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Analytics Can Help Investors Gain an Advantage in Currency Management

The right tools and partner can help you focus more time on managing assets.

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Currency Management

Currency Management

A highly volatile and globally interconnected economic environment is rife with risk and opportunity for nearly every institutional asset allocator or manager. Opportunity doesn’t recognize borders, however, so many institutional portfolios should manage exposure to foreign exchange (FX) as part of their investment operations.

“Volatility and the knock-on effects of the Fed rate increases this year have had a significant impact on cable [the exchange rate between USD and GBP] and returns related to many currencies, including the euro and yen,” says Andy Lemon, Head of Currency Management, Northern Trust Capital Markets. “One of the knock-on effects is that significant amounts of P&L can result from hedging strategies to reduce the impact of this volatility. But even with liquid funds this can be a challenge because when the fund comes to roll their hedge, they will either need a cash buffer – which means the cash is not invested into the fund and so can cause drag on performance – or they may need to sell assets to be able to fund the realized P&L. This can be particularly challenging for illiquid funds.”

Andy Lemon

Andy Lemon

Performance attribution data analytics are key from a currency management hedging perspective for asset owners and managers invested across multiple non-base currencies. Global investors in a non-base currency share class need to understand the various attributes of any divergence they encounter.

“It could be interest rate differential or valuation lag,” says Lemon. “Unrealized P&L can also act as a drag on the fund. Performance attribution analytics may help investors visualize the divergence. That’s incredibly valuable for asset managers. For example, if you want to explain why FX is the reason investors are getting 5% return instead of the 6% the fund is reporting, it’s often easier to show than tell.”

Currency related challenges will likely increase if the global economy hits the rough waters expected in 2023. Larger redemptions as investors chase returns may reduce the size of some funds and put a greater emphasis on performance.

“In a highly volatile, recession-driven scenario, managers may need currency data and analytics quickly to interrogate performance divergence,” says Lemon. “It could become even more of an issue.”

Success aligned to hedging policy

Successful currency management syncs with an investor’s hedging goals. Some investors seek to generate alpha while others wish to reduce the impact of currency volatility on the fund. Whatever the appetite for hedging, a strong currency management solution could provide timely alignment.

“Asset owners often want to hedge their international asset currencies back against the base currencies,” says Lemon. “For example, a U.S. pension fund invests in Europe and Asia and then hedges those foreign currencies back to U.S. dollars. From a data analytics perspective, you want to see if the hedge is working and to what degree. How effective is it? Analytics can show the impact of spot translation risk and whether it’s negative or positive depends on interest rate differential. So, if your spot translation risk is reducing the performance of the fund, your hedge should give you back that P&L.”

One currency management tool that Northern Trust provides clients allows them to run “what if” scenarios. This aids data-driven decision making and can inform what an investor may want to consider in the future.

“Let’s say your policy was to hedge 50% – a win-some/lose-some approach,” says Lemon. “But what would happen if you hedged at 75% or 100%? Our analytics tool has functionality that allows you to see what your hedge return would have been if you’d have changed the hedge ratio in real time. When you use the tool, your spot translation risk is stable because that’s not changing – the variable is the hedge ratio you set. Would you have gained more and offset more of that spot translation risk if you’d had a higher hedge ratio? Or if the currency is going against you, should you have had a smaller hedge? It allows a CIO to adapt to how the market and currencies are varying for the period using real data.”

Asset managers of funds with multiple non-base currency share classes are focused on performance divergences between the base currencies of the fund. The Northern Trust platform provides graphs tracking each non-base currency against the benchmark (base currency), and breaks down what’s driving any divergence, including the hedge ratio because an investor may be able to shift that to 100% within a volatility band.

“And when it comes to how frequently you’d do that, we can track the impact on transaction costs as well,” says Lemon.

Mark O'Donoghue

Mark O’Donoghue

The logic behind outsourcing

Managing currency exposure is a complex and nuanced challenge for allocators and managers. To view currency management as just another accounting exercise that can be handled in-house and without sophisticated data analytics in some cases can be akin to leaving opportunity on the table. Specifically, performance attribution analytics may help reveal the elements that drive successful currency management – and make it easier to explain what’s happening to stakeholders in a timely and more easily understood manner.

“Some asset managers and allocators are limited to Excel spreadsheets, but in the case of FX the resulting data is likely not very robust or particularly usable,” says Mark O’Donoghue, Senior Consultant, Currency Management, Northern Trust Capital Markets. “There’s a lot of risk in producing your own analytics and then trying to interpret them for investors or investment board members.”

Advanced performance attribution analytics are most readily and efficiently accessed through outsourcing currency management to a partner with significant resources – a partner who can stay invested in keeping up with changes in technology to provide intuitive tools and help manage FX risk without adding to the workload of investors.

“Asset allocators or managers view currency management as transactional and laden with downside risk,” says Lemon. “When they look at their fixed costs and see capital expenditure on currency management, they often realize their focus should be on selling funds. If you outsource it, it’s scalable and you have the help of a partner with a dedicated system that provides you with the tools for effective oversight and governance.”

An added advantage with a partner such as Northern Trust is that relevant client data is readily available due to its role as a fund administrator and custodian. “We’re agnostic regarding the source of data, but in many cases, Northern Trust already has the clients’ data,” says Lemon. “If there are issues with it, we have the ability to work with internal partners to resolve time sensitive matters. That’s important to asset managers and owners who may need to feed data into their own systems. We have tremendous flexibility with the formats we use to deliver the data to suit the needs of our clients.”

As O’Donoghue notes, Northern Trust delivers performance attribution analytics with “a personalized touch and in a way that is intuitive to use. Clients can drill down to the level they desire, and we make it easier for them to cater to their audience in terms of using graphics and supplying underlying data. That way they can deliver the story around managing currency in the way it can be best received.”

Learn more about currency management at Northern Trust.

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