Debate participants
JT, ClientKnowledge From the various sources of data available, we estimate that the overall market in foreign exchange is now about $2 trillion a day of activity, and of that approximately $500 billion a day is alpha-seeking. By alpha-seeking, we mean activity dedicated purely to seeking foreign exchange returns, whether it’s undertaken by hedge funds, by traditional money managers, as a pure asset class, or by sell-side prop desks unrelated to underlying client activity. Harriett, is there a clear distinction between currency overlay and alpha-seeking strategies at JP Morgan Fleming?
HB, JPMAM Our currency overlay business began in the 1980s and was linked to the assets that existed in the underlying portfolio. Clients wanted those specific exposures managed. Over the years, they asked us to start broadening exposure across a wider range of currencies, even though they didn’t have those currencies in their portfolios. That became what I would now call a long/short currency approach. By the end of the 1990s, more and more clients were thinking of separating currency beta – the strategic hedge – from currency alpha. This should be much more effectively delivered without the kind of constraints that exist when FX is linked directly to the assets. I would estimate that 75% of our clients have now changed to less constrained mandates, whereas 25% are probably still keen to have that link between their portfolio and the long and short positions that they can take. In five years’ time everyone will have de-linked.
AE, MGI I agree. The vast majority are alpha-seeking to some extent. It’s a gradual crossover, as clients are aware of the risks that pure currency trading entails and therefore they still impose a lot of constraints. I think it’s going to take five to 10 years to get there, but it’s certainly moving in the direction of pure alpha strategies.
PP, DynexCorp We have demonstrated to clients seeking portfolio overlay that with a beta strategy they limit themselves to only one side of the market. We convinced them that by pursuing alpha-only as a ‘pseudo-hedge’ – in using both sides of the market – their benefits from the currency market may be vastly improved.
TP, CSAM Over the last few years, currencies have developed as a separate asset class. They compete with other aggressive-style hedge fund alternative investments, looking to add between 10% and 20% a year as a separate allocation. So, that’s another development that may become more interesting in years to come.
| Share of daily e-FX volume (%), 2005 |
 |
Notes: 37% of overall total market
Corporations, real money and leveraged/highly active investors, client banks
Source: ClientKnowledge |
CE, DrKW I think the picture is still mixed. Some clients will let you help them make more money by trying to use options, volatility, correlation or hybrid products. They’ll be open-minded because they understand that you have an advisory role and that you’re here to add value. Others will definitely say, ‘No, I’m just doing the bond or the equity and I really don’t want to look at the foreign exchange’. It is more difficult to convince those clients that they have a risk and that something can be done to mitigate it or benefit from it.
SH, FFT&W Yes, despite the fact that people now talk as though it is proven that you can consistently make money in FX, there’s still a lot of scepticism about whether that is really true. Some equity managers fall into that category.
TP, CSAM It depends who you ask and when they’re asked. Between 2001 and 2004 markets trended and lots of investors made money. Then there are difficult years like last year and this year, and people make less money or lose money. But that differentiates those managers with solid performance in different market environments from those who are just trend followers.
SH, FFT&W In my view most foreign exchange investors don’t make money in non-trending environments. The people who do best in that environment are the counterparties. You do need some sort of persistence of trends to have a reasonable chance of generating good money.
TP, CSAM Sure, but you still need a number of different cycles to identify who is good and who is not good, rather than just one.
Choosing a style
JT, ClientKnowledge Which brings us on to strategy. Assuming that investors accept there are returns to be had in FX, how should they go about allocating risk to seek out alpha?
PP, DynexCorp The basic choice is between systematic and discretionary. Systematic means mostly trend-following, which at times can be pretty simplistic. Traditionally, systematic traders outperform discretionary traders, but there’s been a recent shift. Over the last two years discretionary traders have been outperforming systematic traders, if measured over 12-month windows. It is uncertain if this tendency of better performances from discretionary trading will persist or if it will turn out to be cyclical.
HB, JPMAM I think you should allocate as much risk as you’re prepared to take to discretionary and as much risk as you’re prepared to take to systematic, and then leave the two things to get on.
AE, MGI The big difference is that the discretionary manager cuts risk more quickly in markets where they’re not making money, and the trend-follower takes longer, depending on what model they’re watching. So, sometimes you see bigger drawdowns. Equally, when they get the markets right you see greater returns. A mixture of both is a very powerful combination.
TP, CSAM Diversification of styles is important and it should be implemented at a portfolio manager level, where a firm has different styles of applying currency analysis and currency management. Clients can diversify by selecting different styles of managers or a mix of managers who have a diversified approach.
