MONEY MANAGERS ARE returning to the markets this January full of fear. They can’t afford to lose more, but where are this year’s returns to be found?
Ask any investment consultant and you will be told that expert currency management means less risk and, yes, added alpha. Good, stable performance, just what the doctor has ordered, is possible with currencies.
Investors have tended to scoff at the notion of currencies as return-generating assets. But now that may be about to change. Foreign exchange, the biggest traded financial market in the world, may finally take its place as a legitimate venue for pension funds and others to invest.
Following three years of negative equity market returns, strategists have been putting out various guesses about what 2003 will bring. JPMorgan suggests that by the end of this year the S&P500 will have fallen to 800: another 12% down from where it stood in mid-December when it had already lost over 21% over the course of 2002. Lehman Brothers expects no more than 3% returns on global government bonds this year.
As for credit markets, after the horrific and unexpected losses on big issuers such as Enron and WorldCom in 2002, who knows? There’s also a lot of nervousness about commercial and residential property.
Investors are considering alternative investment vehicles more keenly than ever before. Currencies have a window of opportunity to prove their worth.
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Currency overlay managers, traditionally seen as providers of hedging services to manage the incidental currency exposure taken on by international equity and bond investors, are launching currency-only funds in an attempt to show what they can do. These funds present currencies as a true investment asset – comparable to bonds and equities, not a mere denomination for those – and a source of portable alpha, or investment performance. Currency-only funds take notional capital payments and invest in currencies for their own sake. Whether investors honestly believe currencies are an asset class or not – it’s an old debate – is largely irrelevant. What’s more important is that currency experts can show there are worthwhile risk-adjusted returns to be extracted from the foreign exchange markets.
“[Many investors] think that the return to be made in currencies is not enough to be significant,” says Bill Muysken, global head of research at Mercer Investment Consulting. “But many have never done the sums to actually figure out how big the returns are.”
JPMorgan Fleming, one of the largest currency managers, runs a managed currency fund that returned 13.1% in the year to October 31 2002. Over the three preceding years it had returned 9.2% and, since its inception in April 1998, 8.2% for 8.1% of risk. By comparison, the S&P indices returned -21.9% in the year to end-October 2002, and -3.7% for 19.1% risk since April 1998. Dollar-denominated bonds returned 9.9% and 7.8% for 4.5% risk for the same periods.
Overlay managers do not have the long-standing track records in pure alpha programmes that some hedge fund managers with currency funds can boast. But they do have long-standing expertise in managing currencies.
They know and understand how forex markets work. They can also apply their new alpha strategies to back-dated simulations, which, if audited independently, are at least an indication of the kinds of returns currency managers can generate.
Even if investors don’t want to invest in pure currency funds, they should surely consider what extra returns currency management might wring from international investments in more conventional asset classes.
When equity markets were generating in excess of 20% a year, the 100-odd basis points that good currency management is estimated, on average, to add to an international equity portfolio was too little to be worth a fund’s risk budget. But that is no longer the case.
On an equity portfolio holding 20% international assets, those 100bp equate to 20bp on the entire portfolio. Total annual returns, including dividends, on the S&P500 fell from 21.04% in 1999, to -11.89% in 2001. This makes currencies a more interesting investment prospect than they ever used to be.
But for some reason investors don’t see it.
Desperately seeking alpha A well-known report by Brian Strange at Currency Performance Analytics found that out of a sample of 152 overlay accounts, 14 currency overlay management firms generated average annualized returns between 1990 and 1997 of 1.88% on accounts managing currency risk tied to underlying assets. This was with a standard deviation of 3.47%, and a Sharpe ratio (returns divided by the volatility of returns) of 0.54.
Currency alpha programmes are more flexible, with higher Sharpe ratios, so the returns are potentially greater.
The same is true of information ratios (IR), or returns per unit of risk taken. At currency management and consultancy firm FX Concepts, passive hedging programmes using only forwards typically have IRs of about 0.5. For an IR above 1, or to generate more return than risk, FX Concepts has hedging programmes that use options, and emerging markets-based currency alpha funds. The latter have IRs of between 1.2 and 1.5.
Over the past two years, currency overlay managers have been known to have IRs of between 1.5 and 2.5 on typical hedging programmes, though in the history of overlay management this is exceptional. A longer-standing measurement of IRs in currency hedging would suggest that an IR of between 0.5 and 0.8 is more likely from managers with good track records.
