Download Currency Investor Roundtable

ROUNDTABLE
Currency Investor
Roundtable
The question of currency risk - helping
investors to make the right choices
Currency Investor talks with Karen Shackleton, Chief Executive,
AllenbridgeEpic Investment Advisers, Diane Miller, Principal at Mercer
and Joe Bracken, Head of Macro Strategies, BT Investment management.
Do you think that most Institutional investors are
fully aware of how influential currencies can be on
portfolio performance?
KS: This varies enormously from client to client.
Some of AllenbridgeEpic’s clients are extremely
sophisticated and have put overlay
currency management strategies in
place to manage their currency
exposure. Other clients, whilst
they are aware of the impact
of currency moves on their
portfolio, tend to treat it as part
of the core decision to invest in
overseas assets, and as such do
not seek to quantify or manage the
currency risk as a separate decision.
DM: Institutional investors will
be only too aware of the potential
impact from currency on portfolio
performance. Take the return from
equities over the three years to the end
of August 2011. In local currency terms,
the FTSE All-World Index has had its
ups and downs but, overall, it’s barely
marked time with a return of -1.4% p.a.
over that period. If you were a UK-based
investor in the same markets, you’d not be overjoyed
but at least you’d have achieved a return of 4.1% p.a.
But if you were investing from Australia, you might
find it rather uncomfortable reporting the -6.8% p.a.
return to your Investment Committee, especially if
you could have avoided some of that loss by hedging
the Australian dollar.
58 Currency Investor | Autumn 2011
ROUNDTABLE
The 4% return for the UK-based investor would
actually have all come from sterling depreciation,
not from equity markets. While fortuitous in this
instance, taking a punt on sterling might not have
been what the investment strategy was designed to
target.
In this case, it would have paid off but it may not
always. If you were a client of Mercer, we’d probably
have advised you to hedge at least some of the
currency exposure so as to reduce this source of
unwanted volatility. Then you could have used a risk
budgeting approach to reduce risk overall or allocate
the risk to investments that offer a better expected
rate of return than taking passive currency exposure.
JB: Not on average but I would suspect that there
is a range of awareness. However, I think that in
Australia almost all would have an opinion on where
the A$ is going.
Most investors can see the benefit of a passive
currency hedging policy to mitigate risk. As
currencies become more widely accepted as
an asset class is there likely to be significantly
increased interest for active overlay strategies that
can deliver modest returns and if so, do you see
regional variations in demand for these?
KS: The difficulty with overlay strategies is that their
performance has been somewhat patchy. We still
don’t have a long enough track record to say with
statistical significance whether they can work over
many different market cycles – they still haven’t
been around for long enough – although some
managers do seem to have a better track record than
others. The credit crunch proved to be a particular
problem for quantitative overlay strategies, and
many institutional investors withdrew their overlay
programmes at this time. That having been said,
the desire for risk diversification and alpha remains
stronger now than ever before.
DM: We find it helps to think of currency exposure
as two different types: the strategic currency impact,
whether it should be hedged, and if so, by
how much; and the active currency
opportunity and how this could
best be implemented. The
first is all about reducing
risk and the second is about
using risk to add value, or
alpha, from active currency
management. By considering
these two decisions separately,
investors are likely to achieve a
better result.
Of course, when it then comes to
implementation, it might be more
practical to combine them again, or
maybe not. The hedging is usually
implemented via an overlay but the
alpha generation doesn’t have to
be. There do seem to be some regional
differences at this stage. Recently, we have
seen increased interest in overlay mandates
from North American investors and Australian
investors who want to meet specific requirements;
UK investors tend to prefer to invest in absolute
return currency funds.
JB: The currency risk is part of international
investments. There has been a huge amount of
volatility in the currency markets in the last 4 years.
Depending on your base currency, you would have
Autumn 2011 | Currency Investor 59
Currency Investor Roundtable The question of currency risk - helping investors to make the right choices
an unconstrained basis so the two are not mutually
exclusive.
JB: Yes, probably since the currency overlays are run
at lower volatility and are perceived as less risky.
What steps can investment professionals take to
help educate investors and Plan Sponsors about
the relative merits of achieving absolute returns
with currencies as part of an investment strategy
and not just as a by-product of an active or passive
de-risking program?
“The credit crunch
proved to be a
particular problem for
quantitative overlay
strategies, and
many institutional
investors withdrew
their overlay
programmes at this
time.”
KAREN ShAcKLETON
to be hedged or unhedged to reduce the draw-downs.
In Australia an unhedged mandate would give you
the lowest drawdown and in US a hedged mandate.
