Foreign exchange – how a heightened focus could improve investment returns and reduce costs

Now is the time to turn FX challenges into opportunities

Are investment firms truly clear about the degree of portfolio drag and magnitude of operating risks and costs incurred by their FX activities? Increased volatility – as seen earlier this year – makes this an even more important challenge to resolve.

Why now?

Market volatility – as seen during the first few months of this year – also generated significant increases in FX trading and hedging activity by investors in support of their investment strategies. We estimate increases of circa 70% in the first quarter and circa 45% over the first half of 2020 based on the FX revenue increases reported by leading custodian banks. This magnifies the importance of ensuring FX activities are optimised to ensure no undue drag on investment returns, nor any unnecessary operating risk and costs incurred.

Moreover, operating model resilience has been tested by the urgent need to shift to hybrid home/office working models across the asset management industry (and beyond). As the FX landscape evolves and takes shape around the challenges presented by the pandemic, James Hockley and Aqib Raja from our Asset Management practice, explore today’s opportunities for asset managers, asset owners and service providers.

Common Challenges

For many investment managers, FX execution – and particularly currency hedging whether of portfolio investments or fund share classes – is not their forte and is increasingly seen as an unrewarded risk. We also observe many pension funds – particularly where they have delegated investment management – are unaware of the total FX activity undertaken on their portfolios in aggregate and the potential for portfolio drag to be reduced.

Our belief is the management of FX, perceived by many as an ancillary service, should become a priority when seeking to minimise investment drag and realise efficiency gains.

Existing drivers of FX

We should not ignore longstanding needs and how they are evolving to create a heightened focus on FX

  • Continuing geographical dispersion – of investors and investments – requires
    • Increased FX trading volumes across more currencies – both freely convertible and restricted currencies
    • More attentiveness to hedging needs – at both portfolio and share class levels
  • Developing FX trading technologies, access to increased liquidity, and full transparency strengthen the offerings from specialist providers who focus on the need of the investment community.

Poorly managed FX can quickly run up costs – both for funds and firms; conversely tightly managed FX programmes can reduce FX drag and costs by several basis points.

How can firms address FX challenges – turning these into opportunities?

Wherever you are positioned on the buy-side spectrum – from asset owner to manager to service provider, there are increasing opportunities to position your organisation to optimise value from FX.  For example:

  • Fund managers can seek to alleviate the complexity, riskiness and operationally heavy demands of their in-house FX operating models by outsourcing hedging activities – at portfolio, share class, or on a look-through basis – to specialist providers. The benefits include transferring operational burden and risk, achieving closer returns correlation, and a true and fair allocation of hedging costs.
  • Similarly, pension funds can address disparate FX trading activity executed via multiple counterparties through their third-party managers by exploring FX netting programmes. These can significantly reduce FX turnover and avoid unnecessary drag on scheme returns.

As indicated by the increasing FX revenues earned by the custodian banks, these providers are also investing in their FX capabilities in recognition of the opportunity to capture more and more of investment firms FX turnover. Several have upped their game considerably.

With increased volatility, competitive pressures on maximising fund returns – and for investment firms to minimise risks and costs, together with improved services from specialist FX providers, now is the time to turn FX challenges into opportunities and reap benefits for funds, their investors, and their managers.

James Hockley and Aqib Raja

Authors James Hockley (left) and Aqib Raja (right)

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Throughout my career I have advised the investment industry on creating the operating and servicing models that will best serve their increasingly complex business goals, whether as a banker to – or working for – such firms, or now as an advisor to both.