Special FX? The role currency plays in multi-asset portfolios

Currency plays a unique role in the world. Cigarettes, gold, favours, digital tokens, and smoked fish have all been used as currencies in different contexts throughout history. But how do investors see the role of currency as an investment tool in their portfolios?

Every asset comes with a currency attached to it but, using derivatives, investors can separate the currency exposure from the asset exposure. That separation allows investors to treat currency as its own asset class, making it a flexible tool for meeting the objectives of global multi-asset portfolios. 

It can be used in three ways:

• Strategically. Every portfolio must have a base currency for valuation and tax purposes. This means asset owners must consider what their neutral, strategic currency position is for their base currency portfolio. And for each base currency, there is a different neutral starting position.
• Tactically. Since currencies are a heterogeneous group, correlating differently with different asset classes at different times, portfolio managers can use them tactically to position for shorter term risks and opportunities.
• Systematically. Since groups of currencies with similar characteristics often display similar performance profiles, portfolio managers can build systematic baskets of currencies to obtain the exposure they need.

All three applications can be return-enhancing and/or risk-reducing in a portfolio context, underlining how flexible currency can be as an investment tool.

1.       Strategic: setting the starting point for the long term

The base currency of a portfolio is that in which it is priced. By their nature, portfolios that invest globally hold assets that are denominated in currencies other than their base currency.

If such exposures are left unhedged, their risk/return profile is determined by changes in the spot exchange rate between the foreign currency and the base currency of the portfolio.

Since every portfolio must have a base currency, globally invested portfolios must start somewhere with respect to how much foreign currency risk they are willing to take on.

The two extreme starting points are a) to hedge all foreign currency risk back to the base currency, and b) to hedge none of the portfolio’s foreign currency risk back to the base currency. But these are extremes, and there are more thoughtful ways of setting a portfolio’s strategic neutral currency position.

We discuss the factors to consider in more detail in our series of strategic currency hedging papers, including ‘special’ factors for currencies with unique characteristics^[1]. For now though, it is sufficient to isolate two main factors as being the most important: 1) the base currency of the portfolio, and 2) the asset split between risky and less risky assets in the portfolio.

These two factors are important because, depending on what the base currency is, its relationship with the risky assets differs. If this isn’t managed properly, it changes the entire risk profile of the fund. 

Figure 1 shows a summary of neutral starting points based on those two main factors. The currencies listed on the left are listed in order from least ‘risky’ (defined by their relationship with equities) to most risky. Crucially, the strategic currency decision is more about risk management than it is about return generation.

With this in mind, seeking a strategic currency position that minimises portfolio volatility is typically the starting point for most asset owners’ portfolios. 

After the strategic hedge ratio has been set, it’s then up to the portfolio manager whether to tactically deviate from it. This will depend on their view of the prevailing investment landscape and outlook for individual currencies. It is here where active investors believe there is scope for return generation.

2.       Tactical: using currencies to position for risks and opportunities

Figure 1 already touched upon the fact that some currencies are ‘riskier’ than others. But risk is multi-faceted, so beyond the neutral risk assumption we make for strategic positioning, it is necessary to understand the macroeconomic and asset class sensitivities of different currencies. We don’t go into every currency here, but instead pick out some examples and explain how multi-asset investors apply this understanding in tactically positioning portfolios for risks and opportunities. 

It is worth noting that currency can be used as a proxy for a different asset class or expression of a broader theme, in addition to its use in expressing views about the individual country or countries it is associated with.

Consider the Canadian dollar, for example. It is a developed market currency subject to a credible central bank, strong fiscal governance and monetary policy stability – all features associated with defensive “safe haven” currencies. However the Canadian dollar is – perhaps counterintuitively - typically considered a ‘risk-on’ currency; that is, a currency to use at a time when risk appetite is high.

Figure 2 shows that Canada’s trade balance is dominated by fuels, which are highly correlated with global economic activity, while Figure 3 shows that trade is relatively important for Canada overall. 

Since global trade, and particularly the global demand for fuels, is highly correlated with overall economic activity, the Canadian dollar is typically correlated with the global economic cycle. That, in turn, means the Canadian dollar is usually correlated with global equities, a relationship illustrated in Figure 4.

So, if we wanted to express a view that the world is set for a global growth resurgence driven by an increase in trade, then we could do any of the following things in respect of exposures in the portfolio:

• Buy the Canadian dollar
• Buy oil
• Buy Canadian equities
• Buy global equities

Figure 5 shows the performance of the Canadian dollar compared to the performance of oil. They generally move in tandem, but the Canadian dollar often doesn’t suffer quite as much when oil is out of favour. In that sense, its performance is “asymmetric” (capturing more of the upside than the downside).

Using a proxy can sometimes mean ‘softening’ the view. For example, in 2019, the rise in oil price prices was much steeper than the appreciation of the Canadian dollar.

In addition, using currencies can be more capital efficient due to the use of currency forwards. Derivative instruments are used to separate currencies from other asset classes, so investors must consider the difference between the current, or spot, exchange rate and an agreed future, or forward, rate. This introduces a cost of carry, closely approximated by the interest rate differential between two currencies, which could be positive or negative.

Unlike currencies, commodities do not pay interest. They must be stored, sometimes at great cost. When the future price of a commodity is higher than the spot price it is said to be in ‘contango’, which implies negative carry. Carry/roll, which is essentially the effect of holding a position over a defined period of time, also differs across different implementations.  It often makes the currency version of the trade more efficient to hold, or vice versa. This can be highlighted by comparing the forward price curves of the Canadian dollar to crude oil.

