Currency management forum London

The day started with an introductory session on currency management by Mesirow Financial senior managing director Gary Klopfenstein.

According to Klopfenstein, participants to the currency markets include corporate hedgers, investment managers, central banks, specialist currency managers, banks and tourists.

The G-10 currencies comprise approximately 80% of the market of currencies traded, which is dominated by the US dollar, the euro, the Japanese yen and the British pound. While emerging market currencies encompass 20% of the market.

In addition, he differentiated between passive management currency strategies and active currency risk management. In the passive case, the investor strategic objective is to reduce or eliminate currency exposure, while with an active strategy the investor can generate returns through the active management of the existing currency exposure.

Regardless of whether the investor has a currency exposure or not, it can target alpha generation by investing in currency as a discrete alpha source.

Lessons learnt from 2008

The credit crunch has highlighted the need for pension funds to adopt a multi-strategy approach to currency investing.

Citi director Philip Brass said diversification on asset classes underlying currency exposure was fundamental - but said diversification between investment models, currency pairs and time horizons of exposures was also important.

He said: "The volatility of the investment strategies can really throw you off, but also between strategies and between asset classes."

Brass showed different constructions of models could bring down the correlations between strategies, which, during the crisis, would not "have sprung up as the underlying strategies did".

He added schemes should require enough information from their managers, in particular when systematic - quantitative - strategies are used.

Brass said: "Clients should always have the information required to understand their investments."

He said liquidity should also be of paramount importance to schemes.

Brass explained: "Last year many investors were locked into investments that could not be exited upon request. The FX market is uniquely attractive in the context where the deep liquidity available has reduced the problem substantially." 

Currency risk often not hedged

Pension funds are often failing to take any action to manage the currency risk in their international portfolios.

Investec head of currency management Thanos Papasavvas said significant moves on the exchange rate could erode pension schemes' portfolio performance, depending on the size of their international exposure.

However, he said: "While currency managers have historically had the task to manage currency risk, they have shown they can provide sources of uncorrelated returns, when schemes add a currency overlay to their portfolio."

Papasavvas added that, within this framework, different styles of currency management captured returns in different ways, according to what managers use as drivers of currency shifts.

He said the industry has witnessed a blending of styles lately. "There has been a shift from pure quantitative styles to more hybrid approaches. Managers have added qualitative signals to quantitative models, which, in our view, leads to more optimal approaches."

He added this tendency was in line with the progressive diversification driven by both managers and investors.

Papasavvas concluded that currency managers can add value by "unbundling" the currency risk of a portfolio, managing it as per clients' and consultants' targets and, if required, add returns through active management. 

Hedging driven by currency volatility not returns

Passive currency hedging policy should be driven by the volatility that currency exposure introduces to a portfolio.

State Street Associates head of currency research Jordan Alexiev said  the techniques available for passive hedging strategies were a static hedging policy and a optimal hedging policy.

He said within the static hedging framework, pension funds should seek to avoid a 100% currency exposure hedged, when foreign currencies experience periods of appreciation.

In contrast, Alexiev said 0% should be hedged when foreign currencies experience periods of depreciation.

Despite this, he said: "Some currency exposure is beneficial, insofar as it introduces diversification to the portfolio. Hence, a 100% hedge ratio generally produces sub-optimal results."

He also said currency exposure affect a portfolios risk by introducing volatility and diversification.

Currency ineffective in marketing to pension funds

Currency management has failed to position itself in the market as a mainstream asset class for pension funds despite attractive returns.

Deutsche Bank managing director and global head of foreign exchange strategy Bilal Hafeez said the marketing of an asset class was much more influential than its performance in driving schemes to allocate money to it.

He said pension funds would be better off if their investment decisions relied on more rational considerations.

Hafeez said: "On a risk adjusted basis, currencies have offered superior returns to both equities and bonds since the 1980s."

He also made the case for FX investment also on the basis of the higher diversification effect this asset class would provide pension funds with. 

He said: "The correlation between FX and equities or bonds is low. Since 1980, equities and bonds have had a 26% correlation in monthly returns, while the correlation between individual FX strategies or FX combinations range from -25% to +7%."

Hafeez said pension funds can achieve returns by exploiting the inefficiencies in the currency market just like they would in the equities markets. He said the bulk of currency return is a beta return - simply derived by market upturns - as it happens for the equity market.

However, he said academic studies have shown the existence of statistically significant profits based on the trend-following strategies, although since the 1990s returns have fallen.

He said: "We believe macroeconomic developments that have resulted in weaker currency trends are the more likely culprit for lower returns in the 1990s, rather than the greater number of trend-followers."

He conceded up to last year currency markets saw between three to four years of bear market years. But, he said FX returns were starting to increase. 

He added: "Bull markets are picking up and once they do, they tend to last four to five years. This makes currency the only asset class at the end of a bear market." 

