Currency Risk Management as a Value Lever To Manage Fund Returns

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FOREWORD

Fund managers have been targeting developing and emerging market assets for their growth potential, providing investors with an alternative to the relative lower growth experienced in developed markets.

This is evident from the flurry of activity related to fund raising that has targeted emerging market exposures in the past five years.

Most international funds tend to use a G4 currency as the capital currency for the fund, mostly USD, while investments target non-G4 currencies, such as Asia Pacific currencies linked to the country of the underlying asset investment.

While assets in emerging markets over the past decade generally experienced double-digit annual growth based on investment periods of 7 to 10 years*, annualised foreign currency returns generally experienced single-digit depreciation.

Currency risk management under those circumstances may not to be a major focus, likely due to the comfort derived from the significantly higher local asset returns as compared to the currency depreciation.

KEY TAKEAWAYS

In recent years, currency risk management has become more topical for investors and fund managers. This is driven by generally low or negative local asset returns across the world, combined with relatively high depreciation of foreign currencies. In such circumstances, currency returns can dominate and drive the overall return in USD.
Currency risk is a major driver of asset returns expressed in capital currency.
It is clear that currency (FX) returns have a multiplier effect on asset returns (in capital currency terms). As such, depending on the magnitude of FX returns, currency could potentially significantly enhance or depress asset returns (in capital currency terms).

Fund managers have an opportunity to generate value from both asset selection as well as proactive currency risk management.
Given competitive pressures and evolution of investor expectations, some level of currency risk management capabilities could become a minimum requirement from investors going forward.
When executing currency risk hedging transactions, it is important for fund managers to consider the hedging rationale, the uncertainty of the asset value or timing of valuations, available financial resources for transaction settlements, the creditworthiness of your counterparty as well as the fund manager’s/entity’s own credit standing.