Figure 6 shows that in October 2015 while the Canadian dollar had a positive cost of carry, the crude oil market was in contango. At this time it would have been more beneficial to use a Canadian dollar proxy trade to express a positive view on energy, given the negative carry.

In contrast, Figure 7 shows that in 2018 the markets were experiencing the opposite situation. The crude oil market was in backwardation, the spot price of oil was higher than the future price. This could be seen in the downward sloping forward curve, so there was a benefit to buying and holding oil.

The multiple ways in which currencies can be used to express a tactical view are displayed in the macroeconomic risk scenarios we use in multi-asset at Schroders. Figure 8 shows some typical scenarios developed by our economists, and examples of tactical currency positions that should protect against them or provide returns. Having the flexibility to make currency pair trades (i.e. going long one currency while going short another) is a very useful tool in tactical currency trading, provided portfolio guidelines allow it.

In the event of a China hard landing, an asset owner would need to protect against exposure to countries which are large exporters to China. Selling short the Taiwan dollar or Australian dollar would hedge against this risk. Naturally, such an application of tactical currency management must utilise both quantitative and qualitative assessments of a currency’s suitability.

In considering the efficiency of a hedge against a particular risk (i.e. the protection it provides), we assess both the cost and effectiveness of the hedge. This is illustrated in Figure 9, which plots the sensitivity to equity markets of different hedges against the cost of owning that hedge.

Let’s consider an example of trades that have similar effectiveness, but the cost of carry is more favourable in one compared to the other. Long US dollar vs Australian dollar and long Japanese yen vs Australian dollar – shown in green on the far right hand side of figure 9 (in such currency pairs, the first named currency is bought and the second is sold) – show similar effectiveness but the US dollar version of the hedge has more positive carry.

Perhaps even more importantly, the decline of government bond yields in recent years has meant that traditional go-to hedges such as US 10 year Treasuries now offer less protection against equity drawdowns and less interest income in the meantime. Using currencies, especially the US dollar in recent years, has given portfolio managers a way to own hedges that actually pay out while held.  

This analysis also helps us to compare the use of currencies against more traditional asset classes such as government bonds or gold. For example, while Figure 9 shows a similar carry from US 10-year bonds as for the US dollar vs the Canadian dollar, the latter has a greater negative sensitivity to equities as of January 2022 (both circled in blue).

Recapping the use of currencies to tactically position for risks and opportunities, multi-asset investors aim to: 

• Understand the macroeconomic and asset class sensitivities of currencies
• Use currencies as liquid or efficient proxies for other asset class views and broad thematic views
• Identify specific risk scenarios and consider which currency positions might work well in each of them
• Compare the use of currencies to more traditional hedges such as government bonds and gold.

3.       Systematic: building systematic baskets of currencies to obtain uncorrelated exposures

In the same way that a multi-asset portfolio can be broken down into its component asset classes, asset classes can be broken down into their component drivers of risk and return. By understanding what it is that drives the risk and return of currencies, we can group together currencies that score similarly on a range of different metrics.

For example, observing that currencies of countries that are experiencing increases in their economic growth rates tend to appreciate, we can build a ‘growth momentum’ basket of currencies. Similarly, observing that ‘cheap’ currencies – as measured by comparing actual exchange rates to those predicted by real effective exchange rate models – tend to appreciate, we can build a ‘value’ basket of currencies. 

Given the risk and return drivers of currency and their differing economic rationales, currency basket performance profiles tend to be complementary to one another, i.e. not correlated with one another. They also have a low correlation with equities, the largest traditional driver of risk in a multi-asset portfolio. Figure 10 shows this for example FX Value and FX Growth baskets. 

These currency baskets are designed to be effective diversifiers in a portfolio context under a range of market environments. They are intended to be held for a longer period of time than the tactical positions described in the previous section. This is because, technically, the investment rationale for these baskets is that they are expected to have persistent positive risk premia. That is, a positive return is expected for taking on the risk of investing in a basket.

The positive expected risk premium is not necessarily because of the currencies themselves, but because of the ‘growth momentum’ and ‘value’ elements of the baskets. Currencies are being used to access the positive expected risk premia inherent in growth momentum and value strategies.  

In a portfolio context, these baskets have been shown to offer positive return-to-risk benefits. Figure 11 shows that including a fixed allocation to FX Value and FX Momentum in a model 60:40 equity/bond portfolio can shift the efficient frontier up. This increase in efficiency comes mainly from the fact that the baskets can offer an uncorrelated stream of returns with a positive overall expected return. 

It should be noted, however, that trends that held in the past will not necessarily hold in the future. Ongoing research into recent and expected behaviour of currency baskets is crucial for ensuring that they continue to provide these risk/return benefits.

Summary

Asset owners can use currency strategically and tactically, as well as in the creation of bespoke baskets which can provide uncorrelated return streams. 

The starting point for currency exposure rests heavily on the ‘riskiness’ of its base currency and of its asset split between risky and less risk assets. 

Strategic currency allocations are typically for risk management purposes, rather than return generation.

Using currency tactically, multi-asset investors aim to: 

• Understand the macroeconomic and asset class sensitivities of currencies
• Use currencies as liquid or efficient proxies for other asset class views and broad thematic views in order to generate returns
• Identify specific risk scenarios and consider which currency positions might work well in each of them in order to hedge against specific scenario risks
• Compare the use of currencies to more traditional hedges such as government bonds and gold.

Finally, systematic currency baskets can play a helpful role in multi-asset portfolios by providing uncorrelated streams of return and increasing the efficiency of the portfolio.

[1] What is the appropriate currency hedge ratio? Schroders, February 2019.