Karen Watkin
Welcome to AB's Alpha Females, the Multi Asset Investment podcast from Alliance Bernstein. I'm Karen Watkin and I'm a fund manager in the Multi Asset Solutions team here at ab. The Alpha females are those women who have developed unique areas of expertise and made their mark in the investment industry. For many clients, generating income from their investments is a priority. But market conditions are very different now from those that we've had over the past decades. So taking a flexible approach to income and getting original and informed perspectives to investing is more important than ever. In this series, my guests, the Alpha Females share their expert insights on the key questions for investors on the hunt for income. They'll also be telling me about their career journeys, the challenges they faced, and the lessons they've learned along the way. What is the value of money? The answer to that, of course, is that it depends. It depends upon the currency of the money in question and where you're looking to spend it. As global investors trading in capital markets around the world, we must deal in foreign currencies by necessity. And in a world where capital flows freely across borders, managing currency exposure isn't just a hedge, it's a necessity. As legendary investor Warren Buffett once said, risk comes from not knowing what you're doing. And when it comes to currency risk, what you don't know can cost you. Volatility from currency movements has been keenly felt by investors over the last few months. Recent developments surrounding rising policy uncertainty, persistent fiscal deficits, and shifting global trade alliances have seen the US dollar drop almost 10% this year and brought questions around currency exposure to the forest. In a world where portfolios span continents, currency risk is no longer a footnote. It's a frontline concern. Being able to successfully navigate currency exposures requires immense skill and knowledge, an understanding of risk, and an integrated approach to investment. Someone who possesses those qualities in abundance is Julia Keating, who is a portfolio analyst here at ab. She works out of our New York office, where part of her role is to quantify the risk involved in various currencies and finds how to get the best return return in different markets. Julia, welcome to the podcast.
Julia Keating
Hi, Karen. Thank you for having me.
Karen Watkin
So, let's start with the basics. Can you give me a simple explanation of currency how it impacts portfolio returns and why it's so important for investors?
Julia Keating
Yeah, absolutely. So, as you discussed, in Multi Asset, as we're building solutions for for clients, we tend to invest in global markets. And investing in global markets opens up a lot of opportunity and potential return streams. But as you're Sitting in one country, investing in another country, you're taking on the currency risk of that country as well. So say I'm sitting in the United States and I want to invest in equities in the United States, equities based in Europe, equities based in Japan. When I'm investing in those equities, I'm taking on the risk exposure of both the equity and the currency as those equities are priced in those currencies. And so I'm assuming two risks. First, the price movement of the equity, and the second piece is the price movement of the currency. And so when you repatriate, when you take profit on those investments, you feel the currency movement as well as the underlying equity movement. And so as global investors, it's important to consider the base currency that you are investing in and the impact that currency fluctuations can have on your investments globally.
Karen Watkin
That's great. Thanks for giving such a clear explanation. And so as a multi asset investor, when you're thinking about hedging that currency risk, you're looking not just across equities, but we look across asset classes as well. So when you're thinking about the amount of currency volatility that can come along with those different investments, how does that impact how you're thinking about the relative currency risk?
Julia Keating
Yeah, I'll start with the two pillars of traditional pillars of an investment portfolio, which are equities and bonds. So if we start with bonds, the type of characteristics that we are expecting from bonds is that these are generally lower volatility assets that provide some measure of safety and income to a portfolio. If you invest in a bond outside of your home jurisdiction, the currency volatility can often swamp the volatility of the bond that you're investing in and become the primary risk and not necessarily the secondary risk. And when that happens, it may end up overcoming the key characteristics that you're trying to access from those bonds, the stability, the income, and particularly in risk off events, the safety that you're looking for. So when we think about bond investments, we typically hedge out 100% of the currency risk that we are taking, so that the currency volatility doesn't overcome the key characteristics, both return and risk characteristics of the bond exposures that we are investing in. If we then turn to equities, equities are a more volatile asset class. And with equities we are taking diversified exposure, looking for growth, capital, appreciation and income as well over longer horizons. But as more volatile, as a more volatile asset class, currency is not typically the overarching risk here, currency is a secondary risk when you're investing in equities and can often provide diversification against the volatility of equity markets and provide a smoother return path over time if managed properly.
