Vantage Global Investment Fund s (VGIF) Currency Benchmark

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1 Vantage Global Investment Fund s (VGIF) Currency Benchmark VGIF s Members opinions appear to divide over the merits of the Fund s Currency Benchmark - some seem to feel that it s too clever by half, while others consider it confusing and an unnecessary distraction. The most frequent observation is that because investment into the Fund is in US dollars and the Fund accounts and reports it price in US dollars, the Fund is viewed as a US dollar asset and only the US dollar return is relevant. Yet, we are as convinced now as we were in mid 1995 when establishing your Fund s benchmarks, that the establishment of the Currency Benchmark is theoretically and practically appropriate, and in Members best interest. It is important in the management of your Fund s assets, and reporting performance in terms of the Currency Benchmark gives Members the clearest view of how their investment is doing in the quest to build global purchasing power. We have not done a good job of explaining this differentiating feature of your Fund. This note is an attempt to correct that deficiency. It outlines the background to the Currency Benchmark, and its implications for fees, its theoretical integrity and its practical application (Appendix). The Background The Currency Benchmark is currently weighted 50% in the US dollar, 35% in the Euro, and 15% in the Japanese yen. The chart below shows the value of the US dollar versus that of the Currency Benchmark for the ten years preceding the Fund s inception in January 1996: 105 US dollar versus Currency Benchmark for 10 years prior to VGIF inception US$ vs Currency Benchmark

2 By the end 1995, the US dollar had been falling for ten years against the major European currencies and against the Japanese yen, and the Currency Benchmark had strengthened by 30% over that period against the US dollar. Many of the European based advisors we spoke to at the time were lamenting that the global funds into which they had invested, while reporting double digit returns in US dollars and charging performance fees based on those US dollar returns, had in fact declined in value in their clients reference currencies. Most felt that the US dollar was a structurally weak currency, and that measuring returns in that currency tended, over time, to overstate the increase in global purchasing power. We listened to them and resolved to ensure that your Fund didn t suffer from the same defect. Hence we defined your Fund s Value Added as its return relative to the return that could be earned by investing Risk Free in six-month government securities, not only in the US dollar, but including the Euro and the Japanese yen in approximately the same weightings that those currencies represent in world trade, and in the FT World Index i.e. in the Currency Benchmark. Over the ten years prior to your Fund s launch in January 1996, the return of the Risk Free Rate so defined had exceeded the return of six-month US dollar treasuries by 28% in total or 2.5% per annum. Of course, since your Fund s launch the US dollar has generally been on a strengthening trend while US interest rates have, until recently, been higher than European or Japanese interest rates. Hence the Risk Free rate in Currency Benchmark has lagged the cumulative return on 6 month US treasuries by 24%, or 3.6% per annum. This strengthening of the US dollar means that since inception, the return of your Fund measured in US dollars has generally lagged its return measured in Currency Benchmark. Since inception to 31 December 2001, your Fund returned 81.2% in US dollars after all fees, versus a return of 113.5% in Currency Benchmark. The relative difference between the two returns of 17.8%, or 2.8% per annum, is a measure of the relative strength of the US dollar against the Euro and Japanese yen over the period. Should the US dollar weaken against the other major currencies, as it has over the long term and a trend that we now expect to resume, your Fund s US dollar returns will exceed those measured in the Currency Benchmark. This has implications for the performance fees the Fund bears. The Implication for Performance Fees The implication of measuring your Fund s Value Added relative to the Risk Free Rate in the Currency Benchmark is that your Fund pays performance fees only if the Fund does better than Members could do for themselves by investing in short term government securities on a currency diversified global basis. Were the US dollar to fall against the Euro or Japanese yen, as it has done on average over the past thirty years, your Fund would not earn fees simply due to that decline in the US dollar s value. This feature is advantageous also for investors who think in US dollars, as when the US dollar falls, their global purchasing power diminishes. As the bulk of their assets is likely to be