Data from research consultancies Russell and Intersec show that over a five-year period, the median added value in global equities was 1.7%, global fixed income -0.3%, and currency 1.1%. This was with median IRs of 0.2, 0.0 and 0.6, respectively. In other words, though equities generated more returns, the return per unit of risk taken was, on average, worse than in currencies.
Investors are beginning to take notice of currencies. “There’s more interest in pure alpha plays,” says Peter Wakefield, product strategy director at Record Currency Management. “Making money is a big priority. That doesn’t necessarily mean that clients are looking to take on more risk but the time is coming for currency alpha programmes.”
Hedge fund manager Aspect Capital, for example, aims for 20% returns on its currency fund, which takes a minimum $50,000 investment. The past 12 months have been this fund’s best performing. But Aspect’s currency fund has a 15% exposure to emerging markets, which is too risky for many clients. Many overlay managers’ currency alpha funds shy away from emerging markets.
Currency fund managers generally tend to find their returns being compared not with those of broad asset classes – debt, cash, equity, property – but with that mainstay of the alternative investment world, hedge funds. “Hedge funds are more leveraged, with bigger absolute returns,” says Wakefield. “We [at Record] are unlikely to make 20% in currencies, but that’s because our overlay fund clients are not typically looking for leveraged products. They are attracted by the high quality of currency returns, but not by the possibility of leveraged returns.”
Hedge funds and overlay managers’ alpha funds look similar on the surface. “Currencies are the ultimate long/short strategy because they’re the most liquid and most difficult-to-value assets in the world,” says Michael Collins, global currency product manager at Deutsche Asset Management (DeAM). But, to date, clients have wanted safer, more conservative services from overlay managers, and will often constrain them in their mandates more. Hedge funds, on the other hand, are specific funds that have ready-established investment policies.
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Currency-only hedge funds are also taking off among retail investors. In Japan, press adverts urge retail investors to consider the yields that currencies offer them. And in the US, independent forex trading companies are offering managed currency accounts. Gain Capital, for example, uses its Managed Account Program to invest clients’ money in currencies. Since its inception in October 2000, the programme has had gross returns of 68.7% and has never had a month in which it has lost more than 2%. Now the fund is less leveraged – it used to offer margin trading of 5:1 – and projected annual returns are more modest, in the region of 10% to 20%. But that’s still more than enough to garner growing interest, according to Gain’s CEO, Mark Galant.
“Bonds are near the top in price, equities are down and venture capital, where endowment and pension funds have put discretionary funds in the past couple of years, has done poorly. This is all good news for forex. There doesn’t seem to be anywhere else to turn. Everyone is looking to scrape together every source of return, which makes them willing to take a look at currencies as an alternative asset,” he says.
For institutional investors uncomfortable with the thought of currency-only funds, Barclays Global Investors (BGI) has developed a more structured way to gain exposure to currencies.
BGI’s dedicated asset allocation vehicle, the Ascent asset allocation fund, is a fund into which a small proportion of a cross-asset portfolio might be invested. In essence, this alternative asset allocation attempts to generate portable alpha by taking leveraged positions in currency forwards in particular but also in equity and bond futures. Hence active views are taken on asset markets around the world, and active positions in the overall traditional asset allocation fund are spread out over more assets.
For example, if a client took 1% of a cross-asset portfolio and invested it into BGI’s Ascent asset allocation fund, the alpha target on that 1% for the entire fund might be 20bp. To generate those extra 20bp might require an active tracking error of 25bp on the Ascent asset allocation fund, which could be taken as, say, 20bp of risk in bonds and equities, and 15bp in currencies. (This does not add up to 25bp because of the lack of correlation between currencies and other assets.)
Assuming the manager generated its target 20bp of portable alpha, about 9bp would be attributable to currencies alone, and 11bp to equities and bonds combined.
Pure currency alpha programmes have grown out of active hedging techniques and, in reality, if investors are concerning themselves with currencies at all they are more interested in hedging currency risk already taken on a fund’s underlying assets than in investing in currency per se.
Currencies are an unavoidable source of volatility. Passive hedging – the most conservative way to deal with currency risk and one that that sticks to a predetermined hedge ratio – has long been the most popular method. Alternatively, active hedging allows deviation from the benchmark amount of currency risk to be hedged.