Karen Watkin
So, you're having to think about the relative volatility or risk you're getting from those currency exposures according to the asset class that you're investing in and the role that you want those to play in your portfolio. So it makes sense, as you said, that you want to think about hedging some of those currency risks accordingly. But I guess another dimension that we need to think about as investors is what's that starting point? So what is your home currency when you're thinking about hedging those risks? And I guess it can make quite a difference. Say, if your starting point is you're a U.S. investor with the dollar as your base currency versus, say, sitting on this side of the pond as a sterling investor. Can you explain perhaps how that impacts how investors might think about the amount of currency risk they may want to hedge?
Julia Keating
Yeah. So, we've done a lot of research on this topic in multi asset, and what we've generally found is that there's no one perfect formula for assessing the perfect hedge ratio that you might want to implement with your equity exposure. But the way we think about it is generally the same way that we think about a long term asset allocation where we set essentially an expected asset allocation, a set amount of equities, bonds, commodities that we want to hold, and there's a long term allocation that we are anchored at, and we sort of move around that as, as market dynamics change. We think the same way about currency exposure where when we're setting up these long-term asset allocations, we look at our currency exposure that we're taking and we try to set what we believe to be a optimal strategic asset allocation. And then from there, as currencies fluctuate, as dynamics change, we can move around that strategic asset allocation. We found that generally Speaking, roughly a 50% hedge ratio has historically been close to optimal across base currencies. And the reason is because dynamics change over time. But you typically find that you'll achieve a better Sharpe ratio with a partially hedged equity allocation than you would at either extreme, fully unhedged or fully hedged.
Karen Watkin
And so, you mentioned that over the long term, that gives you a good outcome and can help smooth some of that volatility and that risk. But you can have some pretty big fluctuations over the short term. And we've certainly seen that year to date in terms of the depreciation of the dollar. So how do you think about then perhaps making those short-term tactical shifts around that long term strategic hedging ratio you might have?
Julia Keating
Yeah, so I think there are three key considerations when you're adjusting that hedge ratio. And the first is the expected return of your currency exposure. That's sort of the most important. Do you expect that your base currency will move up or down relative to the currency exposure that you're taking, and how will that impact your total return? So the first piece we would start with is our expected return outlook for the currency. And if my base currency, the dollar in this instance is expected to appreciate versus the euro, that might offset the returns from European stocks that I'm getting back. And so, if I have a very strong view that my currency will appreciate, I might reduce my hedge ratio a little bit to not impact the equity return that I'm getting back from my European stock allocation. So, a second key piece that we think in addition to expected return is what is the utility that this currency exposure is providing to my portfolio? Is it diversifying? Is it going to reduce my volatility or is it going to amplify it and may enhance returns in some scenarios, but might also amplify losses? And the third piece that we would typically think about is what is the cost of hedging my currency exposure? When you're hedging a currency exposure, the typical tool that we would use is a currency forward where we essentially lock in an exchange of currency at a future date and that is discounted for the short-term interest rates in the two markets of which you are exchanging. So, if I am a European investor and I want to hedge my dollar exposure because the dollar has a higher short-term interest rate, there is a cost to doing that. And so that's the third piece that we would take into account is how much do we want to pay, if we are paying, in order to hedge this risk? And so, we would take these three considerations and try to balance them.
Karen Watkin
That's really clear in terms of those key dynamics that you're trying to navigate. You talked about having a view on where the expected kind of valuation of a currency may go or the expected return. What are some of the drivers that you need to understand when you're trying to forecast or predict where currency movements may go?
Julia Keating
There are a lot of different factors that can influence a currency's movement and sometimes they are agreeing with one another and sometimes they are not. A couple key ones that as investors we tend to monitor would first be the carry. And again, this is referring to the short term interest rate differential between two currencies. When central banks are hiking rates or are expected to hike rates, that means that the currency in which that is happening in may become more attractive for other investors to hold. And at the same time, because the interest rates are rising, it becomes less attractive to hedge. A second one would be valuation. And there are a number of ways that you can try to value a currency. A very common one would be purchasing power parity. We call it ppp. Essentially, this is a way in which we try to assess what is the fair value of a currency. If I want to buy a basket of goods here in the United States, what is the exchange rate at which I could buy the exact same basket in Europe? And I would be agnostic to which currency I'm buying it in. Right. And the deviation of where a currency is right now relative to its purchasing power. Parity is one way of trying to value whether a currency is expensive or whether a currency is cheap. And then there are global dynamics that also affect currency movements. A big one is global growth. When global growth is strong, certain more cyclical currencies might have a better expected return than when growth is falling. Investors are looking for safety. In that case, some currencies that are typically considered more safe haven currencies might be a better place to turn.