3 denominated in the falling US dollar, to pay performance fees on their global investments merely because of the decline in relative value of the US dollar, at the very time that they are getting poorer on a global basis, would neither be equitable nor logical. VGIF s Investment Benchmark and Approach VGIF is a global equity fund with a neutral investment position specified by its Investment Benchmark of 50% FTWI and 50% Risk Free. From this it follows that the Fund s neutral currency exposure is logically not 100% US dollars, but a combination of US dollars and other major global currencies that underlie the FTWI and the Risk Free basket. While the true underlying neutral currency exposure of the Investment Benchmark is dynamic and reflects the relative weighting of the country equity markets in the FTWI over time, for simplicity and clarity of calculation, the directors of the Fund have resolved that the Fund adopts a fixed Currency Benchmark as its neutral currency exposure. This Currency Benchmark, currently 50% US dollars, 35% Euro, 15% yen, can be modified by the directors from time to time to reflect significant changes in the country weightings in the FTWI. The Investment Approach of the Fund is consistent with the determination of the Fund s neutral currency exposure as the Currency Benchmark. The Manager seeks to add value by over or under weighting currencies relative to the Currency Benchmark weightings. This focus on managing your Fund s currency exposure relative to this neutral currency position makes your Fund, we believe, distinctly attractive relative to most global investment and hedge funds, which typically measure performance in US dollars and charge performance fees based these returns (typically without a hurdle rate such as your Fund s Risk Free Rate). The Fund s return in its Currency Benchmark is the truest measure of its performance, and gives a clearer picture than the US dollar return of the increase in global purchasing power that the Fund generates. Conclusion. We believe that, properly understood, your Fund s management and reporting relative to its Currency Benchmark distinguishes it from most other global investment funds, and makes it particularly attractive to conservative long term investors who are focussed on absolute returns and building wealth in terms of global purchasing power.

4 Appendix : The Theoretical Basis This section is somewhat technical, for which we apologise, but is included to demonstrate the theoretical and practical integrity of managing the Fund s assets and measuring its returns relative to the Currency Benchmark. Remember that VGIF s Investment Benchmark, or neutral position, is a weighting of 50% deployed in the Financial Times World Index including income (FTWI), and 50% deployed risk free. This is meant to represent a neutral position for conservative global investors, who might consider it prudent to place half their funds in global equities and half in risk free securities. The 50% of the Investment Benchmark invested in the FTWI would have the currency exposure of the constituent country equity markets according to their weightings in that index. At present that is approximately 50% in the US dollar, 30% in the European currencies, 12% in the Japanese yen and 8% in other currencies. So the half of the Investment Benchmark invested in the FTWI would have by default a currency deployment approximating that of the Currency Benchmark. The other half of the Investment Benchmark, that part represented by risk free securities, is denominated in the Currency Benchmark by the directors of the Fund. This reflects the return that a prudent investor would achieve by depositing his funds in a basket of currencies, reflective of each major currency group s relative weighting in world trade and in world GDP. So, if the Manager takes no decisions on currencies or on shares, then he would denominate the assets of the Fund in line with the Investment Benchmark, with 50% in the FTWI and 50% in risk free securities in the Currency Benchmark. The currency exposure of the Fund would then approximate that of the Currency Benchmark and would clearly not be 100% in the US dollar. It is axiomatic that if the Manager takes no investment decisions, the Fund s investment position is neutral. If the Fund is neutrally positioned it is unable to add or subtract value. Measuring the returns in the Currency Benchmark ensures that the Fund does not appear to have created value while being neutrally deployed merely by the strengthening of the Euro and the yen against the US dollar, nor does it appear to have destroyed value should the US dollar strengthen against those two currencies. The alternative, of measuring the Value Added return in US dollars would make the Fund s value added, when neutrally deployed, subject to the return of the US dollar relative to the other major currencies. In times of US dollar weakness, the Fund s neutral exposure to the Euro and the yen would cause the Fund to appreciate in US dollars, and the Manager would be rewarded while taking no investment position. That would clearly be wrong. Vantage Investment Management is charged with adding value relative to the Fund s neutral position, and its performance fees should clearly be based on the extent to which it does in fact add value for the Fund.

