Thesis Asset Management's head of research, Matthew Hoggarth, on why now is not the time to hedge 'risk-on' sterling.
'Sterling-based investors have had a rough ride over the last 18 months. Currency positioning has been a significant differentiator of portfolio performance, whether the currency linkage has been explicit or via the underlying economic exposure of the equities held.
The range of performance among managers contributing to the ARC GBP Private Client indices has widened, something which has not happened in the dollar and euro indices. Currency positioning is making as much difference to relative returns as asset class views. However, currency exposure is often the result of asset class decisions rather than an active choice.
At Thesis we have always sought to judge currencies separately from asset classes. Occasionally this results in hedging the currency exposure of funds. A few years ago that usually meant working with our chosen manager to launch a hedged unit class of their fund, but hedged unit classes are now much more prevalent which makes it simpler to implement our choices.
We find that hedging decisions are generally most effective when there is a strong conviction on the drivers behind the direction of a currency forecast. Over longer periods the cumulative effect can be neutral as other factors exert themselves. It therefore makes sense to remove a hedge when the initial rationale for it has diminished. This can be annoying from a CGT perspective, because switching to unhedged units triggers the full gain on both the hedge and the underlying assets.
We could avoid this by using a separate hedging instrument; however, on balance we feel that the fund manager is best placed to size the hedge as they know their portfolio best. This is especially significant where constituent companies have international revenues or costs, or may have implemented hedging themselves.
A different mindset is required when you are thinking as much about a general trend for your home currency as for a view on the direction of each currency pair. I recently spoke to the manager of a Norwegian pension fund, who commiserated with me that sterling has become so easily buffeted about, more like the swings expected from a commodity currency such as the krone. He asked whether we were considering taking a more long-term hedging view and consistently protecting at least part of the portfolio against exchange rate movements.
Opinions differ on the value of long-term hedging. Some studies point to higher risk-adjusted returns from consistent hedging, while others see currency exposure as part of the diversifying benefits of overseas investment. This can certainly be an important factor for sterling portfolios, as a ‘risk-on’ currency like sterling is positively correlated with equities and the economic cycle. It tends to weaken against the dollar, yen and Swiss franc in times of market stress, raising the sterling value of holdings in these currencies.
For now at least, the short term influences are generally political. Sterling certainly looks undervalued against most other Western currencies on a purchasing power basis, but the uncertainty around Brexit is holding it back.
There is potential for further weakness if negotiations falter or monetary policy in other countries tightens faster than expected, but in the medium to long term we expect sterling to strengthen as optimism returns and therefore we do not wish to hedge against it.'
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