Currency confusion: it's all relative

Brandon Snow's picture

Another yuan bites the dust

With China finally joining the currency debasement party (in a small way to start), I thought it would be important to discuss currency and its impact on perception of returns.

Over the last 12 months the currency market has seen significant volatility and directional change. Of course, what makes currency so complex is that it is all priced relative to each other – there is no real common denominator. To further complicate things is the global reach of companies these days.  For instance we have owned a French company that trades in Swiss franc with nearly half its business coming from the U.S. - how do we hedge that?  It’s clear these days the impact of currency needs some deep thought.

Take a look at what markets have done in various currencies year-to-day through July 20, 2015:


Source: Bloomberg

A Canadian investor who bought European stocks at the beginning of this year is probably feeling pretty good about that decision, given that the Euro STOXX is up 17.2% in C$. However, investors buying the same stocks in the U.S. have actually seen only a 4.9% return, unless they decided to hedge out the currency exposure. Do U.S. investors who bought the hedged version of the European equity ETF know that they were really speculating on currency?

Again, currency is a difficult concept to master because it’s all relative. Sitting in Tokyo, where asset prices have skyrocketed since its QE, people are more confident and have a stronger sense of security as they feel wealthier than they were before the monetary experiment began. However, on a global purchasing power basis they are actually worse off.

We can look at this on a fundamental basis as well.  When we review EPS for the MSCI World over the last four years, you can see there has been next to no growth:

Source: Bloomberg

Of course the MSCI world is calculated in U.S. dollars. In Canadian dollars, this is what has happened:

Source: Bloomberg

In Canadian dollars, we have seen high single digit compound growth! Taking into consideration the source of the growth, I don’t think we should be extrapolating it into the future.

What’s important to note is that currency isn’t a core skill for anyone in my line of business, but it has been a massive head wind or tailwind this year for fund managers (depending on your home market, where you invest and your approach to hedging). With continually changing monetary policy stances and relative battles on the economic momentum front, I imagine currency will continue to be a significant relative driver of performance into the future.  What's important when investing is understand the source of performance for a company, a market or a fund and with currency such a dominating factor over the last year you have to be careful not to extrapolate recent results into the future.

Comments

Submitted by Jim Durnin on

Good morning Brandon,

We report the net of fee returns of investments held to clients in C$. Once the C$ bottoms in the next year or two, it will be important for fund managers to have the competency in place to at least partially hedge the eventual rise of the C$, otherwise, particularly in global or U.S. funds, performance will be mediocre or poor. Some fund managers do this already and have either gained the competency or hired the expertise (contracted) to address the significant swings in currency. Advisors/mutual fund purchasers cannot do this and it must fall onto the fund managers/fund companies. As usual, there will be winners and losers. Even a very unsophisticated hedge policy will take some of the pain away in owning a global product when the C$ starts to rise. The good news is that Cambridge has time to think about it and hopefully institute a policy to address currency. Using cost, or lack of knowledge/expertise is not a good reason in 2015. It was ok to not have policy in 2000 as the C$ worked it's way lower, but it still hurt over the next 10 years as the dollar went from about $0.62 to $1.10. I am hopeful to not have a repeat over the next 10-15 years.

Thanks,
Jim

Brandon Snow's picture
Submitted by Brandon Snow on

Hi Jim,

Thanks for the comment.

When I mentioned currency not being a core competency for fund managers I meant it isn't where mutual fund managers tend to create value for their clients. It has become a big risk when investing and is something we have to think a lot about.

Currency is a risk that has to be understood, quantified and controlled as well as possible and our team at Cambridge institutes an active hedging policy. We set our hedges on a monthly basis for all cross currencies and are notified, due to trading or performance, if our hedged position gets more than 5% above our targeted amount. We had been fully exposed to the US$ over the C$ for nearly four years. However, with the drastic move we have already seen, we want to reduce this risk exposure for clients and have since added some hedges. As always we will focus on the risks we are taking on when investing and ensure we are being compensated for the risk or reduce it as much as possible. 

Thanks for the question,
Brandon

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