Setting the parameters

Lynn Strongin Dodds looks at currency as an asset class and discusses the factors investors should consider

When markets are defying gravity, few investors pay close attention to generating alpha from currency. Now bearish conditions prevail, so an active strategy comes into sharper focus. Performance, though, has been less than stellar and in this volatile environment, investors have to be more mindful of the risks and choose their managers wisely.

Diane Miller, head of European currency research at consultant Mercer, says: "Median returns have been somewhat flat over the past two to three years but there are several good managers who have a strong record of adding value over most periods. Manager selection is key. What we are seeing is a greater differentiation between those who can control risks effectively and those who cannot. In general, we are seeing a greater interest in active currency strategies. In the UK, about 8% of pension schemes were using active currency management, up from 7% in 2006. The number this year is about 4%, but the number of funds in the survey has increased."

Torquil Wheatley, director of global risk strategy for foreign exchange at Deutsche Bank, also believes that investors should take a longer term view. "From 1990 to 2007, our currency return benchmark shows that, on an excess return basis alone, currency was up 3.9% compared to bonds at 2.4% and equities at 3.5%. We are seeing a significant interest in active strategies from pension funds because of the low correlation to both equity and bond markets, and the clear diversification benefits this brings."

The other major advantage, according to Thanos Papasavvas, head of currency management at Investec Asset Management, is the alpha that currencies can generate. The 2007 tri-annual Bank of International Settlements survey shows that currencies are one of the most liquid asset classes with over $3trn (€1.9trn) dollars traded daily. As a result, there are opportunities to be exploited.

"This is mainly due to the fact that the majority of participants are non-profit maximisers such as central banks, corporate treasurers and tourists. Central banks try to set their exchange rates for economic or political reasons while corporate treasurers hedge their balance sheet risks. The low correlation of active currency strategies to other traditional asset classes also enables managers to add a separate source of alpha and diversify their risk."

In the past, pension schemes have viewed currency management as a way to protect portfolios from foreign exchange parity fluctuations, which mainly emanates from the overseas or fixed income components. Fund managers would employ forward contracts to reduce all or part of a portfolio's exposure.

As Michael Schütze of Allianz Global Investors, says: "The classic currency investment strategy was to look at the underlying portfolio and create a passive overlay that hedged the risk. Active currency in portfolios is mainly via an active overlay to a scheme's international exposures or by taking on currency as a separate or alternative asset class."

Mike Shilling, chief executive officer of Pareto Investment Management, which is part of BNY Mellon AM, notes: "The best way to construct a currency alpha strategy is not to be constrained by the currency exposure in the underlying portfolio. For this reason it is important to separate an alpha strategy from a risk management overlay, which needs to address the underlying exposures directly, but can also be managed actively. There are two objectives here; one is to manage a pre-existing currency risk in the portfolio, the other to take new risk to generate alpha from currencies."

While large, sophisticated funds are ahead on the active currency curve, there are regional differences, says Helie d'Hautefort, managing director of specialist house Overlay AM, a subsidiary of BNP Paribas. UK pension funds have been forced to find better ways of controlling volatility by diversifying risks, largely due to mark-to-market accounting. In addition, their exposure to international equities and foreign exchange swelled as they broadened their horizons.

"Active currency strategies are popular in the UK because the pension fund market is consultant driven and they have grasped the concept of diversification and uncorrelated returns. The Germans and French are behind but it is less important in that they are more euro-based and have less exposure to international securities," he says.

Wherever the scheme is based, active currency strategies need to take account of a particular fund's risk/return profile. Investors usually express their risk budget in terms of tracking error, and Papasavvas notes that a typical pension fund will target 150bps to 300bps with a tracking error target of 2-4% over their international holdings. 

Michael Victoros, FX Investment specialist at Fortis Investment says one of the questions asked about the risk budget when making strategic allocation to a currency fund is how much cash should be invested. "This depends both on the tracking error that the investor wants to add to the portfolio via active currency management and the risk available within the specialised currency alpha funds on offer," he says. "Typically, the higher the tracking error of a currency fund, the less cash an investor needs to allocate to meet the risk budget. This will depend on the investor's risk tolerance, cash availability and credit rating with the banks."

Another important factor is the hedge ratio benchmark. "Investors have to determine how much of their portfolio's risk they wish to hedge and then this becomes the benchmark against which to manage and measure the currency management process," Victoros says. "An active currency overlay allows the hedge to be adjusted - depending on the expectations of exchange rate movements. If a £100m UK pension fund has 20% invested in US equities, it can set its benchmark ratio at 50%. This means that the manager will hedge 50% of the 20% invested in US assets, or 10% of the dollar exposure. If the view is that sterling will appreciate against the dollar, the hedge can be more than 50%."

Investors should pay closer attention to the strategies and the risks they pose. Over the past few years, quantitative or technical analysis has grown in popularity as a way to both evaluate what the markets are doing and determine their future direction. These systematic trading strategies worked well when volatility was low but they have suffered during the recent market turbulence. By contrast, fundamental or discretionary analysis, which assesses the impact of macro economic trends and relative monetary policy developments on currencies, have fared better.

Figures from the Parker FX Index, which tracks the performance of reported and risk-adjusted reported returns of 83 global currency managers, showed that on a risk-adjusted basis, discretionary models significantly outperformed systematic ones over the past year. Its discretionary index rose a risk-adjusted 0.71% in the three months to February, while the systematic index dipped an adjusted 0.06%. While these returns may look insignificant, they look relatively healthy when compared to the S&P500 index which plunged 10%, the MSCI Europe, off 12%, and Nikkei 225 index which tumbled 18% in the first quarter.

Papasavvas notes, "What we have seen is that fundamental strategies have outperformed quantitative over the last year, but I believe that the most efficient approach to currency management is the use of both types of analysis. The quantitative approach did not hold up in the current highly volatile market but it has its place."