For
anyone sitting in the offices of a UK charitable organisation
that pays for goods and services, raises funds and carries
out its general business in good old fashioned pounds and
pence, the rise and fall of the rand or the yen may appear
irrelevant.
So the dollar is weak against the pound? Shopping in New York
may look appealing but how will that affect the charity? What
effect could a falling euro or a soaring New Zealand dollar
possibly have on the finances of your average UK charity?
If you invest purely in the UK, then you might be right in
thinking foreign exchange movements may not affect your finances
in a huge, or at least a very direct, way. But if your charity’s
investment portfolio includes overseas assets, for example
shares in overseas companies or units in foreign funds, then
currency fluctuations may have more of an impact than you
might think. Many charities will have exposure to overseas
markets through far-flung unit trusts and common investment
funds without really considering how their base currency can
affect the value of their investments.
After all, if you invest in overseas markets then you are
likely to have bought foreign shares in foreign currencies.
So in theory, returns on a foreign asset class could potentially
be decimated by a fall in the value of the currency it is
held in. Put crudely, if the value of your investment in a
US unit trust rises 50 per cent but the value of the dollar
drops by 60 per cent, you stand to lose out.
Indeed, it is not only charities with overseas holdings such
as unit trusts and common investment funds that could be affected
by foreign exchange movements. Those charities with any other
form of overseas asset, such as overseas premises or land,
could potentially feel the effect of foreign exchange, or
FX, fluctuations.
If the value of a property in South Africa rises and the value
of rand rises too, then you will be in a strong position,
but if the rand tumbles then the value of that property might
increase, but convert any gains to sterling and they could
disappear. Similarly, any charity with a regular stream of
foreign currency income or expenditure will also be exposed
– what looks like a healthy income in US dollars when
the dollar is strong, would not look nearly so healthy in
sterling when the there are almost $2 to the pound.
The question of overlay
Many would argue that any organisation with foreign exchange
exposure in its portfolio ought to consider whether or not
it should use currency overlay. The answer may not be “yes”
in every case, but the question is nonetheless a relevant
one.
Currency overlay treats currency as an asset in its own
right, and aims to separate the risk of equities and other
assets from the risks involved in currency.
Essentially, currency overlay aims to hedge, or to limit,
the risk of adverse currency movements on an investment
portfolio, typically using currency swaps and forwards.
It can also be used to profit from beneficial fluctuations.
“Currency overlay offers two main attractions for
investors holding investments denominated in foreign currency,”
explains Ron Green, senior manager of product development
and distribution at the Charities Aid Foundation. “Managing
currency risk and generating additional return.”
“People use it because, while they like an underlying
[overseas] asset, they feel uncomfortable about the currency
and so decide to hedge the value of that currency,”
says John Tickle, head of charity investment at Legal &
General.
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Positive returns from currency fluctuations?
Currency overlay can also be used with an ‘alpha mandate’,
in other words to produce a return for the investor. Many
believe that seeking returns from this mechanism simply
increases currency exposure and therefore risk. Indeed,
the idea and objective behind these is similar to a foreign
currency hedging fund.
And while returns on currency were consistently positive,
if very small, over recent years, the end of 2007 bucked
that trend. BNY Mellon Asset Servicing said in December
last year that currency overlay managers had failed to achieve
a quarterly positive median excess return, and indeed saw
a negative return of 0.42%, the lowest since 2004. Over
one and three year periods, managers fared slightly better,
bringing median excess returns of 0.59% and 0.27% respectively.
Alan Wilcock, BNY Mellon Asset Servicing’s Performance
and risk analytics manager, says: “Over shorter periods,
up to three years, we have seen the survey results swing
from positive to negative and vice-versa. However, we have
been accustomed to the longer-term currency overlay statistics
showing median positive performance. The recent five-year
result is therefore quite unusual.”
This is no way to make a fast buck, then, but even so currency
overlay has been a popular tool in the US and continental
Europe since the 1980s. The UK has been slower on the uptake
but the mechanism is now used more widely.
UK investment in overseas equities has increased by 8 per
cent over the past 10 years, according to BNY Mellon, and
pension funds now hold on average an impressive 28.1 per
cent of their assets overseas. With the level of exposure
increasing, there has been a growing demand for currency
overlay as a means of ironing out fluctuations in the foreign
exchange markets.
There are a number of currency management firms specialising
in this form of hedging, so that the mechanism can be outsourced
and treated as a separate part of a charity’s portfolio.
CAF’s Green explains: “Normally this activity
is not undertaken by fund managers but by specialist currency
managers, who likely will utilise sophisticated mathematical
models to inform decision making.”
Many investment banks manage their currency risks in-house,
through their own dealing desks, and offer a currency overlay
product. Similarly, many fund management houses offer collective
investments in sterling as well as in the currency, or currencies,
relevant to a particular fund.
“Many investment funds undertake currency management
to mitigate any change in currency value of underlying foreign
investments,” explains Green. So in these cases the
investor does not need to give any thought to currency overlay,
it is all managed for them without the need for a separate
product.
In these cases it is relatively easy to see whether currency
management helps returns and / or volatility by comparing
performance between the two funds, which, although they
invest in the same assets, may have very different patterns
of performance. Currency overlay as a separate process within
a portfolio adds an extra layer of cost, and this will vary
depending on whether currency is managed in house by an
investment manager or whether the job is outsourced to a
specialist firm.
The more currencies involved in a portfolio, the more it
will take to hedge those investments, and so the higher
the management cost might be. Fees will also vary depending
on whether a charity simply wants to hedge its investments,
or whether it also wants to go in search of returns through
currency fluctuations.
The types of currencies involved will also make a difference.
When dealing with a particularly volatile currency, for
example, the currency manager will be obliged to make more
frequent trades to iron out fluctuations. “A professional
manager will have the advantage of dealing simultaneously
for a number of clients, having offsetting exposures and
ability to trade on the best FX prices,” says Green.
“Given this, costs can be very competitive given the
protection offered.”
Nonetheless, for some organisations, it will be important
to balance out the cost against the benefits, says Legal
& General’s Tickle. “If you are getting
diversification across other assets, is it worth trying
to judge whether a currency is going to go up or down? Is
the cost going to be worthwhile?”
Certainly smaller charities, those with overseas exposure
in the first place that is, may find that diversifying their
investment portfolios in the most sensible way possible
is a more cost-effective way of managing the risk that may
arise from having foreign exchange exposure. Many will not
have the level of sophistication necessary, let alone the
size of portfolio they would need, to make currency overlay
a worthwhile option.
Charities with exposure to the foreign markets of £250,000
or more need to seriously consider currency overlay to hedge
the risks their portfolios face.
However, specialist managers will often only take on clients
where that exposure amounts to £5 million or even
considerably more.
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