The Currency Conundrum
At our latest Insight Event, Mawer tackled currency—specifically our approach and general thinking on the subject. Managing currencies is a difficult puzzle but one we feel is manageable.
Our presentation covered the following topics: • The role of foreign exchange • Beware of predictions • Accept complexity • Diversify 1/Ntelligence • Hedge only known risks
The Role of Currencies. Why Care?
Currencies adjust due to a wide range of factors. Over the past two years, the Canadian Dollar has declined in value (depreciated) relative to the U.S. Dollar (USD) along with many of the other major currencies. Canada is a small open economy—meaning a large degree of our economic activity is subject to outside forces. This results in being exposed to changes in exchange rates. The following are some examples over the past two years showing the impact of a
depreciating Canadian Dollar:
• An increased cost of travel to locations with stronger currencies—particularly “snowbirding” to the U.S. and travel to the U.K.
• Rising food and goods prices due to the fact most of these are imported from trading partners whose currencies are stronger.
• While the price of one barrel of oil (a primary input to gasoline) has declined by 61% in USD, the price of gasoline has fallen just 28.4%. Most of the difference can be attributed to the exchange rate, while the balance has been booked as profit by the refiner.
• A weak Canadian Dollar has been good for investment portfolios with exposure to foreign markets. Where local market returns have been under 5%, the currency translation effect has provided a boost:
Currency Impact
1-year Returns to September 30, 2015
Global Equity Fund U.S. Equity Fund
Actual Fund Return (CAD) 18.6% 22.9%
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What About Hedging?
We have been asked this question with frequency over the years. First, it is helpful to define what a hedge is. In its simplest form, an insurance policy is a hedge. You pay a premium to offset a potential loss in the future. In financial markets, a common approach is to agree to pay a certain price (for a commodity, an exchange of cash) at some future date to lock-in a price (e.g. $60 WTI or 0.77 USD per Canadian Dollar). You have a known obligation and are happy to lock-in a price, regardless of the changes that occur between now and then. At Mawer, we think hedging these types of things often makes sense – you know the amount and the timing.
When it comes to investment portfolios, the amount and timing are typically unknown. Any benefits of directly hedging are difficult to achieve for a couple of key reasons:
1. Underlying investments are themselves exposed to multiple currencies and their own hedging programs. (See Halma Case Study on page 3)
2. Currency markets are similar to weather systems; they are complex adaptive systems—difficult to predict, sometimes localized, sometimes widespread, often volatile. The butterfly effect applies as there can be big outcomes on either side with any small change. (See FXCM Inc. Case Study on page 4)
Case Study #1: Halma PLC
You know the sensor that makes the elevator door stop closing? A British company called Halma makes those sensors. Halma’s common shares trade in British Pounds, but its revenues and costs are in multiple currencies (see chart on previous page). In addition, management may hedge some of its currency exposures so its “realized” revenue mix may be different than what is disclosed.
Halma is a good example of why Mawer does not hedge investment portfolios. How do you hedge three moving parts successfully when you don’t know the amounts and final dates of the transactions? It’s very difficult and arguably not possible to do with regularity and accuracy.
Our approach is to factor in a company’s geographic revenue mix into our overall valuation process. We use these inputs to risk-adjust for exposures to varied markets and currencies. That way, our assessment of an investment’s return potential incorporates the investments’ underlying currency exposure.
Case Study #2: FXCM Inc.
Like the weather, currency markets are Complex Adaptive Systems. The complexity comes from multiple inputs that affect currencies such as: interest rates, inflation rates, economic growth rates, central banks, governments, corporations, terms of trade, financial instruments, and traders etc. A currency quote is a reflection of many moving parts. Add to that the possibility of unanticipated external shocks and adaptivity enters the picture. An example is the Swiss National Bank’s abandonment of the Euro peg. This was a unilateral action that surprised markets and had significant impact around the world for those involved in the carry trade (borrow in low interest rate currency, invest in higher rate currency). Anyone borrowing Swiss Francs had an immediate 17% increase in borrowing costs. In the case of Polish loans denominated in Swiss Francs, that amounted to $32 billion in immediate losses!
In the case of FXCM Inc., a currency trading company headquartered in New York, the impact of the Swiss Franc re-pricing wiped out a large part of the value of the company in just a few days (about an 88% decline in four trading sessions). This is an extreme example but it points out the potential for currencies to experience wide swings due to an external shock at the whim of a government or a central bank.
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A Risk Management Approach
One strategy Mawer uses to manage currency risk within the context of a portfolio is diversification. This is not a new concept. Diversification is even mentioned in the Talmud, the central text of Rabbinic Judaism with the oldest
manuscript dating back to 1342. It encourages followers to split their assets into thirds: one for business, one kept liquid, and one in land.
Conceptually, diversification works by dividing things by 1/N where N is the number of assets. If N=1, you’ve put all your eggs in one basket. What about the International Monetary Fund—how does it diversify IMF Reserves? It diversifies among currencies but not in equal portions. This is more of a 1/Ntelligence approach. That is what we subscribe to. How a Reserve Bank Diversifies:
1/Ntelligence Approach
Our approach is that we can go beyond 1/N by adding intelligence within our investment process. That intelligence is designed to put the odds in clients’ favour by identifying underpriced assets whenever possible. We believe it is a robust, resilient and durable way to approach the currency conundrum.
In equities we apply a risk-adjustment to a company’s cost of capital based on geographic exposure of its revenues. This ensures we capture geographical exposures in our assessment of a company’s future wealth-creating ability. In fixed income, the Global Bond Fund is designed to be the “Reserve Bank” of Mawer. Within a balanced portfolio, the Global Bond Fund intends to add intelligence around high quality government bonds, which can provide less correlation to equities than would be expected from a true Central Bank asset mix.
Summary
The bottom line is that the topic of currency is complex and can seem daunting to some investors. Keeping the following in mind, can help investors put the odds in their favour:
• Recognize the role of FX—foreign exchange has a big impact on your life and your portfolio
• Beware of predictions—In a complex adaptive systems it’s almost impossible to make good predictions consistently
• Accept complexity by diversifying intelligently • Hedge known risks
