Beware: The Currency Tide May Be Turning
How are your Japanese investments performing this year? Well, Japan’s Topix market is down around 7% year to date so probably not too great. But, assuming you are not a yen investor, did you remember to hedge out the currency risk? If not, the answer is very different. Dollar investors have lost only 2.5% so far this year. Sterling investors are actually up 5.5%. The smartest looking of all, though, are Euro investors who saw the opportunity that Japan presents and are sitting on a gain of over 14% for the year.
We mention this to make the point that decisions around currencies can often be the biggest driver of returns. They may, however, only be mentioned in passing by an investment manager or not at all. We sometimes hear the view that these things even themselves out over the long run or that the risk is diversified. We disagree. Diversification does mean owning a variety of assets that are often not denominated in their own base currency. However, from a currency perspective this is always a one-way bet. Investors become short their own currency to the extent they are unhedged. This means they do well – as in the Japanese example above – when their currency falls in value. Note also that a strengthening currency is nearly always bad. This is, we believe, a hidden risk that sits in many private client investment portfolios.
As an example, look at the case of a sterling investor. First, sterling has been on a general weakening trend for the last four or so years against a variety of currencies, including the dollar and yen. There has therefore been a benevolent tailwind for many diversified (unhedged) portfolios.
Since 2007, sterling has also been itself a risk asset. This means that when equity markets have fallen sterling has often weakened at the same time. Again, as with Japan this year, a weakening local currency has damped down equity market volatility and has sometimes turned losses into profits. Sterling investors have, in effect, been rewarded for doing the easy thing (i.e. nothing) when it comes to currency risk.
However, this benevolent trend cannot continue indefinitely and when it reverses the unwind could be painful. It may also lead to increased (not reduced) portfolio volatility. June provided an example of what might be in store. The S&P 500, for example, fell 5.8% for the month at a time. Unusually, though, sterling actually strengthened against the dollar by 2.8%. This gave total notional losses of 8.6% for a sterling investor as well as higher volatility.
Having benefited from the short sterling trade at the end of 2008 and the start of this year we are now predominantly currency neutral across our sterling, dollar and euro portfolios. We look to avoid large, one-way bets in our client portfolios. A large short-position in your own currency (even if it is in the name of diversification) looks like one of these to us. For now, particularly for sterling investors, this bet has paid off but we are not currently positioned for this good fortune to continue.
Chris Brown, Co-Chief Investment Officer, IPS Capital
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