scenarios where currency exposure–risk–is considered a good thing: where exposure itself is the investment.
Active currency, or Currency-as-an-asset-class, represents an investment in currency itself. This means the Investor is buying a foreign currency when its value is considered to be at a low point, with the intention of selling that currency when its value increases. This is referred to in the industry as seeking exposure because, in this type of investment, the exposure to foreign currency is not considered a risk, it’s considered an opportunity. But as a Manager, you really have to know what you’re doing before you go placing your Investor’s money in an active currency fund. And few of us are qualified to do so. This type of investment requires a high level of understanding of currency markets, and the ability to make global projections on market fluctuations. This is where the Economists add value. They deal regularly in these high-risk foreign exchange investments. It’s what they do. So we will leave it to them, and we’ll continue to focus on the currency exposure that applies to our Investors every day, and that we are fully qualified to manage, which happens to be every other asset class outside of active currency.
In every asset class where the Investor is investing in a mutual fund or any other type of grouped portfolio, currency exposure is a risk. Not only does an Investor need to see success in the organization he’s invested in, but if that organization is based in another country, he also has to hope that the currency fluctuations will not have adverse effects on his returns.
Here’s a simple example:
Bruce and Leslie are investing USD$1000 in a company in Japan. On the day they invest, their thousand dollars is worth 115,000 Japanese Yen, so their total investment is 115,000 Yen.
A year later, the company has done well and shares are worth more. Their investment has doubled and is now equivalent to 230,000 Yen. If they take out their investment today, Bruce and Leslie will have doubled their money! Or so it seems.
They contact their Financial Advisor, excited at the notion that they’ve doubled their money, and their Investment Manager tells them that in fact, their investment value has stayed exactly the same. Bruce and Leslie are shocked and confused. How is this possible? Their Manager then explains that while the investment product (the fund they invested in) was doing well, the Yen was steadily dropping in value all year. The day they made the investment, the Yen was worth .0085 cents US, and today, a Yen is only worth .0045 cents US, so their 230,000 Yen, if exchanged today, would only be worth $1000. So while it looked like they made money, they in fact just broke even. The currency risk, in this case, got the better of them, and a greater risk is that the Yen could continue to drop in value, and their investment could, in fact, end up being worth less than the amount they put in. So while their investment doubled, their return did not. Because the investment currency did not equal the fund currency. The fund was calculated and managed in Japanese Yen, and Bruce and Leslie’s investment was made in USD.
This means that Bruce and Leslie paid a fee to a professional, certified Investment Manager to have their money exposed to an asset class, and the Manager passively took on currency risk with no expertise on the subject. This means they passively took on exposure and paid a fee to do it. So they effectively paid a fee for expertise that does not surpass their own. They may as well have gone to Vegas and bet on black.
While it wasn’t intentional on the Investment Manager’s part, it resulted in a terrible outcome for Bruce and Leslie. No one here, not the Manager or Advisor, nor the Investor, was sufficiently educated in currency exposure management.
Does the average consumer pay attention to the performance of every currency his investment is exposed to every day? Does the average Investor even know how many different currencies are at play within his portfolio? Does this consumer even pause and acknowledge that he should pay attention? Does he call upon his Advisor or Investment Manager to make changes to his portfolio when he sees a shift in currency markets?
In the majority of cases handled by the vast majority of Investment Managers, the answer to all these questions is no. The Investor doesn’t ask himself, or anyone else, any of those questions. He who does is considered an exception, a savvy Investor, or possibly an inspiration to an Investment Manager who lacked the prompting to deal with currency risk at any deeper level than the basic extent to which he does now.
The industry mentality that prevails, and that seems to be accepted by Investors is that you simply accept the risk. This is true in part because of the possibility of a favorable outcome. But that’s not enough of a reason to treat hedging as only a part-time, or half-hearted activity. It should always be at the very least offered to Investors. Let them make an informed decision and consciously decline it if they so choose, but to deny them the information and the option to hedge marks a lapse in the fiduciary responsibility Investment Managers owe to their ultimate clients, the Investors.
And this is where things can start to change. With a greater understanding of currency exposure and risk, consumers will start to demand more attention to its management.
Fear of the unknown is a powerful deterrent. Consumers and Investment Managers alike are guilty of avoiding this topic because they don’t realize that a greater understanding of it is accessible, and with the understanding will come a skill set that qualifies Investment Managers to effectively manage this previously feared yet unavoidable component.
It’s also true to that a mandate doesn’t currently exist to warrant any extensive knowledge of currency hedging on the part of Investment Managers since they aren’t even required to offer a hedge in the first place, as noted previously.
It is actually understandable that management of currency risk is often minimized even though this is an industry that specializes in paying attention to global monetary activities. Again, I come back to the fact that currency is not a profit center, but rather a byproduct of investment and distribution activities that are exactly the activities that provide an important service to Investors and make investment management companies profitable.
The impact of currency risk on returns has been long considered a reality that needs to be accepted when choosing foreign investments. For many Investment Managers, it had been left out of the equation.
So let’s start at the very beginning, let’s understand what currency risk really is.
I’ll explain it using realistic scenarios based on my personal experiences. The characters you’ll meet each represent a combination of people I have worked with over the years. I’ll share with you a few examples of the typical situations that played out during the course of my time as a Software Analyst in financial services, and through these stories, you’ll gain the understanding of everyone’s unique perspective on a common situation. While the specific examples and characters used here are fictitious, the situations are very real and typical.