Confessions of a currency manager

Executive summary:

• Predicting spot exchanges is tricky, but there are still ways of adding value in currency markets, including through a disciplined approach we call currency factor investing
• Being a value investor requires more patience than most investors realise
• Loss aversion is a common behavioral bias that can lead currency managers to make poor decisions
• A trusted partner – especially one whose been through all the market cycles, learned all the lessons, and built robust processes to apply those lessons to your specific circumstance – can be of great value for currency investors.

Having been through several bear markets, Van Luu, our Global Head of FI and FX, has his fair share of scars. As such, Van has seen even the largest investors make both good and bad decisions when it comes to managing currency. In this article, he shares the view from the currency trenches.

Confession #1: Currency markets are hard to predict

Maybe most investors would say this about their own asset class, but currency markets are really hard to forecast. When I rejoined Russell Investments eight years ago, I received a warm welcome from many familiar faces. A typical first conversation went like this: “We have been in need of currency forecasts, and it is really great that you are coming onboard to take ownership of the currency call.” Behind the pleasantries, most people must have quietly thought: "The poor guy. Currency prediction is such a fool's game." Some more plain-spoken colleagues told me as such.

That’s why we often advise clients to hedge their currency exposure from international investments when the exposures are incidental, i.e., a by-product of the decision to buy foreign stocks and bonds rather than a deliberate currency bet. While predicting spot exchanges is tricky, there are still ways of adding value in currency markets through a disciplined approach we call currency factor investing. This avoids many of the behavioural biases that currency investors can suffer and that I learned about through my own painful experience.

Confession #2: Being a value investor requires more patience than most investors realise

Everyone wants to be like Warren Buffet. And I don't mean that everyone wants to play the ukulele and praise the merits of his favourite soft drink. What I mean is that everyone wants to be a value investor like Warren Buffet. Warren's maxim is that you should buy companies for less than they are worth and hold them forever, and you don't have to worry about intermediate volatility. Sounds easy enough. But how do you know how much a company is worth? The fair price should equal the company's discounted cash flows, so you need to forecast the company's earnings, which doesn't sound that easy.

It gets even more complicated with currencies. Currencies are the calling card of an entire country. Economic growth, inflation and political risk all could have a bearing on a currency's value. Fortunately, economists have come up with the concept of purchasing power parity (PPP) to serve as a powerful value anchor for exchange rates. It is theoretically compelling and has historically performed well as a measure to rank currencies for a currency value strategy (more on that below). However, for individual exchange rates, it can take a long time to return to their PPP fair value, often many years. Clients usually do not have the patience to wait that long for a currency call to pay off. It is therefore important to make value bets across many different currencies. For diversification of process, I also learned that considering other variables and factors is essential, like price trends and interest rates.

Confession #3: I am no stranger to loss aversion

Loss aversion is a common behavioural bias that can lead currency managers to make poor decisions. I have to admit, even seasoned investors like me are drawn to loss aversion – tempted to sometimes holding onto losing positions for too long, hoping that the market will eventually turn in my favour. This is closely related to being a value investor.

I have seen many other currency investors hold onto losing positions for too long, hoping for a turnaround. This can be a dangerous approach, as losses can quickly accumulate and erase any gains. To avoid this bias, we often set stop-loss orders to limit potential losses and take profits when trades are successful. A different way of building a stop-loss system is to follow a trend strategy. With a trend strategy, I buy and hold what has been performing well, but automatically bail out of that position when the price trend reverses based on pre-defined rules.

Confession #4: Learning to avoid confirmation bias

Confirmation bias is another common pitfall that investors face. This bias occurs when we seek out information that confirms our existing beliefs and ignore information that contradicts them. This can lead investors to make poor trading decisions, as we may not consider the pertinent information.

One way of avoiding confirmation bias is to predefine the information set that I will act on. Interest rate differentials between currencies (also known as carry) have proven to be a powerful determinant of currency returns. For example, the New Zealand dollar currently offers around a 4% higher interest rate than the Swiss franc.  Using carry is about being humble in your ability to forecast spot exchange rates. Suppose that I believe in the random walk theory, which holds that the best forecast for tomorrow's spot exchange rate is today's rate. If that is the case, the interest rate differential between two currencies is the best return forecast. Going long the high-yielding and short the low-yielding currency then becomes the logical recommendation.

How to beat the biases: Process, process, process

Prediction of spot exchange rates is notoriously hard. Fortunately, we can use the disciplined systematic process of currency factor investing to capture the limited predictability there is in foreign exchange markets. In our view, three factors that have lasted the test of time in currency markets are carry, value and trend. The good news is that investors don’t have to try to beat these biases alone. Work with a trusted partner – especially one whose been through all the market cycles, learned all the lessons, and built robust processes to apply those lessons to your specific circumstance.

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.