But the direction in both regions would be towards a
more dynamic approach of managing currency risk.
Generally speaking in your experience, are active
overlay programs less contested by investment
committees and boards than an unconstrained
currency alpha mandate and if so, why is that?
KS: Personally, I have seen no evidence of that.
Perhaps the difficulty with overlay programs is
that it can be extremely tough for the lay trustee to
understand them fully. Their complexity, the use of
esoteric instruments, and the leverage required to
implement the strategy, can leave trustees confused
and unsure about likely performance outcomes.
Where this happens, the trustees should rely on
their independent adviser to act as the interface, to
challenge the manager and to explore the strategy
in more detail, perhaps outside the investment
committee meeting.
DM: The nature of the program should meet the
client’s requirements. If that is the case, there should
be less scope for argument about the way it is
implemented. An overlay can also be managed on
60 Currency Investor | Autumn 2011
KS: Perhaps the most important point
to make is that a currency manager may
feel obliged to have positions at all times.
In reality, significant opportunities to
add value may only arise sporadically.
Investment professionals can and should
educate investors to be ready to act
promptly in order to capture the alpha, as
and when those opportunities arise.
DM: Investors should be helped to
understand the nature of currency markets
– the large volumes transacted; the good liquidity and
low dealing costs that result; and the high proportion
of activity accounted for by participants who are
not trying to maximise profits. These combine to
give active currency managers a particularly good
start when generating alpha. Analysis of the Mercer
Currency Manager Universe shows that the median
manager has consistently been able to add value over
rolling three year periods on a risk adjusted basis.
This can’t be said of many other investment categories.
Investors should also be introduced to the benefits
that active currency management can provide in
generating an additional source of returns that brings
diversification at the same time.
JB: There are many positive points about active
currency• Active currency makes money
• Currency market is highly liquid, has low
transactions costs, which leads to high capacity
• The return stream is uncorrelated to returns of
traditional betas (equities, bonds, etc)
• So, including active currency in a balanced
portfolio should improve the overall
performance by reducing risk and increasing
returns.
ROUNDTABLE
Should investors be more concerned about the
return attribution process to understand more
clearly about how much of a currency return is
alpha and how much is beta?
KS: Absolutely. In 2008, Richard Levich and
Momtchil Pojarliev analysed the performance of some
17 different currency managers and found that, on
average, the alpha was close to zero (although there
were some individual managers who did well). If I
am paying a currency manager a high performancerelated fee, I want to be absolutely sure that the
return that is being delivered is alpha and not beta.
Performance attribution is essential.
DM: It is important to understand where the returns
come from - if the manager is just producing returns
from beta, then investors should not have to pay
alpha-based fees.
When people talk about currency beta, they are
usually referring to persistent sources of return
that have become commoditised; effects like carry
(exploiting interest rate differentials), trending and
value. While all these can be shown to have worked
well over the long term, they are prone to prolonged
periods when they can be loss-making. A manager
with skill should be able to harness these influences
and others to generate more robust returns. If
investors can understand how managers generate
returns, they will know what to expect from different
market conditions and be better able to assess which
managers really do have skill.
DM: It depends what you mean by currency policy.
If this relates to how currency fits into the investor’s
overall strategy and whether the currency manager
is expected to implement a currency hedge as well,
then clearly the manager chosen has to be able to
meet these demands. If the currency manager doesn’t
have to hedge the assets or is part of a multi-manager
program, then the way is open to consider a wider
range of managers, including small niche players.
Investor preferences and the time they have available
will also affect how much detail they want to get
into. Some will want to know all about the different
active currency management approaches and be
directly involved in the selection of managers. They
will want to consider how different styles will sit
alongside their existing managers, and will have
strong views on what styles they favour, systematic
or judgemental, fundamental or technical, or a blend
of different approaches. Others will be happy to
delegate the decision to specialists. Most will find it
useful to take expert advice, even if they retain the
ultimate decision making power.
JB: The investor’s choice of currency policy may
impact their choice of currency manager depending
on their objective -
JB: It is useful to understand some of the drivers of
the performance and more importantly it is useful
to be aware of the risk management aspect of the
process.
In what ways might the currency policy
chosen by a particular investor impact
on their choice of currency management
practitioner?
“If investors can
understand how
managers generate
returns, they will
know what to expect
from different market
conditions and be
better able to assess
which managers
really do have skill.”
KS: I think the key policy decisions by
the investor of (a) passive or active, and
(b) quantitative or fundamental, will
inevitably lead them to consider different
practitioners. There is no difference
in this respect to the traditional asset
classes where practitioners have different expertise
in different areas. It would be wrong to lump all
currency managers into the same pot.
