The cost of currency: Finding potential opportunity in risk

Exchange rates are buffeted by political decisions and can seem utterly unpredictable, as recent events illustrate (see below). Pension funds and other asset owners are exposed to exchange rate fluctuations through their international portfolio holdings. Many of them see currency risk as an unwelcome by-product of international diversification, and they may try to reduce or eliminate the risk through currency hedging programs.

A great example of this potential problem for diversified investors is the UK’s recent Brexit vote to leave the European Union. This event has given us a stark reminder of the turbulence that can beset foreign exchange markets. Britain’s currency, the pound sterling, fell 11% against the currencies of the country’s major trading partners in the first 10 days after the Brexit result was announced on June 241. The pound bought less than 1.29 U.S. dollars on July 72, the weakest level it had been against the U.S. dollar in some 30 years.

The following Monday, the governing Conservative party in the UK voted for Theresa May to become the new prime minister and take the country into Brexit negotiations. Earlier that day, Japanese Prime Minister Shinzo Abe had announced a substantial government spending program to stimulate the flagging economy. Both events led to a sharp reversal of previous currency trends. From July 11 through 14, the pound rebounded by around 3%. The yen, which had previously been the strongest developed-market currency in 2016, fell nearly 5% against the U.S. dollar in the same period3.

In our view, unmanaged currency exposure from international portfolio holdings is generally very much an unrewarded risk. However, we also think that, when managed thoughtfully, the volatility of currency markets offers valuable potential opportunities to add investment returns.

One way of doing so is through so-called currency factor strategies, which are rules-based strategies implemented with liquid currency forwards. Currency factor strategies are comparable to the smart beta strategies many investors will be familiar with in equities, such as value, momentum and quality.

At Russell Investments we use our currency factor strategy, called Conscious Currency, in our multi-asset and fixed income portfolios. Conscious Currency4 takes positions in the 10 most liquid developed market currencies. It consists of three equal-weighted factors that have historically been shown to be rewarded in currency markets: carry, value and trend.

  • Carry buys currencies with high interest rates and sells those with low interest rates.
  • Value moves into undervalued currencies and out of overvalued ones.
  • Trend tilts exposure towards currencies that have recently gone up and away from currencies that have gone down.

As a rules-based strategy, Conscious Currency was obviously “unaware” of the event risk around Brexit. However, looking at a hypothetical example, this strategy would have correctly picked up the return and risk associated with currencies around the referendum in the UK. By being long the yen and short the pound going into the event, an investor who used a strategy like this would likely have benefitted from very strong returns. Conscious Currency5 returned +3.5% in June alone and +4.0% in 2016 (through 19 July). All three factors in this example – carry, value and trend – would have contributed positively to the recent upswing.

Such strong returns would likely be welcome in any environment, but can be particularly valuable in the low-return world we are in. According to this year’s June Global Index Report, Negative Yield Index Monitor by JP Morgan, 44% of the European and 29% of the global fixed income indices have negative yields as of June 30. When many risk-free bonds, as indicated by the JP Morgan report, are most likely to lose money when held to maturity, a potential +4% sounds like a pretty good pay-off for taking moderate risk.

1 Source: Thomson Reuters Datastream.
2 Source: Bloomberg.
3 Source: Bloomberg.
4 Conscious Currency is a rules-based approach to investing in the currency market which is independently measured, published and maintained by FTSE Russell.
5 As measured by FTSE Russell Conscious Currency Indexes (RCCI).