Karen Watkin
So how would you characterise what you'd think of as a cyclical currency versus a more safe haven currency? What drives that?
Julia Keating
Yes. So, a safe haven currency is a currency that, as I mentioned, investors turn to during uncertain times, during high volatility moments when risk assets are falling. And these currencies typically outperform as investors are rotating from riskier assets to safe assets. Examples of a safe haven could be the US Dollar. This currency has large liquid bond markets that foreigners will allocate to during periods of distress. Right. One of the first safe havens that an investor would turn to would be U.S. treasuries. And so these types of things can support currency valuations of safe haven assets during periods of volatility. Conversely, if we talk about a cyclical currency or a commodity currency, these are typically currencies that export commodities or other cyclical products, typically manufactured products. And when global growth is strong and exports are booming, this is typically supportive of those currencies. But the converse is also true. When growth is falling and export demand is waning, that can also weigh on these currencies.
Karen Watkin
That's great. So, I'm Interested? You talked about this idea of the safe haven currencies and the dollar being one of those, and I think that's been a real hot topic recently in terms of does that remain the case? So I'm really interested to hear your views on what's happening now from global investors and how they're thinking about the role of the dollar going forward. Do you think it retains that safe haven characteristic?
Julia Keating
The dollar does remain unmatched in terms of currency peers that have the depth of liquid assets that the U.S. treasury market has backed by credible institutions such as the Fed. But what has happened this year is that there has been some concern from investors around the direction policy is taking. A little bit of uncertainty, and we've seen investors reallocate away from the dollar. To my mind, what is happening right now is a step towards diversification, but not necessarily moving away from the dollar completely because there really isn't at this point a credible alternative as a reserve currency.
Karen Watkin
It's notable, I think, as you talk about all these multifaceted kind of drivers of what goes into the currency markets, that it's clearly an important risk that investors need to manage. But I'm interested. Do you think it also provides opportunities to capture return?
Julia Keating
Yes, absolutely. So far, we've mostly talked about a strategic hedge ratio and increasing or decreasing that hedge ratio around your one base currency. But currency markets absolutely have the opportunity to access alpha opportunities as well by taking a more nuanced view on currencies. So, we have both quantitative and fundamental teams that have deep experience in currency management and currency alpha management. And we've developed a number of tools to help us assess the risks around currencies as well as the attractiveness of currencies. And we can leverage those insights to take more nuanced views and say, not just hedge our risk, but also add return on top of that from taking more nuanced views across our currency management.
Karen Watkin
And so, it seems like such a lot that you need to navigate when you're thinking about all these different dimensions. So how do you tackle that breadth of economic drivers, market dynamics, and all those different elements that you've talked about to bring together your currency ideas for a portfolio?
Julia Keating
We are constantly both monitoring the currency fundamentals. What does the carry look like, what does the current account look like? What is the global growth and inflation backdrop? How is that likely to change and how is that going to affect the currencies that we're investing in? At the same time, in multi asset, we have a global macro research team that is following the developments across economies that we can leverage their insights on the domestic growth and inflation backdrop of those economies and the trajectory there. We have a quantitative research team that has built systematic tools that are designed to assess the current attractiveness of one currency relative to another. And we can leverage those tools as well to help inform our decisions. And we also have fundamental investors that have long deep experience in managing from a fundamental side currency markets. And so we can leverage all three of these pieces of expertise across multi asset to bring those together and help inform our decisions around our currency exposure.
Karen Watkin
And I wondered, have you started to think about or broaden out even outside of the traditional currencies, have you thought at all about, I guess, non fiat currencies, Whether that's crypto or to the extent we're seeing things like gold become a bigger part of portfolios investors, do you think of that kind of within that currency mix or is that something kind of very separate to how you would think about any portfolio exposures?
Julia Keating
So, I think gold is a very interesting one because as we talked about how investors are looking to diversify away from $, not fully get rid of their dollars, but looking to diversify. And if you look at central banks, for example, that have very high allocation to dollar assets, one of the things that we've seen them do in recent years is start to buy more gold. And so there has been a structural demand for gold as a safe asset. And as investors have taken a step away from dollar this year, that has also resulted in increased demand for gold, which can act as a safe haven as well and can particularly protect in periods of geopolitical risk and uncertainty.
