Be done with risk as trade heads in the right direction

One of the consequences of international diversification is that investors suddenly find themselves vulnerable to changes in the value of sterling.

When just 5% of your portfolio was in dollar-denominated assets, no one seemed to mind about a five or even 10% adjustment over the long term. But with many investors now pushing the international element of both their bond and equity positions past 30%, the FX issue has become a headache.

There is a risk of holding assets in foreign currencies where the trade goes against you. If that was not bad enough you could also find your supposedly safe sterling equity holdings hit as the big FTSE 100 players report an increasing percentage of their sales and profits in either dollars or euros. By some measures, upwards of 60% of the weighted value of UK FTSE 100 earnings are now derived abroad, mostly the US.

At the moment none of us seem so worried, if only because the trade is heading in the right direction. All of those euro- and dollar-denominated assets are now worth an awful lot more since the euro pushed below 1.15 and the dollar below 1.50. Every hedgie I talk to thinks this trade has further to run. In the past three weeks I have talked to three different hedge fund managers or global asset allocation gurus who reckon we are heading to euro parity within eight weeks. But this trade will turn and there is a chance that turn could be sharp, sudden and violent.

Effects of FX

FX rates are the markets chosen macro-based battleground with hedge funds irresistibly drawn towards deep, liquid and easy-to-trade-in markets. Every major trader I talk to seems to have a big view on a key currency. Also, look at the amount of money being raised by FX-based ETFs and other assorted products, as well as the huge amounts of money inside macro hedge funds. As with commodities, one has to question the degree to which all of this new additional speculative capital might begin to influence the underlying markets: markets still largely controlled by trade-based flows.

I have a sense international bond and FX traders are picking their battles with governments through the prism of FX rates, increasing volatility in markets that have traditionally been much less volatile than equities. Even speculative activity is eventually forced to adapt to the basic long-term fundamentals of markets.

Both Anatole Kaletsky and Bill Emmott (the former Economist editor) have commented in The Times that sterling is looking strongly undervalued in fundamental terms. Based on purchasing power parity measures sterling is looking at least 20% oversold.

I would not be surprised to see the euro sterling rate snap back to over 1.20 by the beginning of next year and the cable back above 1.60 if not 1.70. A sudden spike back to $2 on the cable might not even be out of the question. For long-term investors all of this speculative froth should not matter as they sit tight, but we all know investors do not really think that way. Positive FX moves always seem to attest to the investor’s market timing, which then rapidly turns to outright scorn aimed at the adviser when the trade moves the other way.

Hedging out this exposure is still a risky business and largely the preserve of the big institutions. I talked to a hedgie with experience in FX who suggested the big FTSE 100 companies were myopic in the extreme about their FX hedge risk control, leaving it all to overpaid and over-rated investment bank traders who frequently messed it all up. He tried to offer his expertise to control that risk exposure but treasurer after treasurer in the FTSE 100 seemed unwilling to pay for his expertise. “They would say, ‘We get all the expertise we need for free via our investment bank’,” he said, adding that these corporate treasurers were “fools” for trusting them.

Advisers and private investors are forced into more expensive, options-based protection, where the time offered on any deal is rarely more than nine months and the cost hideous, even if you use listed products.

Some clever firms have tried to step into the breach. One of the latest is MarketGuard, which offers to protect an investor’s portfolio against any sudden move in sterling. It is a simple idea, in that you pay a fixed premium to insure a fixed sum over a specific term, but it does not come cheap. Hopefully, this idea will stimulate other providers to come up with better deals. Until they do, we could all be in a pickle that could worsen as sterling strengthens. Then again, there is always an alternative: to run all of our portfolios as dollar-based investments and be done with the risk.

David Stevenson is a Financial Times columnist and consultant. Email him at davidcstevenson@gmail.com