Heightened currency volatility is radically impacting recent equity returns in emerging markets and in some cases, masking their relative performance. The violence of these exchange rate movements is underlining the fact that emerging-market equity funds - unlike their fixed-income counterparts - seldom ring fence their holdings from currency fluctuations.
"Traditionally, equity fund managers don't hedge currency risk because there is little correlation between stock performance and currency movements," said Adrian Lee, president and founder of Dublin-based Lee Overlay Partners.
But the severity of local currency movements in emerging economies ranging from Brazil to the Czech Republic to South Africa this year means foreign investors can no longer take this assumption for granted.
With its component mining sector bolstered by the global commodities boom, South Africa's blue chip Top-40 Index has outperformed global markets to decline just 0.8 percent from the start of the year. But in US dollar terms, the same index has sunk some 13 percent after taking into account the rand's 12 percent slump against greenback over the same period of time.
On the flip side, the nearly 11-percent appreciation of the Brazilian real against the dollar means the country's stock market has risen 3 percent in dollar terms since the start of the year - in stark contrast to its 7.5-percent dip in local currency terms.
NO TANGIBLE PLAN: While emerging debt portfolio managers say the importance of currency-risk hedging has risen with the growing divergence between bond and currency markets, their equity counterparts are less likely to take steps to ameliorate the impact currency movements on their assets.
"A tangible strategy for currency hedging is still rare among equity funds as it can be labour intensive and take money off the table," said Alex Tarver, global emerging markets product specialist at HSBC asset management arm Halbis. Some hedge funds and institutional investors outsource the management of their foreign exchange risk to external currency overlay fund managers but most equity managers view forex hedging as an extra, and not always necessary, layer of decision-making.
Currency hedging is also costly because of the relative lack of depth in emerging currency trading volumes and widening gap between US and emerging market interest rates. Equity investments are seen to have a lower correlation to sovereign risk - a further disincentive when one considers that most local currencies, notwithstanding the sharp depreciation suffered by the South African rand and the Turkish lira, have risen this year.
"Currency movements tend to be noisy but over the long term they are just reflective of the economy and not the driver of economic performance," said Steve Tael, portfolio manager for Nicholas Applegate in San Diego, which runs $1.5 billion in emerging market stocks.
VALUE DESTROYED: Investment managers say forex is ultimately only among a plethora of factors in any investment decision. "In the short term, a lot of value can be destroyed when the currency weakens. But we look over a five- to 10-year horizon," said Mark Gordon-Jones, global emerging markets equities investment manager at Aberdeen Asset Management in London.
"We take it into account when valuing companies. We like companies that can cope with currency weakness and tend to pay less for a business in a country where we expect forex weakness," he said. But stock pickers also leverage on currency weakness in a country by buying into exporters that will see foreign revenues boosted by a more favourable exchange rate and their local costs decline after currency conversion.
Portfolio diversification over country and sector is also likely to lessen the impact of the movement of any single currency, investors said. "Currency levels hold implications on the sector performance but it's a waste of time to hedge against it. All you do is create fees for investment banks," said Matthias Siller, an investment manager at Barclays Asset Management.
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