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The effects of currency losses should never be underestimated

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Michael Markov (pictured) of Markov Processes International (MPI) comments that the performance of world bond managers has hit a conundrum. The top performing managers of last year are now at the bottom of their peer group; and last year’s worst performers are this year’s best, the firm writes.

 “One of the key reasons for this is because of the fluctuating value of the US dollar relative to foreign currencies. The Dollar Currency Index (DXY), which measures the performance of the US Dollar against a basket of foreign currencies, has had large swings in performance since January 2015. For example, during 2015, it returned 9.25 per cent. From 1 January 2016 to 31 June 2016, it returned -2.52 per cent.
 
“The strengthening of the dollar harms managers who are receiving payments in a foreign currency, because their foreign receivables equate to less dollars. But the opposite holds true with a declining US dollar.
 
“Investors need to understand the currency hedging decisions and currency exposures of their managers. But determining currency exposure of a fund is not an easy task, especially if the fund manager actively manages currency risk. In most cases, looking at thousands of long and short positions in currency forwards, futures and options could provide misleading information about hedging levels.
 
“However, one way to cut through this ‘confusion’ is to determine the ‘implied currency exposure’ through the use of a returns-based approach; creating a portfolio with dynamic currency hedging that mimics the fund’s performance and applying this proprietary technique using MPI’s DSA (Dynamic Style Analysis) factor model and 18 months of weekly data to the funds in Morningstar’s world bond category.”
 
To highlight this, MPI analysed the five largest managers that showed more than a 20 per cent currency exposure on average over the past 18 months. Funds were compared to the Euro and UK Pound to determine currency exposure. The average currency exposure of these funds was 43 per cent of AUM.
 
Currency exposures were responsible for a 2.876 per cent loss out of average performance of -2.93 in 2015. YTD, currency exposures are responsible for a 2.82 per cent gain out of an average return of 7.03% in these five funds.
 
The firm writes: “World bond funds were dramatically affected by Brexit, which occurred on 24 June 2016. This mostly created a positive effect as bond prices increased as investors moved to less risky assets. Currency returns in the Euro and GBP were -1.92 per cent and -10.41 per cent respectively during the period from 24 June 2016 to 1 July 2016 while the average return for a world bond manager during this time was 0.70 per cent. But funds that showed an exposure to Euro and GBP of over 20 per cent had an average return of 0.54 per cent.
 
“Currency movements are often a major cause of fund gains or losses and in times of uncertainty investors can be caught unaware of their manager’s currency exposure. Therefore, understanding currency exposure and hedging policies are an essential part of any investor due diligence on a manager. Recent changes in the dollar and the effect of Brexit on currencies prove that the effects of currency losses should never be underestimated,” the firm concludes.

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