FOR WHOLESALE CLIENTS ONLY.
NOT TO BE DISTRIBUTED TO RETAIL CLIENTS.
November 2016
CASE STUDY: MANAGING EMERGING MARKET
CURRENCY RISK
EMERGING MARKETS HAVE EXPERIENCED A SHARP IMPROVEMENT IN ECONOMIC GROWTH OF LATE DESPITE
THE WEAK GLOBAL BACKDROP. MACRO FUNDAMENTALS CONTINUE TO POINT TO A WIDENING GROWTH
DIFFERENTIAL TO THE DEVELOPED WORLD. THE CASE FOR INVESTING IN EMERGING MARKETS MAY BE STRONG,
HOWEVER INVESTORS OFTEN OVERLOOK THE CURRENCY RISK IT CREATES IN THEIR PORTFOLIOS.
Many investors allocate a portion of their international assets
to emerging markets. The performance of these investments
depends on both the asset returns and the fluctuations of
emerging market currencies. Most of the currency risk associated
with diversified emerging market investments is actually explained
by the movements of an investor’s base currency versus the
broader developed market currency universe. To learn more
about our proposal for managing emerging market currency risk,
please read our detailed paper titled How to Make Emerging
Market Currency Risk Work for You.
Emerging market currency returns can vary significantly
depending on an investor’s domestic currency. Our paper
explores why this is the case. In short, the answer is inextricably
tied to the specific movements of investors’ base currency as it is
the expectation that the basket of emerging market currencies
will appreciate versus the basket of developed market currencies
over the long run that attracts investors to the asset class, rather
than versus a particular developed market currency. This suggests
that we should consider two components of emerging market
currency risk: the behaviour of an investor’s base currency against
developed market currency exposure in aggregate and the
behaviour of developed market currencies in aggregate against
emerging market currencies. Many investors in emerging market
assets are often implicitly targeting a return from emerging market
currency. But by decomposing currency risk in the way laid out in
our paper, we think it is possible to reduce the concentration of
base-currency specific risk, therefore potentially improving the
chances of this return being realised.
Directly hedging emerging market currencies also raises practical
issues as most emerging market currencies are quoted as
non-deliverable forward contracts against the US dollar, and these
instruments are less liquid than the deliverable forward contracts
traded in developed markets. This makes direct hedging
expensive for investors and more difficult still for non-US investors.
We propose adopting an unhedged stance on emerging market
currency risk against a diversified basket of developed market
currencies rather than a concentrated short in the investor’s
base currency. Figure 1 shows how the emerging market currency
return changes as we diversify away from the Australian dollar
as the base currency. The EM currency return from the Australian
dollar base is simply the unhedged currency return of the
MSCI emerging market index. The EM currency return with the
diversified developed market base is achieved through the
combination of the above and the performance of an overlay
that diversifies base currency risk. The overlay is a basket of long
Australian dollar forward contracts versus an equally weighted
basket of the Canadian dollar, Swiss franc, euro, British pound,
Japanese yen and US dollar. While converting a negative return of
-0.68% per annum into a positive return of 3.03% per annum, base
currency diversification also significantly reduces the volatility of
the return stream, with annualised volatility decreasing from
11.49% to 7.97%.
Figure 1: Diversifying base currency risk
80
60
40
%
20
0
-20
-40
Aug 00
Aug 03
Aug 06
Aug 09
Aug 12
Aug 15
EM currency return, Australian-dollar base
EM currency return, diversified developed-market base
Source: Insight Investment, as at 31 August 2015.
Please note the value of investments and any income from them
will fluctuate and is not guaranteed (this may be partly due to
exchange rate fluctuations). Investors may not get back the full
amount invested. Where model or simulated results are
presented, they have many inherent limitations. Actual results
may be materially different than the results presented.
management overlay
4
2
0
-2
% -4
-6
-8
-10
Figure 3: Diversification around the UK referendum
Currency weights (%)
Figure 2: Diversifying base currency risk with an active risk
particularly beneficial as sterling fell considerably in value
following the UK’s vote to leave the European Union in June 2016.
The strategy’s momentum signal sold sterling, with the pound
weakening as the referendum result approached, effectively
overweighting the level of diversification via the British currency
(see Figure 3). Underweighting the Japanese yen and US dollar
were also positive calls as these currencies were two of the
stronger developed market currencies over the quarter.
2.10
2.05
2.00
1.95
1.90
1.85
1.80
1.75
1.70
100
90
80
70
60
50
40
30
20
10
0
Apr 16
■
May 16
Jun 16
AUD ■ CAD ■ CHF ■ EUR ■ GBP
GBP/AUD exchange rate (RHS)
■
Exchange rate
At Insight, we decompose emerging market currency risk as
outlined above, and then recommend managing the idiosyncratic
risk of the investor’s base currency relative to a dynamic developed
market currency basket. We have a live track record of an active
approach, the results of which can be seen in Figure 2, that extends
the hypothetical results shown in Figure 1. The strength in the
Australian dollar over this live trading period has meant that
emerging market currency return has been negative for Australian
dollar-based investors and that a better outcome would have been
achieved by increasing the level of base currency diversification.
The actively managed outcome, which actively diversifies the
concentrated short Australian dollar exposure implicit in an
emerging market allocation has delivered a return improvement
of 4.71% over the period.
Jul 16
JPY ■ USD
Source: Insight Investment, as at 31 July 2016.
Sep 15
Dec 15
Mar 16
Jun 16
Sep 16
EM currency return, Australian-dollar base
EM currency return, diversified developed-market base
EM currency return, active risk management
Source: Insight Investment, as at 30 September 2016.
Our approach has been particularly successful in the period
since the UK referendum in June. The allocations of our dynamic
developed market currency basket during this time are shown
in Figure 3. The high allocation to the British pound was
Into the final months of the year, our approach is continuing
to diversify the concentrated short Australian dollar side of the
emerging market currency risk by replacing some of it with short
British pound, Swiss franc, euro and US dollar exposure. It has
tilted away from the Japanese yen with this currency exhibiting
some strength over recent months. If sterling continues to
weaken, we should see further benefits of this diversification
over the remainder of the year. The strategy’s risk management
process also stands ready to automatically return to a
concentrated short Australian dollar exposure, should the
Australian dollar experience a sell-off.
FIND OUT MORE
Insight Investment
Level 2, 1 Bligh Street,
Sydney NSW 2000
+61 2 9260 6655
Bruce Murphy
Director, Australia and New Zealand
[email protected]
www.insightinvestment.com
Telephone calls may be recorded.
Call charges may vary by provider.
Margaret Waller
Director, Investment Strategy
[email protected]
This is a marketing document intended for professional clients only and should not be made available to or relied upon by retail clients. Unless otherwise
stated, the source of information is Insight Investment. Any forecasts or opinions are Insight Investment’s own at the date of this document (or as otherwise
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The value of investments and any income from them will fluctuate and is not guaranteed (this may partly be due to exchange rate changes) and investors
may not get back the amount invested. Past performance is not a guide to future performance. This document must not be used for the purpose of an offer
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