Emerging market (EM) currencies have taken a beating this year as rising US interest rates and softer economic growth pose a double whammy to the region. The MSCI Emerging Markets Currency index has tumbled by over 6.0% as the US Federal Reserve marches on with its tightening cycle to rein in inflation.
Against such a turbulent backdrop, it has become important for investors to also consider how fluctuations in currency values and find ways in managing currency exposure in their portfolio. In our latest Fundamental Flash, we look at the importance of managing currency exposure and why investors should also diversify from a currency perspective.
Same Market, Different Results
Currency volatility can be a huge factor that impacts overall performance returns. With more pronounced movements in currency markets now, it has become doubly important on how an investor needs to be managing currency exposure in their portfolio.
Graph 1 shows how the total returns of the benchmark KLCI differ greatly when seen from both a Malaysian Ringgit and US Dollar perspective. For example, a foreign investor who invests in the local market will yield lower returns when the value of the investment is converted back from Malaysian Ringgit to the US Dollar, where the local currency has been weakening against the Dollar.
Conversely, when a local investor invests in a foreign asset and the corresponding foreign currency appreciates, the investor would reap higher returns from the investment.
In Graph 2, a Ringgit based investor would yield higher returns when the value of the investment in Singapore equities is converted from Singapore Dollar back to Malaysian Ringgit.
Managing Currency Exposure: To Hedge Or Not To Hedge?
Some investors may opt to hedge their portfolios to minimise the risk of adverse currency swings and its impact to performance returns. This is where an investor chooses to solely focus on investment gains or losses directly from the underlying asset into the portfolio as opposed to any currency movements.
Thus, an investor can protect investment returns from adverse currency fluctuations and instead focus the bulk of his investment entirely on the performance of the underlying asset class.
On the flip side, the investor would also forgo favourable forex movements when the portfolio is hedged as no currency gain is recognised. There are different considerations that an investor should think about when deciding to hedge.
Chief among them is the investor’s own objective and risk appetite. A more aggressive investor may be able to tolerate a larger amount of volatility in his portfolio and may opt for an unhedged currency class.
On the other hand, a more conservative investor who requires a steady income stream may choose to invest in a hedged currency class to shield returns from unfavourable forex translation. Some investors may also decide to take a view on a particular currency if it will strengthen or weaken and subsequently decide on how to hedge their position accordingly.
For instance, if an investor expects the US Dollar to continue strengthening against the Ringgit, the investor may pick an unhedged currency class when investing in a US bond fund to clip the coupons and also benefit from currency gains. However, investors should refrain from being too reactive or timing currency movements.
It is extremely difficult to predict short-term movements of any currency with sufficient accuracy as there are a variety of factors that can influence a currency’s direction.
These include monetary policy action, inflation levels, fiscal position, political stability, trade balance and overall attractiveness of the country’s goods and services. It often involves a degree of speculation with some guesswork involved to predict the spot rate of any currency.
In the long-term, the value of a currency will reflect the fundamentals of the country and the resilience of its economy to withstand external shocks and outflows. What’s more important is for an investor to focus on the fundamentals of the country that the investor is allocating in, which ultimately drive market cycles and performance returns.
Managing Currency Exposure: Building A Multi-Currency Portfolio
The aim of any investor is to build a well-balanced and diversified portfolio so that gains from one asset class can offset losses from another. This includes managing currency exposure, where currency gains from one currency can cushion losses from another.
For mutual fund investors, they can build a portfolio composed of different currency hedged and unhedged classes to diversify their currency exposure. For instance, an investor could consider starting with a 50:50 currency mix, where 50% of their portfolio is designed to take in currency translation exposure (e.g. US Dollar, Australian Dollar perspective), whilst the remaining 50% is reserved for currency hedged exposure (i.e. Ringgit perspective).
This allows an investor to look past immediate currency concerns and also benefit from currency movements in either direction over the longer-term. This is how you go about managing currency exposure for better investment returns.
About the Author
Lee Sheung Un is a Communications Officer at Affin Hwang Asset Management. A millennial, he is still finding that balance between wealth, freedom and purpose. Views expressed are his own.