Karen Watkin
That's really interesting. And I think we're certainly in a period where we're seeing some relatively big structural changes potentially. And I think it just highlights even more, as you've talked about today, how important it is to think about the potential risks you have in your portfolio from those currency exposures. Not just in terms of managing that short term volatility, but really thinking about the longer term role that some of these currencies may play in investors portfolios. So Julia, you've clearly developed a huge amount of expertise in this area over the course of your career. I'm really interested to hear what brought you to finance and asset management in the first place.
Julia Keating
Yeah, so I would say my interest in the industry sort of originated actually during the the global financial crisis. So I was growing up outside of Manhattan in the suburbs during that time and I lived in a town that a lot of people that lived there worked in the city, commuted to the city and worked in finance. And the ripple effects and the fallout from the financial crisis was very much felt. And so that was something that really stuck with me. And when I went to university I took an economics class, sort of the first chance I had and quickly turned into an economics major. And from there I was hooked. And as I mentioned, shortly after I joined, after graduating I joined AllianceBernstein full time. And it's been a really great experience.
Karen Watkin
And so, kind of eight years down the path. What would you say to new graduates today that may be considering working in asset management?
Julia Keating
Well, I'm still learning quite a lot every day, but I would say that approaching markets with a combination of curiosity as well as humility is important. Things are always changing and you need to be flexible and adapt to those. You want to try to be flexible and adapt to those changes, but at the same time you want to ground yourself in solid research that can give you comfort and conviction in applying your learnings and investing and sort of managing market movements and changes. So I would say that is key as well as trying to leverage and open yourself up to insights from experienced investors around you that have expertise in these areas and that can share experiences from before you were in the industry can be incredibly valuable.
Karen Watkin
That's great advice. So before we wrap up, you've talked so much about what investors need to think about with regards to their currency risks and opportunities for returns. What would you say are the three critical things to remember when thinking about currency?
Julia Keating
So I would say when you're investing in global markets, you open up a lot of opportunity and potential return stream for investors. But it's important to remember that when you're accessing these return streams, you also are accessing currency as well. And you have to make a decision around that. Currency exposure Currency exposure can provide diversification and enhance a portfolio's risk and return characteristics. But it can also, like everything else in a portfolio, it moves and it can provide as well negative P and L if you're not paying attention to what's happening in your portfolio. So it's something that needs to be managed to provide the best outcome for your clients. And I would say developing a framework to manage currency risk in your portfolio can add a lot of value. Both a strategic framework as well as a shorter-term framework to try and manage. As we've discussed, the shorter term moves that can add or mitigate volatility in your overall experience.
Karen Watkin
They're great insights to remember, Julia, and you've done a fantastic job today explaining all those different drivers around currency and how investors need to think about it. So thank you so much for sharing all of that and thank you for your time today.
Julia Keating
Thanks for having me, Karen.
Karen Watkin
Well, I think it's clear there's no better time to be talking about currency than perhaps where we are today. We're seeing big movements in the currency market and quite rightly there's a lot of questions around what the outlook is, particularly for the US Dollar going forward given current market dynamics. And I think that just serves to illustrate, as Julia has explained, that currency is really a risk that investors just cannot ignore in their portfolios. And I think my main takeaways from Julia is that it's so important to think about that currency risk both strategically in terms of understanding how your currency exposure interacts with the stocks and bonds and other investments in your portfolio, but also tactically to be able to navigate these shifting market dynamics that we're seeing with some fairly sizable currency movements. I think Julia also did a great job of explaining actually the multiple dimensions that you need to think about with regards to currency in your portfolio. So really understand how it interacts with the rest of your investments to know is it a risk that you need to hedge? Is it a source of diversification against the other investments you have in your portfolio, or can it be actually an additional source of return? And I think if you can build that deep research to really understand all of those drivers, currency can play a really important role in multi asset portfolios. And that brings to an end this episode of AB's Alpha Females, the Investment Podcast from Alliance Bernstein with me, Karen Watkin. If you've enjoyed this episode, don't forget to tell your colleagues and friends about only remains for me to thank Julia Keating. This episode was produced by Richard Myron from Earshot Strategies.
