Managing forex exposure could be the most important decision global investors have to make in a persistent low-return world, Bridgewater co-CIO, Bob Prince, told the International Forum of Sovereign Wealth Funds (IFSWF) Auckland conference this month.
Prince said if the next decade and beyond follows the expected course of low growth and subdued returns – and with maxed-out central banks unable to spark economies into action – high currency volatility is likely to be the norm.
“Currency might be more important than assets,” he told the IFSWF crowd. “Not many people have thought through the implications of this.”
The previous 12 months had already featured some “double digit” forex swings that had material effects on portfolio returns. For instance, Prince said the return differential between a hedged and unhedged portfolio of UK assets was in the order of 35 per cent over the last year.
Investors need to look at currency across their entire portfolios, he said, to understand their exposures compared to a risk-neutral position, with any deviation from that to be “considered explicitly as alpha”.
While forex volatility may present one of the thorniest technical challenges, Prince said investors would have to adopt one of three philosophical positions in a low-return, risk-distorted world.
“Either you accept lower returns, take more risk, or take risk more efficiently,” he told the IFSWF audience. “A few investors may accept lower returns, a lot are taking more risk but not many are taking risk more efficiently.”
More specifically, Prince said investors need to think about managing “systematic” risks as well as non-systematic risks relating to particular asset classes, securities or managers.
He said in general “the world has done a great job” of managing non-systematic portfolio risks through diversified asset allocation strategies.
“But very few people have diversified their asset allocation mix,” Prince said.
However, managing systemic risks by diversifying asset allocation itself requires investors to think beyond the standard correlation-based techniques.
“If you want to diversify your asset allocation mix you can’t do it with correlations,” he said, because correlations between asset classes have “shifted massively” over time.
For example, stocks at one time were positively-correlated with bonds but the two asset classes are now considered negatively-correlated.
Prince said Bridgewater – often considered the world’s biggest hedge fund with US$150 billion under management – tackles the problem by weighing up the “underlying pricing of asset classes” relative to a range of four fundamental economic and financial factors: growth, inflation, risk premium, and discount rates.
“These are the four forces that drive asset classes – they are like the four laws of physics,” he said. “Everything we see is a configuration of these forces. We think about forces, not assets.”
Prince told the IFSWF delegates all asset classes had a ‘beta’ to the underlying four forces, which could be used to construct a portfolio that balanced the systematic risks without giving up return expectations.
According to Bloomberg, the Bridgewater Pure Alpha II and All Weather funds returned -10 per cent and +14 per cent respectively over this calendar year to end of September.
“Pure Alpha I, which targets lower volatility than the Pure Alpha II version, rose 0.3 per cent for the month and pared losses through Sept. 30 to 6.7 per cent,” the Bloomberg article says.
The Connecticut-based Bridgewater, launched in 1975 by founder Ray Dalio, deals only with institutional clients including a handful in New Zealand. For example, the New Zealand Superannuation Fund 2016 annual report shows the $30 billion plus entity had invested almost $270 million in the Bridgewater Pure Alpha II strategy.