Of all the asset classes in finance, currencies are the least understood. Funnily enough though, everyone thinks they know everything as, after all, we all exchange currencies when we go travelling. Even a child understands that you convert one for the other, according to some formula. You can do so practically anywhere with the friendly people at the currency exchange shops at airports, your bank or you just leave it to your credit card company to figure it out. Easy. What’s not to understand?
Well for one thing, there is that little matter of the exchange rate and fee you pay for any transaction. This is where it starts to get confusing. You see, even though your bank or currency exchange shop may advertise that your transaction will be 'commission free', the rate at which you actually transfer your currencies can be very far away from the actual market rate, costing as much as 3% at the bank, and more than 10% at the airport.
It really blows my mind that for an asset class that is probably the most liquid in the world, with billions of currencies exchanged every second of every day, and yet still, the fees are so much higher than if you were to buy a stock, bond or even a fund.
Then there is the whole ‘exposure thing’, which is so often ignored by even the most sophisticated financial services professionals. Let’s say you buy a broadly diversified index of stocks, such as the MSCI World, and let’s say that you bought the ETF in Sterling, would your currency exposure be Sterling? What if you sold your Sterling and then bought the same index but in USD, would your exposure be in USD? The answer is that neither are correct. This is because what matters is what currencies the underlying stocks are traded in, not what currency you bought the fund in.
I met one five star fund manager a couple of years ago who was running a global stock portfolio. When I asked him what his currency position was, he promptly replied that he didn't take currency risk. When I pointed out that most of his portfolio was in fact invested in equities in more than 20 currencies, and that a large part of his returns could probably be explained by the move in the currencies, rather than his ability to pick stocks, he became very nervous and begged me not to tell anyone.
So, what is it about currencies that make them so difficult to truly understand? Maybe it is the way they’re are quoted as a pair. Honestly, how many of us have been confused when we look at the EUR/USD rate versus the USD/EUR rate, particularly when they were trading near 1 and you had to figure out if the Euro was strengthening or weakening just by looking at the ratio?
Fact is, currencies are one of the most difficult areas of finance and the very reason that many of us are still overpaying for our exchanges ('commission free' of course).