PPP provides active approach to currency value management

This article is part of
The Guide: Currencies

PPP provides active approach to currency value management
 A currency’s value may be so distorted that it is not feasible for investors to replicate, as was the case with the Japanese yen in the late 1980s

Currencies are almost always associated with short-term trading and speculation, rather than long-term investing. Prices are normally quoted to four decimal places and positions are more likely to be held for days or months rather than years. 

But it would be a mistake for long-term investors to simply ignore currencies altogether as these seemingly random short-term movements can have an enormous impact over the long run. 

For example, over the past 10 years the FTSE World index has gained 4.4 per cent per year when measured in US dollars. But for a sterling-based investor, the same basket of equities would have returned twice as much in the same period. This puts investors in a difficult position in the sense that currencies are very difficult to predict, yet too important to ignore. 

When faced with this predicament, many investors simply accept the currency exposure that comes with their investments. Others may decide to hedge their portfolios to match benchmark weights. For instance, if Japan represents 10 per cent of the global equity market, an investor could tweak their currency holdings to ensure that the yen is also roughly 10 per cent of their overall currency exposure.

The problem with this approach is similar to that of passive equity investing in that it takes no account of value. In this example, having a 10 per cent exposure to the yen may or may not be a good decision, but that will ultimately depend on the currency’s underlying fundamentals, rather than an arbitrary weight decided by a benchmark provider. 

In extreme cases – such as the bubble era in the late 1980s when Japan accounted for an unusually large portion of the global benchmark – a currency’s weight may be so distorted that it is neither sensible nor feasible for most investors to replicate. 

In the same way that active stockpickers can assess the valuations of individual companies, an active approach to currency management can also be value-oriented. One way to do this is by looking at purchasing power parity (PPP). This can be done on either an absolute basis, which compares actual prices, or relative basis, which compares inflation-adjusted prices against their own histories. In theory, PPP should tell you whether a particular currency is over- or undervalued at the current exchange rate.

In practice, both absolute and relative PPP models are far from perfect, but they can provide a decent starting point for further analysis. For example, the US-China comparison is especially problematic because the Chinese currency has not floated freely over its history and so relative PPP probably overstates its overvaluation relative to the dollar.  

At best, models such as PPP can only act as a guide to currencies likely to be good long-term stores of purchasing power. How well these models reflect the economic reality of the country and its ability to support the value of its currency also needs to be considered. At a time when many countries apparently prefer weaker currencies as a policy tool, it is a challenge to find ones that can be relied on.