When you invest globally, gaining access to foreign markets and equities, you’re also exposed to foreign currencies.
Most funds and investors seek to hedge this currency exposure when it’s not favourable, to reduce portfolio risk, said Michael Sager, vice-president and client portfolio manager, multi-asset and currency management, at CIBC Asset Management, during a late-October interview.
If you think of a Canada-based equity investor or manager who adds exposure to Japanese equities, for instance, it’s likely that she’s “thinking about the relative attractiveness of those equities [and] the local return. They don’t think about any forecasts for the exchange rate,” he explained.
“So it’s very much inherited currency exposure,” leaving investors who are seeking the underlying assets to either ignore the currency exposure or get rid of it by hedging, he said. “Either way, they’re not [in the currency market] to make a profit explicitly from currency.”
However, there are active managers who seek currency exposure and trade globally, Sager said.
These managers, who look for alpha through leveraging currency efficiencies that can help boost portfolio returns, understand that the currency market is, “in some ways, very different from other asset classes,” he said. “It’s much more liquid, [with] the daily turnover in foreign exchange [being] multiples higher than the [other] liquid asset classes,” including equities in general.
Further, the currency market is predominantly driven by the transactions made by non-investors, or those who aren’t seeking a profit, he said. This means there’s opportunity for active managers to capitalize on resulting inefficient trading activity and volatility.
Sager said about half of daily flows are driven by market participants who aren’t seeking to maximize profit, including tourists exchanging money, and central banks.
The latter get involved in currency markets as a means to an end, such as achieving an inflation target, he said. They’ll do that by “either buy[ing] or sell[ing] foreign currency, depending upon whether [they] want to weaken or strengthen the domestic currency.”
“We’ve seen data, in many studies, that show central banks actually lose money from foreign exchange interventions,” he added, pointing to studies released by the Reserve Bank of Australia, Deutsche Bank and the European Central Bank over the last couple decades.
Overall, non-investor participants in the currency markets aren’t there to “add value to portfolios, but to undertake transactions,” he said.
Today’s currency market
Earlier this year, some active managers were forecasting that the end of accommodative monetary policy from central banks would boost currency funds.
The Federal Reserve’s interest rate hikes have driven up the value of the U.S. dollar, which, along with trade tensions, has negatively impacted some emerging market currencies and increased volatility in the currency asset class.
The U.S. Dollar Index is sitting close to its 12-month high of US$97.69.
When searching for currency opportunities, Sager said active managers look beyond major players like the greenback, euro, pound and yen. These are “bigger” and “more liquid,” he said, but with more currency exposure, there are “more decisions and opportunities” that can lead to added portfolio value.
“Instead, managers typically focus on a broad cross-section of currencies that include both developed and emerging markets. All of the currencies can be used to exploit market inefficiencies [and] add an additional diversifying source of return,” he said.
Also read: Consider alternatives as markets moderate
This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.