5 The establishment of the Fund s neutral currency deployment as the Currency Benchmark is actually predicated by your Fund s investment approach. Remember that the Fund s preferred investment approach is to be fully invested in global equities, and then to proportionately hedge the associated equity market exposure by the sale of stock index futures. Hence, the neutral position of the Fund would be to invest all of the Fund s assets in global equity markets in their weightings in the FTWI, and then to sell half of the exposure to these equity markets through stock index futures. The Fund s currency exposure, when thus neutrally deployed, would approximate the Currency Benchmark. The Fund s return would be 50% FTWI and 50% Risk Free Rate, as the combination of the 100% invested in the FTWI and the 50% hedged through the sale of stock index futures, would return 50% of the FTWI return plus the 50% of the Risk Free Rate i.e. 100% FTWI plus 50% FTWI hedged back is equivalent to 50% FTWI plus 50% Risk Free, which is the Investment Benchmark. This is because stock index futures on any equity market are normally priced according to the risk free rate in that market s home currency less the dividend yield on that market. As an example, if an equity market index is currently priced at 100, the 1 year risk free rate is 10%, and the dividend yield on the equity market index is 2%, then the price of the 1 year stock index future on that equity market would be % - 2% = 108. Hence buying the equity market index at 100, and selling the 1 year stock index futures on that equity market at 108, would return 8% plus the 2% dividend yield = 10% over the year i.e. the risk free rate. This is intuitively logical, as a fully hedged position carries no investment risk and hence we would expect it to return the risk free rate. The reason that the Fund has selected this investment approach of being fully invested in equities and proportionately hedging the equity market risk through the sale of stock index futures, is that we believe that Vantage Investment Management s core competency is equity selection, and that over time the portfolio of shares selected by the Manager will return significantly more than the equity markets to which the portfolio is exposed and proportionately hedged. We recognize that at times equity markets become extremely overpriced and hence risky, and that the ability to hedge these markets has the potential to reduce volatility as well as to enhance return. When the Manager invests the Fund s assets in a portfolio of selected shares and proportionately hedges the equity markets to which the portfolio is exposed, the Fund s return from the proportion that has been hedged will consist of the return of the portfolio relative to that of the equity markets that have been hedged, plus the risk free rate. This hedged component of the portfolio s return is independent of the direction of equity markets, and is likely to be much less volatile than the return derived from the un-hedged component of the portfolio. For example, if the Fund s portfolio returns 20%, the Manager hedges half (50%) of the portfolio, the equity markets that are hedged return 10%, and the risk free rate is 5%, then the return of the Fund would be approximately equal to 50% * 20% + 50% * (20% -

6 10% +5%) = 17.5%. The actual calculation, for those more mathematically minded, would be 0.5* *((1.2/1.1-1) +0.05) = %. Using the same example, but assuming that the manager hedges all (100%) of the equity market exposure, the Fund s return would be approximately 100% * (20% - 10% + 5%) = 15%. (Actual calculation gives %) However, we should be aware that owning the equity market means owning the currency! Hence when the Fund, neutrally deployed, invests 100% of its Net Assets in the FTWI, its currency exposure would derive from each constituent country s equity market weighting in that index. For example, if the Japanese equity market s weighting in the FTWI is 12%, and therefore the Fund s neutral exposure to the Japanese equity market is 6%(i.e. 50% of 12%), and that 6% neutral exposure is derived by the Fund investing 12% in the Japanese equity market and hedging 6% back through the sale of Japanese stock index futures, then the exposure to the Japanese yen of this neutral position is 12%. Hence investing 12% of the Fund s assets in the Japanese equity market and selling Japanese stock index futures equivalent to 6% of the Funds assets would return the Japanese equity market return on 6% of the Funds assets, the Risk Free Rate in yen on 6% of the Fund s assets, but expose 12% of the Fund s assets to the Japanese yen. So the Fund s neutral exposure to the Japanese yen of 15% in the Currency Benchmark approximates the exposure that derives naturally from the Fund s investment approach. The same equations apply to the neutral exposure to the US equity market and the US dollar, and to the European equity markets and the Euro. Hence the Currency Benchmark weightings are entirely consistent with the investment approach of the Fund.