Hughes, who runs Apollo’s four multi-asset funds with Craig Wetton, Steve Brann and Ian Willings, says the team is paying more attention to share classes’ currency and whether it is more appropriate to take hedged exposure when buying holdings for their portfolios.“Currency is one of those things that’s always interesting - it can have big influence on your performance without you realising it,” he said.
“Different parts of the world are starting to diverge in terms of what stage of the cycle they’re at - so you have the question of whether the UK or the US will start to put rates up first but you have Europe running negative rates and likely to employ QE before the year’s end.”
“All of those influences are having a big impact on currencies’ performance - and everyone’s portfolios.”
Fund investors have two basic options when it comes to currency exposure - buying a hedged share class or an unhedged share class.
Hedged share classes aim to remove currency risk and deliver better returns to the end investor when a currency is weakening; unhedged leaves the investor exposed to currency risk but can boost returns when the currency is strengthening.
The most obvious example in recent times of how currency exposure can affect returns for fund investors is Japan. The yen weakened significantly during 2012 and 2013 as the Japanese government outlined an ambitious plan to stimulate its flagging economy.
Using Legg Mason Japan Equity, which was the best performing in its sector last year, as an example you can see investors in the hedged and unhedged share classes experienced very different returns.
Performance of hedged and unhedged share classes
Source: FE Analytics
The above graph shows returns for the year following 1 March 2013, when the fund’s hedged share class launched. An investor in this version would benefited from gains of 49.80 per cent over the 12 months while those in the unhedged share class would have returns of just 27.13 per cent.
In 2011, when the yen strengthened after investors fled to safe-haven currencies as the eurozone debt crisis intensified, the reverse outcome would have been seen with the unhedged investor outperforming the hedged.
Hughes says Apollo is most interested in unhedged dollar exposure at the moment, given the likelihood that the currency will continue to strengthen as the Federal Reserve moves to tighten its policy stance.
“You’ve seen central banks announce different policy measures that have a big impact on currency. If you look at the dollar at the moment, it looks like it should strength against other major currencies so there’d be some value to be had.”
The dollar is close to the strongest it has been in more than a year against other major currencies, although analysts say the greenback has further to run with support from the actions of the world’s major central banks.
John Higgins, chief markets economist at Capital Economics, points out that the dollar actually weakened against the other major currencies on a trade-weighted basis over the 12 months after two of the Fed’s past three tightening cycles but argues this is unlikely to happen this time around.
“In 1994, the Fed took markets by surprise, prompting a sell-off in US assets that contributed to the dollar’s decline. It is unlikely to do so again,” he said.
“And in 2004, the US current account deficit was nearly 5 per cent of GDP, causing concern that the dollar was fundamentally overvalued and needed to fall. Today the deficit is only around 2 per cent of GDP.”
“The upshot is that, by end-2016, we continue to expect the dollar to have strengthened further to $1.20 against the euro, to $1.60 against sterling, and to 120 yen.”
When it comes the euro, however, Hughes is less positive. The euro has dropped against currencies such as the dollar and the Swiss franc recently, while sharp falls were seen again last week when the European Central Bank unexpectedly cut interest rates in an attempt to stave off deflation.
French prime minister Manuel Valls recently called on the ECB to lower the value of the euro, arguing that it would help the currency bloc to fight off the threat of deflation.
Eurozone inflation slowed to just 0.3 per cent in August, well below the official target of just under 2 per cent and its lowest level since 2009.
Hughes said: “We’re not big fans of the euro as it stands. The way Draghi is taking and the recent economic data would suggest there is going to be some structural weakness in that currency for some time and as a result we’d try to avoid euro exposure where possible.”
The ECB is expected to unveil more aggressive changes to its monetary stance in the coming months.
Many market participants have called for QE from the bank to boost the ailing economy and lift inflation.
Howard Archer, chief UK and European economist at IHS Global Insight, said: “The ECB’s latest moves, in conjunction with those enacted in June and still kicking in, should have some beneficial impact in weighing down further on the euro, weighing down on eurozone bond yields and market rates, and making bank lending to the private sector more attractive.”
“Certainly, there are immediate promising signs with the euro immediately hitting a 14-month low against the dollar under $1.30 and bond yields dipping.”
Given that the Fed is approaching the end of its tapering programme and the Bank of England looks like likely to lift interest rates next year while the ECB may soon embark on quantitative easing, Hughes says currency exposure can’t be ignored by investors.
“Each of those situations have had a big impact on the overall return of your underlying holdings. This is leading us to think more and more about the currency of the asset class we’re buying,” Hughes said.
“Normally you’d just buy the sterling version and say ‘that’s fine’. But given the divergence and what’s going on around the world, it seems to be suitable to think about different currencies and how to take exposure.”
“Which currency you buy is becoming the second question you ask after deciding on an asset class rather than just taking some sterling exposure. It’s something that we need to consider in each transaction.”