Opinions vary about whether active hedging is a risk-reduction or return enhancement strategy. But what counts is what investors expect to gain from the risk budget they are prepared to spend. “Without using a lot of leverage, it’s hard to make returns in currencies, and a lot of people shy away from them because of that,” says Mark Holman, global fund manager at Sarasin Investment Management. “They’ll never become as mainstream as equities as a place to look for returns. But currencies are important in the overall investment process. They should be incorporated into the overall investment decision, not looked at in isolation.”
Overlay managers welcome the allocation of more risk budget to currency hedging, and the separation of strategic and tactical decisions. “Once you’ve worked out a strategic hedge ratio and a passive hedge programme, we’ll often do that for you for a couple of basis points only,” says Collins, at (DeAM), as if it’s the simplest thing in the world. “What we’re more interested to know is what you plan to do with the remaining exposure? If you ask me to actively manage the residual exposure, I’ll actively spend that allocation to earn an additional excess return. Client constraints are often quite restrictive because many think that all currency managers do is manage risk. They just don’t see currencies as a source of return.”
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| *Returns may be net or gross of fees, unless specified**Average IR can be deceptive. Currency returns are episodic, so IRs can vary from year to year. |
Less risk, more return
But active hedging programmes can be used to add risk to a portfolio without cancelling out the risk reduction of a passive hedge. In fact, the extra risk in the active hedge may stem from the risk reduced by the passive hedge.
Take, for example, a typical basket of shares held by a UK investor with a 20% international holding. Standard deviation of returns on this portfolio might be in the region of about 18%, made up of a risk to returns on the equity of about 15% and a risk to returns on the currency exposure of about 8%. Because equities and currencies are uncorrelated, together this would make about 18% overall risk on the portfolio.
A 100% hedge on the foreign currency exposure would remove the 8% currency risk, leaving the 15% risk on the equities. With an active overlay programme, an overlay manager might then add an extra 2% to the risk budget by investing in currencies to make a return and add alpha. In overall portfolio terms, this extra currency risk might equate to about 0.1%.
So, in total, risk on the portfolio is reduced to 15.1%, and the possibility of generating currency alpha is added.
But still investors don’t get it. One large UK corporate pension fund – one of the few pension funds that would talk to Euromoney about currencies – admits to implementing a typical passive hedging strategy. All equity-linked currency exposure is permanently unhedged, all bond-linked currency exposure is 100% hedged. “In the fixed-income categories [of our fund] we need stable returns. We don’t want to take a hit on currencies too,” says the head of finance at the fund. “But in the equity portfolio, most of the risk and return comes from equities, not currencies. Equities are more risky but we know what we’re doing there. We simply try to diversify that risk away.”
It’s true that any type of hedge on any asset has cashflow implications. And budgeting for draw-downs on currency forward contracts is easier on a passive hedge. “If you pick a hedge and stick to it, it shouldn’t cost too much,” says Muysken at Mercer Investment Consulting. “A 100% passive hedge, on average, shouldn’t cost more than about 15bp a year as a percentage of the hedged assets.”
He adds that, for fund managers worried about currency risk, this is cheaper than the risk in reducing international asset allocation.
The implications of getting risk management wrong are much greater than before. For example, new accounting standards in the UK such as FRS 17, which stipulates that pension fund assets must be measured using market values and all surpluses or deficits recorded on balance sheet, mean that the volatility and risk imposed by currencies on a fund’s portfolios must be accounted for.
FASB rules in the US also stipulate that corporates must state assumed returns on pension funds, which, for most, lie at about 8% to 10% for S&P500 investments. That now looks rather optimistic. Pension fund managers need to justify these return assumptions and get as close to them as possible. This means looking for new sources of alpha, such as currencies.
Most passive currency hedging programmes opt for a 50% hedge ratio – the “point of minimum future regret,” says one overlay manager – which means that half the currency risk borne by international investments is hedged, usually back to the portfolio’s base currency.
But if investors are going to implement a 50% passive hedge, why not go one step further and make the remaining 50% of currency risk work a little more actively? “There is evidence of active returns to be made on currencies, so if you’re going to go to the trouble of setting up an overlay programme, you might as well go active,” says Frank Del Vecchio, forex investor strategist at Citibank. “Over time, active [overlay] tends to add more value than passive programmes. Once comfortable with a passive strategy, most pension funds are opting for a more active strategy with some return anyway.”
