For FX’s sake! How not to manage FX

22.08.2023

The Drawdown sat down with Alpha’s MD of Institutional FX, Ashley Hall, to discuss some of the challenges facing investment managers when it comes to currency volatility. You can read their full article below.

Over recent years, heightened volatility in the currency markets has highlighted the vulnerability of returns due to currency risk. Because of this, managers are increasingly turning to FX hedging strategies to ensure returns aren’t lost to currency fluctuations. However, despite the swathes of FX providers keen to tap into the market, Ash Hall, Managing Director of the Institutional FX division at Alpha Group, argues that the wrong application of forecasts, strategies, and products is often causing more harm than good.

“One of the most common mistakes we see is managers using FX market forecasts or technical analysis as the primary driver of their decision making,” says Hall. “In doing so, they will hedge a percentage of their requirement based on how attractive they perceive the rate to be versus future expectations. The problem with this approach is that it leads people to hedge in disproportionate amounts – either too much or too little, based on where they believe the exchange rate is going to go. This then amplifies their concentration to a particular exchange rate, and if the market moves against them, returns are eroded, and capital may be tied up in significant margin calls, both of which undermine the fund’s performance.”

Hall explains that if the objective is to manage risk, any guidance around forecasting should only be considered within the framework of a broader strategy. For example, a risk management strategy may mandate that a fund hedge 20% of its requirement in a quarter. When choosing the exact date to do so in that quarter, it can therefore make sense to look at exogenous factors and evaluate when is likely to be an optimal time to trade, rather than blindly picking a day. But Hall insists the guide rails need to be in place first. “The reality is, no bank or broker can consistently predict the currency market because if they could, they would be approaching you to invest money in a currency fund, not brokering FX.” says Hall. “If we know this to be the case, a strategic approach always needs to be the starting point for someone looking to manage risk.” In other words, GPs can be unstuck if they confuse a purely speculative approach with a risk management approach.

Tailored to your needs

Given the importance of a strategic approach to managing currency, perhaps unsurprisingly, there are an increasing number of foreign exchange providers who also offer FX Risk Management services. Hall himself acknowledges this but also warns that not all strategies are created equal. “Whilst we welcome a more strategic approach to currency management within the industry, too often we’re seeing generic strategies being put forward which fail to properly accommodate the complexity of the fund. What works for a corporate won’t necessarily work for a fund. And what works for one fund rarely works exactly the same for another. For an FX risk management strategy to be truly effective, the approach needs to not only be bespoke to the fund’s specific structure and assets but also evolve with the various stages of its lifecycle. Unfortunately, there is no one-size-fits-all approach – no silver bullet.”

A healthy scepticism towards forecasts, combined with a tailored approach to strategy, therefore, seems to be a good starting point for anyone evaluating their current approach to managing FX. Regarding FX execution and deciding which products to use, we asked Hall if there was anything else clients should be aware of.

“Fundamentally, the products you use should be determined by your strategy. For most, this will be a combination of spot and forward contracts, with varying levels of flexibility around settlement and collateral terms depending on their requirements. Where we often see funds go wrong is when they have been sold so-called ‘outperformance products’. These products offer the ability to outperform the market but do so in exchange for high levels of risk. It’s effectively a gamble, and for that reason, we would never endorse them as part of an effective risk management strategy.”

With a successful approach to managing FX so dependent on how well it is tailored to the fund, there is inevitably no one ‘right way’ to manage FX. However, Hall highlights that fundamentally the purpose of each strategy is fairly simple: “Funds need to decide when to hedge, how much to hedge, how far forward to hedge, and which products to use. The challenge is getting to a point where they are answering these questions based on the underlying and evolving profile of their fund and that those decisions can hold up to scrutiny if required. This is fundamentally the role of an FX risk management specialist like Alpha.”

With macroeconomic uncertainty continuing to cause turbulence in the markets, The Drawdown, alongside Alpha Group, is hosting a private dinner to discuss how FX can be managed more effectively in an unpredictable market, and share some real-life examples.

Click here to register your place.