Participants
Katie Martin, Dow Jones Let me start by setting the scene a bit. The most recent study from the Bank for International Settlements found a one-third rise in daily trading volumes to $1.9 trillion a day. Financial accounts and hedge funds formed a big part of that boom, with their share of the volume rising to about a third. That segment is understated too as prime brokerage relationships allow clients to execute under their banks' name. So it appears that the battle to convince investors that currencies do provide a meaningful source of returns has been won. Monica, why has this asset class sprung to life as it has?
Monica Fan, RBC Capital Markets If you look at the performance of traditional asset classes over the past four years, they've produced poor returns. Naturally people are looking for positive absolute returns and they can find those in the FX markets. Increasing investor education has encouraged people to move into so-called non-traditional asset classes, and the willingness of consultants to advise their clients to invest in absolute return funds has also played an important role.
Harriet Baldwin, JP Morgan Fleming Katie called FX an asset class. I think it's more accurate to say that FX is a medium of exchange between different asset classes. You can create an asset class out of FX returns, but it's not an asset class in the same way as fixed income or equities because currencies have a unique characteristic: they don't have a theoretical expected return, they're just a way in which we denominate other asset classes. That said, the growth we've seen is a function of two things. First, increased global diversification: when you invest internationally you get currencies as a side effect and you have to think about what you're going to do with them. Second, as Monica points out, the expected returns on traditional asset classes have been much lower. So any kind of alpha – excess return – that you can get is valuable and FX does give you opportunities to get excess return.
Michael Shilling, Pareto Partners I think there has been a change in investors' view of what is the active risk in their portfolios. Larger-cap equities, for example, have been disappointing and the active management of them has consumed investors' risk budget without adding any additional value. So investors have started looking at active sources of return separately from the underlying asset classes and been splitting out their allocation of risk. This has led to the debate on the difference between beta risk and alpha risk. Currency has come to the fore because active currency management is one of the pure sources of alpha risk – there's no beta associated with it – so it's pure transportable alpha. That has attracted people's attention.
Bob Jolly, Gartmore Remember too that people have found through the years that currency managers do actually generate this alpha and that return is typically uncorrelated with other asset classes. As a consistent diversifier FX generates more return for a given unit of risk, which is the name of the game.
Henir Foch, BNP Paribas Don't you think there is too much money chasing too few opportunities? Returns are declining and access to FX liquidity has drawn many more people into the markets removing opportunities?
MS, Pareto Partners Well we are talking here about scaleable alpha. When you look at all the money that's pouring into hedge funds you start to expect the return to come down because opportunities are going to get arbitraged away. But with currencies, if more money goes in it helps, it doesn't dilute the alpha that's available.
HB, JP Morgan Fleming I would pick you up on that Michael. Hedge funds like to follow trend-following strategies. For that inefficiency to exist, insufficient people must notice it in time. If more participants follow this model, then does that destroy the strategy or does it simply exacerbate the trends?
MS, Pareto Partners If everybody followed the same strategy, that would be true, but they don't.
HB, JP Morgan Fleming I think this comes back to Bob's point that currency managers seem to be systematic winners. It's hard to find a currency overlay manager who hasn't made money. For that to happen, there have to be systematic losers and in the FX markets they are central banks and also the global equity managers moving from one stock to another across a border and ignoring currency. These two sources of systematic loss will, I think, continue.
BJ, Gartmore All the evidence is that in the medium and long term people make money out of trading currency, whether they be hedge funds, CTAs or currency overlay managers. FX is one of the more consistent alpha sources and it's one of the more consistent diversifiers. So with FX in a portfolio construction framework you generate more return for a given unit of risk, which is the name of the game. To argue that this will not continue to be true you have to argue for some fundamental change and a permanent shift to a different regime which involves ranges rather than trends. I can't see that.
MS, Pareto Partners People who believe that the market has changed and opportunities will be fewer and smaller are focusing too hard on the short-term conditions we've seen in the market. But we've had periods like this before. The key to making money, if you have a strategy which makes money out of one or other of the environments, is not to lose too much in the other environments.
HB, JP Morgan Fleming Speaking for the currency overlay industry, there are three main areas currency overlay managers look at. One is trend following; the second is relative interest rates – the carry trade; and third is currency relative value – are we at extreme levels of over- or under-valuation? Those three sources of excess return have very different characteristics. Technicals will give you lots of little losses, but they'll have some very big gains when you're in a big trend and that's why they're favoured by hedge funds. Carry trades will give you lots of little gains on average, but there'll be some very sharp periods of downturn – the big obvious ones were the break-up of the ERM in 1992 and dollar/yen in 1998. And the third strategy tends to be very episodic. Extremes in valuation are rare and tend to overshoot, so you have to go through a period of under-performance before you get the move back. And so that strategy tends to be favoured by much longer term investors.