What’s more, existing overlay clients are increasing the amount of assets in their currency programmes. In the past two years, clients of Pareto Partners, a top-five firm for currency overlay, have added $3.4 billion to their overlay programmes.
“A typical [active] mandate has a 50% hedge, with the option to reduce that as low as 0% or increase it to as much as 100%,” says Harriett Richmond, managing director and head of currency management at JP Morgan Fleming, another of the largest currency overlay managers. “It’s within that opportunity set that we can look for 1% to 1.5% incremental returns per annum.”
A simulated example from AG Bisset, a US overlay firm with $2 billion under management, does better than this. Its 10-year active overlay programme beginning in March 1992 shows an aggregate return, before fees, on a group of euro-based funds of 45.7%, or 3.83% a year. It hasn’t been a straight run upwards – between December 1993 and December 1995 the simulated fund fell fairly consistently, for example, and it fell again between June 2001 and June 2002 – but it compares favourably with 40% returns over the same 10-year period on an unhedged programme. And though returns on a 100% hedged programme are much more stable over time, they return -2.5% over the same 10 years.
Insurance costs The downside of active overlay as a return-enhancing strategy is that more risk is necessary if it is to be done effectively. And the more risk taken, the greater the possible draw-downs on hedges that move out of a client’s favour. “This is the only business where a client has to write a cheque,” says Arun Muralidhar, director of strategy at overlay firm FX Concepts. “It’s critical to manage those draw-downs.”
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According to FX Concepts, a good way to define the risk reduction and return potential of an overlay programme is to decide how much loss a fund can take, extrapolating from that the risk budget and tracking error that the overlay manager is allowed. This, then, should be mapped to expectations of returns and draw-downs, considering the overlay manager’s past performance.
Muralidhar also advocates overlay managers and investment advisers pushing clients to be freer with their mandates. Many clients are happy with an information ratio of about 0.5 – that is for every 1% of risk taken a 50bp return is generated. But if they want to see returns rise, they need to allocate more of their risk budget to currencies.
Alternatively, they should allow overlay managers to hedge more creatively using options other than forwards. Options broaden the scope of investment opportunity, though they can be costly positions to close. Typically, CIOs whose expertise is not in currencies have shied away from using currency options but as they become more savvy about risk management so they become comfortable with more innovative ways to manage volatility. The greater opportunity offered in having more products to choose from also means that returns can be made more stable over time.
“It takes courage to push clients to let you be more innovative and be more risky with their risk budget,” says Muralidhar. “This is a business that is still evolving so you can’t be too sophisticated in front of some. But clients are pushing for the highest pay-back per unit of risk, and options strategies help flatten the lumpiness of currency returns.”
Another way to take more risk is to incorporate more currencies into overlay programmes. Typically, active overlay mandates are constrained to using no more than the G3 currencies plus a portfolio’s base currency. But if the overlay manager has expertise in 15 currencies, why not allow them to cross-hedge across that entire universe? It may seem like speculation – oddly a word still more attached to dealing in currencies than to equity or bonds – but when an expert currency manager buys and sells currencies, it is no more a speculation than equity and bond portfolio managers buying and selling stocks or bonds on the belief that the price is going up or down.
If currencies remain only a small part of an investor’s portfolio but it still sees them as a source of alpha, overlay mandates need to be flexible. “We look to have the least restrictions possible as the fewer the restrictions, the more we think we can get returns per unit of risk,” says Andrew Dales, director of currency research at Barclays Global Investors.
“New clients coming to currency overlay are generally coming with more active programmes and we are making clear the effects of constraints from the beginning.”
The fewer restraints on an active hedge programme, the more it begins to look like a portable alpha strategy, and there are psychological hurdles for overlay clients to jump with that.
“It’s often a peer-group issue,” says Dales. “Trustees don’t want to move from the type of funds they are already doing but there will be an avalanche of moves to overlay once they see their peers doing it. Unfortunately, the problem is that those that are doing it already don’t want to publicize it. People are scared of being in the press if they lose money [on currencies].”
Given that almost everyone is losing money somewhere these days, this fear no longer seems justified.
In the past 10 years, the S&P500 year-on-year annual returns, including dividends (see chart), have risen from less than 10%, to a peak of 37.58% in 1995, to a low at the end of last year of -21.35% (December 17 2002). The last time the index returned less than this was in 1974.
