FX debate (part two of two): The changing face of overlay

Euromoney Has the argument about the value of active currency management been won?

HDH, Overlay: Yes. The equity managers are focusing on their core business, which is selecting the best stocks, and the asset management company or their clients are selecting a currency overlay manager to manage the risk and hence the return. We’ve even seen over the past couple of years a combination of passive mandates and portable alpha and currency, which is quite interesting, because that means the investors can have a strategic passive hedging ratio and, on the other hand, it can benefit from a portable alpha, derived from absolute-return currency programmes, of which he can calibrate the risk and return he wants to get and to be added on to the hedging process.

RG, UBS: We are also seeing our clients getting those types of mandates, where the passive portion is being separated from the alpha. We also see that this alpha is being packaged in both managed accounts and funds.

HS, RBC: Exactly. As there has been more international diversification there has also been a realization that there exists an inherent continuing currency risk that needs to be managed. Corporate foreign exchange risk is a by-product of what a company does. It’s not a risk in terms of an investment decision that a company has made, unless of course it’s hedging capital in subsidiaries.

AE, Millennium: I agree. We have now won the argument about the value of active currency management. The question has moved to what sort of currency manager suits your objectives and whether you want a systematic or discretionary manager or a combination of both? Historically, most clients that want to allocate money will go for a combination of styles, as this gives better diversification of risk and returns. For example, discretionary managers outperformed in April and May and carry strategies during the summer when volatility was low.

HDH, Overlay: We have also seen more clients relying on banks’ research to build their multi-manager programmes, classifying managers by style and track record, of course, but combining them, creating a coalition of managers, and that has been very useful for the clients and for us.

GK, Bank of America: The work that my colleague Amy Middleton has done illustrates that the behaviour of discretionary managers is more difficult to quantify. Yet we also found that distinguishing behaviour between trend-following and fundamental managers is critical to the asset allocation decision. Given the recent market conditions we expect to see further capital allocated to fundamental strategies, and we track this closely.

HB, JPMorgan: There’s a premise in asset management that if you can increase the breadth of the decisions you make you will get better outcomes. So people have removed constraints from their original currency overlay mandates so that you can go long and short the full range of currencies. The logical next step is to put that in a commingled fund structure, because then it doesn’t matter what your assets are or what your base currency is. So more people are opting to go down a fund route, which makes the accounting easier. Once you go down the fund route, you want to put in as little cash as possible to get as much return as possible, so it then becomes a question of how much leverage you’re prepared to take.

RG, UBS: In fact we come across more and more high-levered funds (leverage higher than the usual maximum of five). We’ve seen a considerable number of funds like this being planned, and some of the existing ones are already closed to new investors.

Ubiquitous alpha-seeking

Euromoney The real money manager has historically used currency overlay risk management, but more recently has moved towards alpha total return, and basically created internal hedge funds. How much of the institutional money management growth has been in the overlay side, compared with the total-return product?

MS, Pareto: Well it’s difficult to distinguish between them sometimes, because the overlay product can be either active or passive in itself. You could be managing a pre-existing risk, which is what we think of as overlay, which comes from the international investment. If you do that actively it’s also an alpha product. Or you can be disregarding a pre-existing risk, taking new risk in the currency market, in which case you’ve got an absolute-return product. So we would like to distinguish between risk-reducing activities and risk-taking activities, and we’ve seen both expand very significantly over the past two or three years.

JS, Deutsche Bank: From the banks’ perspective the risk-reducing trades look like index-tracking business. The value added to this business is low transaction costs and high operational efficiency. These are not the only skills required for risk-taking or alpha production.

MS, Pareto: No, the risk-reducing product is defined by what it is overlaying. An institutional investor has international investments, and therefore a pre-existing currency risk. I’d consider managing that risk to be a risk-reducing activity. It can be active, so it can be adding value, generating alpha, but it’s based on what was there in the first place, as opposed to trying to make money in the currency market, regardless of other investments.

AE, Millennium: In effect you have the dual aim of reducing risk while increasing returns.