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| “One of the beauties of EM is that it has got a lot more accessible real alpha and there are many more opportunities to take advantage of inefficiencies.” Russell Thompson |
Evidence is growing that institutional investors are regaining their appetite to allocate more capital away from traditional developed markets and into EM investments. Asset consultants are advising on the benefits of investing in equities and debt in high-growth areas, and more and more hedge funds are offering specialist EM funds. “It’s a very good idea to be looking at the EM world, and EM currencies are a clear source of disposable alpha, but you’ve got to know what you’re doing on a variety of levels,” says Thompson, who co-founded The Cambridge Strategy in 2003 with Peter Henricks.
In contrast to a typical bond or equity portfolio in developed markets, where there has been an increasing trend to outsource currency exposure management to external overlay managers, currency overlay on EM portfolios is still in its infancy. Indeed, few currency managers even look at it, explains Thompson.
That is because, unlike currencies in developed markets, EM currencies – with scope to appreciate – can offer robust risk-adjusted returns. However, Cambridge emphasizes the importance of understanding the specialized risk profile that accompanies EM investments.
“The distribution of returns on assets in the EM world is very non-normal and it’s very important to adequately manage the tail risk associated with these investments,” says Thompson.
Liquidity constraints are also a key consideration, particularly in EM currencies.
“In many of these currencies, the liquidity is there until suddenly it’s not,” warns Thompson. “You’ve got to be aware of how much liquidity there is, what your counterparty will quote you, and in what size.”
Cambridge views EM currency as an investable asset class in its own right, and offers three currency alpha programmes – extended markets, Asian markets, and global EM – in addition to its equity products and its flagship EM macro fund, Apollo.
The results of its alpha programmes have been impressive, even during times when the macroeconomic environment was uncertain. Since 2006, the global EM alpha programme has generated annualized returns of almost 14%. The Asian programme has returned on average 11% annually and the extended markets fund 8%.
In 2011 – a year when high intraday volatility and sparse trends caused many currency managers to deliver poor results – Cambridge’s Asian and Global EM funds generated returns in excess of 10%.
“Cambridge’s long-term performance record for the emerging market currency space is among the best in the business,” says Andy Woolmer, currency portfolio manager at SEB Asset Management, who has been investing in Cambridge’s Asian and Global EM fund for four years.
Woolmer attributes Cambridge’s success during difficult periods, such as 2008 and 2011, to the firm’s willingness to be short EM as well as long of them, a strategy which is different to most EM strategies.
“They have a strong systematic process which is buffered with some very talented and experienced traders,” says Woolmer.
Changing paradigm in EM correlations
In recent years, investing in EM has been heavily influenced by the risk-on, risk-off phenomenon that has compressed correlations across asset classes in the developed and emerging world.
During risk-on periods, EM assets and EM currencies would typically rally, as would currencies such as the Australian dollar. When risk sentiment turned negative, the reverse would happen, and typically the US dollar would outperform.
This trading environment reached its height during the autumn of last year when global markets were seemingly driven by the latest headlines surrounding the eurozone crisis.
For those less-experienced market participants, they might be led to believe that markets have always behaved this way. This is not the case, and for FX market veterans like Thompson, a return to some older norms might not be far away.
“We are slowly returning to a period where fundamentals are going to reassert themselves and the compression of correlation is going to start unwinding,” he says.
The recent equity rally alongside the US dollar appreciation was an indication of this and saw some dislocations in EM emerge.
“One of the beauties of EM is that it has got a lot more accessible real alpha and there are many more opportunities to take advantage of inefficiencies,” says Thompson.
He argues that the equity rally seen since the start of the year is one early sign that a reversal in previous trends might be starting to gather pace. As investors become less inhibited by risk aversion, and cash –currently sitting on the sidelines – starts to find a home, investors will start paying more attention to the fundamentals, explains Thompson.
Cambridge says a return to macro fundamentals might also give rise to more frequent situations where the fundamentals of a country in the EM world might be beneficial for equities, but might not be so beneficial for the currency.
Thompson cites a good example of this is in the recent actions by the Turkish central bank. A lack of credibility in the central bank, which recently cut interest rates in an attempt to stave off capital inflows, prompted Cambridge to go short lira, though the fundamental backdrop for equities remains supportive.
Cambridge says it is important to be aware of the implications that changing correlation dynamics will have for risk management.
“Portfolios that have been constructed using typical measurements of VaR – using, say, data looking back over 200 days or utilizing normal distribution assumptions – may not accurately reflect the tail risk that is potentially in a portfolio as correlations begin to dynamically change,” says Thompson. “Previous risk-management mechanisms may therefore become redundant.”
For instance, an investor that had EM risk hedged by being short euros might find both sides of that portfolio starting to unravel in the current climate.
“It won’t happen overnight, but as we start to get back towards normality, there could be some opportunities that some people do very well out of, and others will do very badly because their portfolios are constructed using market dynamics that won’t be as relevant as we move forward,” says Thompson.
It is navigating these idiosyncrasies of EM, given its track record, that Cambridge hopes to capitalize on, but more generally it offers investors an opportunity for developed market practitioners to escape the benign and, at times, one-dimensional returns of G3 currency markets.
“You can call the euro wrong and still make money, because you can see these other opportunities in these other EM currencies and across the asset classes in the EM world,” Thompson concludes.