Risk should be event estimated with turbulent markets

Risk parameters estimated from full samples are not reliable measures of currency portfolio risk during periods of market turbulence.

State Street Associates head of currency research Jordan Alexiev said it is possible to identify so-called "multivariate outliers" from which event driven risk can be estimated.

He said: "Risk parameters estimated from events may better represent portfolio risk during turbulent regimes."

Alexiev said the average correlation of all assets is 20% in normal markets, but it tends to increase in turbulent times.

He added the correlation of currency alpha with other asset classes tends to diminish in turbulent times.

In particular, he said carry strategies - an approach in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate - underperform in turbulent markets, while they outperform in quiet ones.

He added: "Conditioning carry on turbulence can substantially enhance risk-adjusted performance."

Spotting when a quant model is broken is primary concern

Stop-loss programmes are a better failsafe risk management tool for quantitative currency models.

Citi Foreign exchange managing director and global head of quantitative investor solutions Jessica James said there were two approaches to stopping trading within a currency model.

She explained: "One way to go is to have an indicator, such as a risk index, that can identify the types of market regimes that are managing the model. The other one is to have a form of stop-loss policy based on the model's performance."

James said with the first approach a model can continue to lose money without the regime indicator signalling a stop to the model, if there is even a minor mis-specification of the indicator.

She indicated stop-loss programmes were a better failsafe risk management policy. However she said: "The addition of stop-losses deteriorates the performances of trading strategies in the backtests. Stop-loss policies exist to serve a protective purpose rather than to improve performance."

Crisis caused shift to discretionary management

The credit crunch has caused a shift towards discretionary currency management.

Citi director Philip Brass said, prior to the credit crunch, the responsibility of currency and the absorption of the underlying risk lied with banks.

However, he said: "The lack of appetite for risk and the depletion of assets caused a lot of volatility in markets. As a result currency managers had to adapt processes to take this change of landscape into account."

Brass said the main change was a shift to management styles which incorporated qualitative elements.

Mercer principal Diane Miller added the viability of systematic or quantitative styles depended largely on their flexibility to adapt to different circumstances. 

She added: "In theory, since the competition is reduced, managers should be able to operate more easily."

Managers agreed systematic managers will continue to be a fundamental part of the currency managers' community. 

Hermes Fund Managers head of currencies Momtchil Pojarliev said: "Every systematic manager can show a back test, while if you are a discretionary manager you can only discuss with clients your process and the previous job experiences of the managers. Therefore, systematic managers will stay, even though they are going through a tough time."

Brass added some systematic managers actually thrived in last years' environment - adding that 2008 represented a "fantastic opportunity to get data at the tail of the curve that would not otherwise be available".

Thames River Capital fund manager Bill Muysken said both systematic and discretionary managers were among both top and bottom performing ones in 2008, according to the tracking of his company does on currency managers.

However, he added the spread between best and worst performers was much wider last year. 

Style matters

Different investment styles are the most important factors to take into account when selecting a currency manager, Mercer claims.

Principal Diane Miller said style gives a basis for determining manager edge and provides a way to evaluate manager returns.

She added: "We want to see that they are not just taking a passive approach." 

However, she warned naïve style indices represented only past sources of alpha and often lacked proper risk controls.

In addition, she said those indices often do not capture all investment approaches, such as the ones based on an intraday time horizon.

She pointed out Mercer's currency managers research is based on four factors: the ability to generate new ideas to add value, the way in which those ideas are translated into portfolio construction, the management of capacity constraints and the outlook for the business. 

Equal monetary allocations leads to concentration on volatility 

Equal monetary allocations in multi-manager currency strategies would result in risks being concentrated in the more volatile strategies.

Thames River Capital fund manager Bill Muysken said equal risk allocations made more sense - as this would imply setting monetary allocations in such a way so they are inversely proportional to risk levels.

Despite this, he conceded there might be grounds "for tilting the portfolio away from such an equal risk approach".

He cited the examples of tilting in favour of managers in which the scheme has confidence in or with more competitive fee structures.

In addition, he said currency portfolios could be tilted with the aim at enhancing diversification of the underlying portfolio or at moderating exposure to common risk factors.

Negative alpha hidden

Currency funds offering positive returns might conceal a negative alpha, a manager claims.

Hermes Fund Managers head of currencies Momtchil Pojarliev said there were four factors, representing four well known strategies - carry, trend value and volatility - which explain a significant part of fund returns.

In the cases of returns which are easy to replicate Pojarliev said managers often do not "deserve the fees they ask for". 

He said: "With an appropriate benchmark you can get an exposure to this level of beta with indices replicated by products such as exchange traded funds."

He added the negative alpha would derive from negative exposure to profitable factors benchmarks and weak timing ability.