Foreign exchange has been a rare source of positive return recently, but investors shouldn’t expect a dazzling choice of managers, writes The Cambridge Strategy’s chief executive PETE HENRICKS. One of the few asset classes to perform in recent times has been foreign exchange. Managers in this space have delivered positive returns to investors, whether wholesale or retail. In particular, it has been institutional investors that chose to opt for this “asset class” that have warmly welcomed the positive returns, especially in last year’s volatile investment climate.

But is foreign exchange an asset class in its own right or is it a derivative of an asset class that’s acquired by investing in foreign equities or fixed income? The jury is still out. For those investors that opt for the former position – foreign exchange as a distinct asset class – the aim is to generate alpha by buying or selling a variety of currencies. In the past five years, in particular, trading in this asset class has certainly become more sophisticated with specialist firms creating customised solutions for clients; the most common approach has been overlay programs that go long or short in a currency against a pre-determined benchmark.

That benchmark can either be passive, where the investor decides to simply hedge the currency to prevent foreign exchange losses, or active, where the aim is to outperform the benchmark, either by “under-hedging” currency in the belief it will under-perform or “over-hedging” in the belief it will outperform. How does this work in practice ? Assume a superannuation fund has a one billion Euro equity and fixed interest portfolio. If the Aussie dollar starts rising against the Euro and the fund fails to act then its absolute returns will fall because of the losses that will be sustained when those Euros are converted back into Australian dollars.

In this situation the overlay manager would buy Aussie dollars and sell Euros forward to manage that hedge, so if the Euro depreciated against the dollar then the hedge would start generating profit to offset the losses on the underlying foreign currency assets. In these markets, positions have to be constantly reviewed. An excellent example is the Aussie dollar when it started to rapidly come off its highs against the US dollar last year. Investors with a passive hedge quickly discovered that although the foreign currency assets might have been generating profits, the hedge is generating losses that have to be funded. Indeed, some funds were forced to sell assets to meet margin calls on the hedge – hardly a desirable situation.

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