DiANE MiLLER
Autumn 2011 | Currency Investor 61
Currency Investor Roundtable The question of currency risk - helping investors to make the right choices
• Passive management versus active
management
• Manage liquidity risk
• Manage drawdowns, which is the same as
saying winning by not losing
• Achieve asymmetric returns
• Add currency alpha
Passive overlay strategies are widely perceived as
being fairly straightforward to implement. Is that
true?
KS: I have a clear memory (in my former life as a
quantitative fund manager) of introducing one of the
earliest currency dynamic hedging overlay strategies,
for a Japanese client in the 1980’s. I don’t remember it
being at all straightforward to implement! There were
so many different moving parts it required skill and
attention to monitor the underlying exposure, and
the hedge, and to adjust it accordingly and in a timely
fashion, in markets that were often unpredictable
and fast-moving. It required a global custodian with
instant access to all the relevant input data, first class
quantitative modelling and expert trading skills.
Perhaps it is more appropriate to say that passive
strategies are more straightforward in terms of being
able to predict what sort of trades are likely to be
implemented?
DM: Passive strategies require efficient
implementation at low cost and the ability to meet
cash flow requirements. They should be relatively
straightforward to implement provided that they are
properly set up with the right attention to all details,
such as how to meet cash flows even when market
conditions are adverse. This will require having a
process in place to deal with unexpected events.
JB: Passive management is more straightforward
compared to active management. However, there
are still a lot of issue to consider for example, how to
manage liquidity risk, what instrument to use, how
to manage counterparty risk. How often to roll your
hedges.
What do you see as the key attributes of a good
currency manager?
KS: As an independent investment adviser, I lean
towards currency managers who have an absolute
62 Currency Investor | Autumn 2011
passion for the currencies in which they trade, who
have an instinctive understanding of the behaviour
of the markets, but who can clearly demonstrate
the ability to think independently of the herd.
Experience matters a lot in this respect. Apart from
that, my list of key attributes is unsurprising: trading
skills, presence in the foreign exchange markets,
quantitative modelling skills (if appropriate), good
fundamental analysts on the team, etc.
DM: How much time do you have? We try not to be
too prescriptive as to what makes a good manager.
Don’t forget the advantages of active investment in
currency mean that even the average manager should
be able to add value. So to be good, we need to be
convinced that the manager is better than average.
That means that we are looking for evidence that the
individuals involved are talented and demonstrate
original insights. If the manager is discretionary,
it could be the quality of analysis or thinking
outside the box that convinces us. If the process is
quantitative, we need to know enough about it to be
able to form a view. We also look at the checks and
balances in the process - effective control of risk and
dealing costs - and a supportive business structure
that will foster and sustain any advantages.
JB: Key attributes are to make money, manage risk
and engage the client to tailor a solution that works
for that client. There are many ways of making
returns from currency, discretionary and model
based are popular, a mix of both would be a good
approach. A robust and disciplined risk management
process would also be part of a successful program.
How much emphasis do you think investors should
place on the investment style of managers (i.e
discretionary, systematic, active, passive, etc) and
how important are the merits touted by investment
specialists of exploiting more diversified
strategies?
KS: I think all styles, strategies and claims should be
examined with great care and scepticism. If there is a
genuine fit with the existing portfolio, then it is likely
to be a suitable approach, regardless of the label put
on it by the manager.
DM: Investors have to understand the nature of
the manager they are appointing. For starters,
there’s a big difference between an active and a
passive approach! If an investor is looking at
active currency management, some styles will be
ROUNDTABLE
Many investors are looking beyond developed
markets to take advantage of opportunities
in both emerging and frontier markets. Do
you think recent Currency Wars, where fast
growing countries take radical steps to prevent
appreciation of their currencies, will dampen
investor appetite for portfolio exposure to some
regions?
KS: The decision to get exposure to emerging and
frontier markets is a strategic one and the
risks associated with these economies is
“The investor’s choice
part of the education process that trustees
of currency policy
should undergo before investing in these
may impact their
regions. Periods of turbulence may affect
choice of currency
the tactical timing decision for any new
manager depending
investments in emerging markets but it is
on their objective.”
unlikely to dampen investor appetite in the
longer term.
JOE BRAcKEN
better in certain conditions but all will only be as
good as the quality of the people responsible. In
theory, a more diversified strategy should do better
than a less diversified approach, but only if all the
components are equally good. So a narrower strategy
implemented well might be better than a more
diversified strategy that is only average.
