Investment Funds 2019: Foreign Exchange (FX) – the asset class
The importance of FX risk management to institutional investors has grown significantly in recent years writes RBC Investor & Treasury Services’ Roger Exall. He says this has been primarily due to currency volatility caused by geopolitical events coupled with further expansion into new markets, whether that be mature, emerging, and/or frontier. He says that not all institutional investors are implementing an effective FX strategy to measure and manage the associated risks, while ensuring they are optimizing execution efficiency.
All cross-border investing has the challenge of dealing with the associated FX exposure. In not implementing effective FX execution and hedging strategies, an institutional investor may miss the opportunity to reduce costs and maximize the risk adjusted return profile of their investment portfolios.

To hedge or not to hedge?
The current approach to FX hedging varies significantly and is generally dependent on a number of factors including the strategy of the portfolio being managed, the number of markets of investment, and even the culture towards FX within the investment house. No currency is immune to volatility and hence tackling this potential exposure is essential. Yet FX is not viewed by everyone as an independent asset class, to be expertly managed, but merely a means to an end in initiating an underlying trade settlement. This approach is taking unnecessary exposure which can ultimately affect the performance of the portfolio.

FX touches a number of areas within a fund lifecycle and the approach in capturing all components can additionally vary from one manager to another. Focus on the cross border distribution aspect for a mutual fund manager tends to be viewed as a necessity. In this context, share class hedging is commonplace, especially in Europe, to provide end investors with a hedge back to their home base currency. On the other hand, hedging strategies for investment management purposes, within investment portfolios, are sometimes not viewed as an equal priority. Cost versus return and internal expertise are commonly cited reasons why some investors are not treating FX hedging as part of their core investment process.

Passive vs. Active
Hedging some or all of the foreign currency exposures within an investment portfolio can help decrease the risk associated with currency volatility but only if it is planned carefully. It is essential that the right specialist expertise is employed to determine the appropriate approach and proactively adjust the program when required.
Passive hedging is commonly used by investors to help protect their investments from currency volatility. This does carry its own considerations, from generating periodic cash flows to be managed and subtracting return due to hedging costs.

Excellence in FX Execution
Another area of the investment lifecycle commonly overlooked is the FX execution on individual trade and income settlements. Generally this is viewed as an embedded feature of the underlying trade. But taking this approach can lead to an inefficient mosaic of FX activities where appointed asset managers are focusing on their particular pocket of responsibility and a consolidated view on behalf of the asset owner is missing. The pension sector (in particular) is a segment that could be missing out on improved efficiency by not consolidating this activity.

By consciously unbundling FX execution, asset owners have the potential to unlock hidden value while also gaining enhanced transparency and operational process consistency. Advancements in technology are delivering new and innovative outsourced products that increasingly automate FX execution workflows, particularly in G20 mature markets, outside of the traditional asset management and custodian space. More fee transparency and granularity - notably by custodians, is also helping to level the playing field and make it easier for asset owners to press the reset button, and take back control on legacy arrangements.

As technology evolves, it will become routine to award large global consolidated FX mandates on an independent basis aided by relatively low switching costs. In the very simplest of terms, consolidating FX activity can deliver multiple benefits, including -
i Minimise all-in execution costs
ii Capture netting opportunities
iii Standardise execution methods and models
iv Provide a single one-size operating model
v Enhance transparency and oversight

Neglecting to net FX flows across multiple investment managers and / or custodians is one of the biggest opportunity losses in today’s fragmented execution world. FX consolidation does however have its own risks. Once the decision to employ a dedicated FX provider there are important questions to be asked, including when to execute netted FX volumes and how to benchmark the execution rates being achieved. Independent published fixings can be helpful in these situations as can more formal Transaction Cost Analysis.
The further layering of passive, dynamic or fully active hedging strategies on top of consolidated operational FX solutions can add up to even more synergies and cost savings.

Another important consideration is whether to execute FX transactions on a principal or agency basis. Many service providers are themselves banks and can provide a one stop shop where they will be both execution agent and counterpart to the trades. Others will execute as agent with a panel of bank and / non-bank FX liquidity venues directed by the client. Both models are valid choices but there are very different implementation considerations.
If executed correctly, FX can be a major benefit to the investment process. With heightened geopolitical risk coupled with the expansion of new investment markets, it should no longer be approached as a required process but rather an important stand-alone asset class.
Roger Exall is head of European FX Sales & TMS Business Development at RBC Investor & Treasury Services.
This article appeared in the December 2018 edition.