Investors no longer have the luxury of long-term views to fall back on. According to Mercer Investment Consulting, in the third quarter of last year the median foundation/endowment pension fund in the US suffered a loss of 9.7%. The equivalent public plan lost 9.6%, and corporate plan 9.5%. And while in early 2000 the average pension plan had enjoyed a funding level of 140% – assets exceeded liabilities by 40% – by the end of the third quarter of 2002, assets had fallen short of liabilities by 20%.
Diversification of assets abroad is set to continue as part of US, and other investors’ response to these setbacks. InterSec Research estimates that the world’s cross-border pension fund assets, which doubled between 1995 and 2000, will rise from $2 trillion in 2000 to about $3.5 trillion in 2005. Currencies are an unavoidable source of risk on international investments and a potential source of alpha.
Dispelling misconceptions For years, investors have remained unconvinced that they are an asset worth investing in. Some that have tried it have had their fingers burnt. “We’ve done tactical currency allocation before and it didn’t add any value,” says the head of finance at the UK pension fund. “Over 10 years, it didn’t do that well, so now we just lump our currency risk in with our asset liability modelling.”
But this time around currencies have more advocates. Overlay managers, risk advisers and now investment consultants are advising clients more urgently than ever before to consider currencies as a source of portable alpha. “It’s just not rational to ignore something that can make your risk budget work well for you,” says Rashid Hoosenally, managing director at Deutsche Bank. “Currencies are a source of risk and return the same as anything else, and maybe a better one.”
Many misconceptions exist about currencies, perhaps because free-floating regimes have existed for only about 30 years. It can take between six months and two years to convince a client of the advantages of currency overlay. In some cases, it has taken 10 years.
But investors illogically seem to miss the fact that what they believe about currencies that stops them from investing in them also applies to any other asset class.
The belief that currencies are a zero-sum game, and that losses will inevitably wash out over time, is true in so much as currencies have value only in relation to another currency. They have no intrinsic expected returns, and someone will always lose in a currency trade. But the short-term volatility that currencies add to a portfolio makes them similar to equities. “On average, if you try to beat the equity markets, you’ll only succeed 50% of the time,” says Peter Eardmans, consultant at Watson Wyatt. “As a means of adding alpha, equity can also be seen as a zero-sum game.”
Depth of liquidity and transparency of pricing mean that the foreign exchange markets are just too efficient to make a profit, some investors also say. But investment consultants at Russell have found that, between 1989 and 1999, 241 currency overlay accounts, including 75 terminated ones, returned an average of 1.05% on top of returns on an aggregate $85 billion in underlying assets, with an average tracking error of 2.25%. Results such as these would not exist if the foreign exchange markets truly were efficient.
Currencies are also no more or less susceptible to event risk than the fixed income or equity markets. But memories of sudden currency collapses, such as the Asian markets crash in 1998, still make CIOs wary.
Anyone who doubts the wisdom of assigning currency risk management to an expert should listen to what Paul Duncombe of State Street Global Advisers has to say about the yen’s rise against the dollar in 1998.
Happy days “We just sat there and watched our profits increase,” the firm’s head of currency management recalls, with understandable satisfaction. “The world and his wife were long dollar-yen because of the 5% carry on the trade. But as the Asian and LTCM crises unfolded, they triggered a lot of stops and the market just went tumbling down. We were short dollar-yen already. Our models had already anticipated a down move and spotted that the dollar was overvalued. That was definitely one up to the models.”
Before joining SSgA, another memorable event for Duncombe had been when the model was short sterling versus the dollar when the pound collapsed in 1992. “We did well out of that too,” he says. “It was very satisfying. Everyone has good periods and bad periods, but as long as your wins are larger than your losses, you will add value over the long term.”
Addressing the issue of currencies does not have to mean investing in a pure currency fund but it should mean more than implementing a static 0%, 50% or 100% hedge without looking at other options as well.
A poll of delegates comprising a cross-section of forex market participants at the Euromoney Forex Forum in May 2002 showed that 84% of voters agreed or strongly agreed that actively managed currencies should comprise a portion of any balanced portfolio. “Investors should have some portion of their portfolio in assets other than equities or bonds. Right now, most people don’t,” says Alex Patelis, senior G10 FX strategist at Merrill Lynch. “But the obsession with equities is coming to an end, and the quest for other assets is a reasonable one.”