The use of more than one manager will allow
investors to obtain diversification benefits while
retaining the use of specialists. Our analysis has
shown that active currency managers tend to have
very low correlation with each other which means
that it can be effective to use a number of managers as
part of a multi-manager portfolio. The best solution
for each investor will depend on the resources they
have available (internal or external) to manage this
process.
JB: The investment style has to match the client’s
objectives and requirements. There is room in most
portfolios for both approaches. A client may choose to
manage part of the risk from a passive management
and part through a specialist active manager or
a combination of complementary managers.
Diversification is very important as it allows an
improvement in the overall performance by reducing
risk and improving returns.
DM: Investors shouldn’t be too worried about
currency wars as they often just delay the inevitable.
Usually, if the pressure is for a revaluation (upwards
or downwards), then dampening those pressures
means they build up so that the eventual move
still happens, but with more force. But that’s why
we want currency experts to manage the process
for us. You ask if investors might be reluctant to
have currency exposure to some regions. If they
are unhappy about these exposures, investors can
restrict their manager’s mandate or select a currency
manager that specialises in a limited range of
developed market currencies. Generally, we would
advise imposing as few restrictions as possible. The
manager’s approach will reflect the areas where it is
strongest and we usually advocate exposure to the
product that best reflects that manager’s skill, be it a
narrower or broader range of currencies.
JB: Currency wars will provide challenges for
currency management and it may dampen appetite
for portfolio exposure for certain currencies. It may
breakdown correlations between currency pair
which would impact hedging processes. However
this should improve the demand for specialist
currency mandates as the environment becomes more
challenging.
Do you anticipate that the European Sovereign
Debt crisis will end up having wider ramifications
for both currency investment and currency
management activities elsewhere?
Autumn 2011 | Currency Investor 63
Currency Investor Roundtable The question of currency risk - helping investors to make the right choices
KS: Institutional investors should make decisions
about their currency management programs in a
strategic manner, independent of current short-term
crises.
They pay their currency manager to respond to short
term market conditions. Whilst there may be a short
term impact on activities, I do not have any evidence,
at the time of writing, as to why there should be any
longer term ramifications.
DM: It already has – just look at the over-valuation of
the Swiss franc. If the pressures on the euro do prove
unsustainable and the single currency collapses, then
managers will have more currencies to trade again
(which increases their opportunity set and may take
us back to the days of super-strong returns), but I’m
not forecasting that to happen in the
foreseeable future.
JB: Yes, I would
agree that the
European
sovereign
debt crisis
is by no
means
over and it
would have
huge impacts
in the currency
markets.
Looking ahead over the next
few years, what key factors are most likely
to influence currency manager performance and
shape the way the industry evolves?
KS: In the current climate, it is extremely hard to gaze
into the crystal ball with any degree of confidence.
The carry trade, currency trends and short term
opportunities are likely to continue to influence
returns.
The quantitative managers had a set-back after
the credit crunch, and it will be interesting to see
how that resolves itself. But at the end of the day,
a manager who can (a) demonstrate alpha within
reasonable risk parameters, (b) deliver consistent
returns over different market cycles, and (c) cope
reasonably well in extremely volatile conditions, is
always going to be on the receiving end of positive
institutional money flows.
64 Currency Investor | Autumn 2011
DM: We identify the main factors as the nature of
currency markets, the impact of regulation and
the returns that managers can deliver to investors.
Currency managers usually do best when there is
enough volatility in markets for them to make money
but not so much that conditions become erratic and
liquidity disappears. Economic divergence can help
foster the right conditions and allow exchange rates
to reflect the different themes.
Currently, the risk on/risk off environment and the
tensions between the highly indebted developed
world and creditor developing markets dominate
but financial markets are always changing and these
themes are bound to evolve in ways that surprise.
The threat of increased regulation is a potential
dampener but currency managers seem to be less
affected than many other categories.
One caveat is that managers
have tended to target
lower risk than
in the past, so
their expected
returns have
also come
down, but
many still
charge the
same fees as
they used to. They
have to take care that
they share enough of the
value they generate with their
investors.
JB: There will be more regulation; more currency
wars, more reserve currency diversification and
central banks will have the challenge of managing
inflation but fostering employment and growth. The
increase in regulation could reassure investors and
perhaps increase their choice of managers. Strategies
which prior to 2008 were part of internal portfolios of
investment banks may be launched externally. Euro
and US$ may lose some of their reserve currency
status as debts levels increase US and Europe’s
sovereign debt crisis continues without a grand
solution.
The stretched valuations in currencies will compel
more central banks to directly intervene which
should provide challenges for currency management.
All of this should lead to an increase in appetite for
the specialist currency manager to manage that risk.