LONDON - When a money manager buys shares of British Petroleum PLC, is he taking on dollar exposure or sterling exposure?
The answer is both. Plus, it matters whether the manager is buying the stock over the London Stock Exchange or through American depository receipts traded in New York, according to Jason MacQueen, chairman of Quantec Investment Technology Ltd., London.
Because oil prices are set in dollars, any petroleum company stock is subject to fluctuations in the dollar. But if the stock is purchased in London, typically only risk to sterling is considered. On the other hand, if the stock is purchased in New York, the manager usually looks at the dollar exposure instead of the pound.
The problem is that traditional analytical tools fail to give an accurate picture of currency risk, Mr. MacQueen said. In response to client requests, Quantec officials have developed a Cross-Country Equity Risk Model that attempts to quantify the often hidden currency exposures of large, multinational company stocks - the type usually held in the portfolios of international equity managers.
These currency risk factors can undermine stock-picking skills of international equity managers, he said. Just because a manager may have a 32% exposure to Japanese stocks does not mean that manager has a 32% exposure to the yen, he explained.
For example, SONY Corp. has operations and sales worldwide. But evaluation of SONY in the portfolio typically fails to quantify these overseas operations and exports.
"The way people treat currency risk is desperately naive," Mr. MacQueen said. When asset allocation accounts for about 80% of added value from global portfolios, ignoring currency risk can hurt performance, he noted.
The problem also affects domestic large-capitalization equity portfolios, because many large companies have become increasingly global. In the United Kingdom, more than 28% of risk of Financial Times-Stock Exchange 100 stocks stems from currency exposures, according to the Quantec model. For TOPIX stocks, 21.8% of risk stems from foreign exchange factors.
The currency risk in Standard & Poor's 500 stocks, however, is much smaller, at 6.9%. But the bottom line is all portfolios contain embedded currency risk.
John Cone, senior vice president at Franklin Portfolio Associates, Boston, said he believes stock picking will become increasingly global over time. When picking automotive stocks, automakers, portfolio managers also should be able to choose among Japanese, German, French and Italian automakers instead of choosing just from the Big Three , he said.
Franklin Portfolio has started using the Quantec tool in building its $90 million in international stock portfolios. He said the tool helps Franklin executives "build global portfolios much more efficiently." Instead of putting them together on a country-by-country basis, as managers traditionally do, the Quantec product helps put the pieces together in a more cohesive, top-down fashion, he said.
In fact, Mr. Cone said he now can build in exposure to the Italian market without buying Italian stocks. Instead, he can buy stocks of companies that have plants in or exports to Italy. Mr. Cone added Franklin will use the model in its domestic stock portfolios as well.
The Quantec product helps portfolio managers build more efficient portfolios and implement more appropriate currency hedges, Mr. MacQueen said. The model analyzes 14,000 global stocks, based on 21 years of data, through a series of filters.
First, it strips out sensitivity of a stock to currency influences. The model then strips out a global equity factor, which reflects how a stock's price is affected by behavior of world stock prices.
It then evaluates stocks by eight sectors: basic industries, capital goods, consumer goods, energy, financial services, resources, transport and utilities. The model identifies which of the factors are statistically significant for each stock.
Finally, the model examines the influence of the home market on each stock, plus any significant influence from foreign markets.
While some treasurers of multinational corporations hedge their foreign exposures, this should be taken into account in the model through the stock's historic performance, Mr. MacQueen said. Only when there is a major change in corporate policy will it take a couple of years for that switch to be reflected in the data, he explained.
That's not necessarily a problem, Mr. Cone explained. "What we are really trying to forecast is the risk that is embedded in the stock price," he said. The market's perception of how the stock will fare "may be more important that the reality of the experience," he said.