Currency Share Classes – They DO make a difference!Ben Raven - Head of Business Development
A recent publication by Natixis demonstrates the degree to which retail clients have been benefitting from GBP weakness. The Q3 2016 UK Portfolio Barometer, recently referenced in Portfolio Adviser, looks at over 100 risk-rated model portfolios and clearly demonstrates how much of recent portfolio “performance” has been derived from a type and level of risk the client is unlikely to even know they are taking.
Within the publication there is a case study on Japanese equities. The case study demonstrates that owning Japanese equities in JPY would have lost investors money over the past year (as much as -20%). However, many UK retail clients have seen the Japanese equity component of their portfolio make remarkable gains (as high as 35%) purely because they own a GBP share class. Client returns have therefore been derived entirely from the currency markets, not from the Japanese equity markets.
Why is this a bad thing?
A client agrees to invest in a portfolio on the premise that they are aware of both what underlying markets they will be exposed to, and the level of risk they will be exposed to. In the example above the client may be told they are being exposed to the Japanese equity market and the volatility of the Japanese equity market. HOWEVER, if this were the case the client would have LOST money over the past 12 months given the Japanese equity market has fallen “off a cliff”. The client has in fact MADE money because they are actually being exposed to:
a) the Japanese equity market AND the JPY/GBP currency pair; and
b) the volatility of the Japanese equity market AND the volatility of the JPY/GBP currency pair.
To demonstrate the impact this may have across a client’s entire portfolio, the study shows the percentage of total portfolio performance coming from the asset allocations versus the currency markets. For the average moderate portfolio, over a 4-month period, approximately 60% of the total return is coming from the asset allocations (equities, bonds and alternatives in this example) with approximately 40% of the total return coming from the currency markets.
Exposing clients to currency risk:
According to Natixis, whether or not to expose a portfolio to currency risk “needs to be considered by advisers as an investment decision on its own”. They also acknowledge it is “impossible to know where sterling will go next” and that ahead of any potential floor in GBP “advisers will need to address the currency exposure in their portfolios”. Currency risk (including the impact it can have on portfolio returns and portfolio volatility) is something that financial advisers should be discussing with clients at the outset, not at a point in time when they think GBP has reached a floor.
A financial adviser is tasked with establishing a client’s attitude to risk (ATR) and matching it to an investment portfolio. If a client has an ATR of 9 and the adviser identifies a Japanese equity portfolio that is rated as a 9, the chances are that portfolio is rated as a 9 based on the volatility of the Japanese equity market alone. Should the volatility of the JPY/GBP currency pair be included we could see that 9 very quickly become a 10 or even greater.
What we know for certain is that recent evidence shows the performance of the Japanese equity market becomes entirely academic should the currency risk not be hedged.
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