Institutional investors learned many lessons from the financial crisis, not least about actively investing in currency.
After many had piled into predominantly quant-based alpha- seeking currency models, which relied heavily on gearing and leverage, investors found these strategies came a cropper when everything blew up and they had to be unwound.
Unsurprisingly, investors were left scarred as a result, but have the wounds healed enough for them to take another look? Investors who hold overseas assets face a conundrum: should they do nothing and accept currency risk as part and parcel of overseas investing? Hedge their exposure completely or passively hedge 50% of their exposure, leaving them half hedged and half exposed?
In reality, the disappointment experienced by many investors during the crisis has meant very few have conducted mandate searches in the UK for active currency strategies in the last few years, particularly those using carry. Prior to 2008, carry strategies were popular as they tended to display a low correlation with broader asset markets, but during the turmoil they became sharply correlated with equities.
Furthermore, because managers’ business cases were often quant in nature and looked at a similar set of indicators – the most relevant being carry – they all faltered at a similar time. Essentially, carry-based strategies sell a currency with a low interest rate and buy one with a high interest rate in the hope of capturing the difference between the two. In theory, carry is great to have in a portfolio as it effectively pays an investor to do very little, but critics say it tends to falter in a risk-off environment.
Broadly speaking, equity markets have been bullish since the financial crisis, but in the event that they sell-off aggressively, for example if the Ukraine crisis exploded and there was an ensuing military conflict, then investors could pile into safe haven currencies, such as the yen, causing a mass exodus out of carry trades against these currencies.
Greg Matwejev, senior director, FX hedge fund sales and trading at Newedge, says when these strategies work they work for a long time and give the impression they are risk-free, but when the market gets overly positioned in them and “your mum, dad and everyone” gets involved then there are risks for investors. “If you have risk-off events these strategies get absolutely smoked,” he says. “They always have a finite period where the Venus flytrap is going to close and whoever is left in there is unfortunately not going to get out.”
The current macro-economic backdrop has also been cited as a reason why carry has suffered. Until recently quantitative easing (QE) and global monetary policy had been for the most part co-ordinated across the globe, meaning the strength of carry signals has been low. According to Pacific Alternative Asset Management Company (PAAMCO) portfolio manager, fixed income relative value, macro, and mortgage strategies, Sam Diedrich, currency pairs within the G10 are struggling to get a 3% annualised carry and so investors have either sought higher leverage or searched elsewhere such as emerging markets for carry.
Diedrich says carry got hurt around May/ June last year when the market began to fully realise the US’s hawkish monetary policy, but there have since been some rate increases in emerging markets to the point where some of the carry signals are now attractive.
However, he cautions that the markets offering this carry are often those struggling at current account level – in other words these countries’ balance of trade, net factor income and cash transfers are weak. Coupled with strong US economic prospects and a possible increase in dollar strength following Federal Reserve chairman Janet Yellen’s recent announcement about rate increases as early as spring next year, this could overwhelm the carry signal out of countries such as South Africa, India or Brazil because their currencies could continue to devalue beyond the parameters of efficient trading.
Others believe the dispersion in monetary policy and performance of underlying countries and regions could in fact benefit currency strategies. This divergence is apparent in Australia and Europe where there is likely to be stability in rates, versus the US and UK where there is likely to remain more aggressive policy; and then the emerging markets where the outlook for rates will be mixed.
This is a situation where fundamental currency managers might be able to profit by taking a view between the monetary policy of two countries. “There are headwinds to carry over the short-term, but there could be ways to profit,” says Diedrich. “Emerging markets can earn you high single digits, but you have to take on emerging market risk in a straightforward carry trade. You have to neutralise the risks, so instead of funding with euro or yen and buying real, you fund in a different emerging market and earn the carry in another one.”
‘Watered-down’ alpha Opportunities, while sparse, do exist but Threadneedle Investments head of rates and FX Matthew Cobon believes active currency management is better as an “add-on” to a portfolio, rather than as a pure alpha-seeking play. This is because often active currency strategies become too correlated to risk assets when they are supposed to do the exact opposite and offer diversification.
Cobon says: “The maintenance of the carry trade before the crisis became its own beta and I very much hope that doesn’t come around again because it ends up being correlated to risk assets and one of the benefits of employing active currency, if you do it in the right way, is you end up with an uncorrelated portfolio of risk, so you add real diversification to the process.”
He adds: “If you want to go and buy stocks, credit or whatever, go and buy them, don’t hide behind something that is highly correlated to that, but is called something else. You are effectively putting a leveraged portfolio together and if your currency portfolio feels like a watered-down version of holding more stocks and you already own 100% stocks, then you effectively own 100-andsomething percent stocks – why would you want to do that?”
Aerion Fund Management – the in-house fund manager for the National Grid pension fund – recently selected Berenberg to run a £3.5bn active dynamic currency overlay mandate, which puts a hedge in place only when a currency is depreciating and is said to address the liquidity risk of having a fullyhedged strategy.
Fully-hedged strategies use FX forwards which roll from one month to the next, but if there is a negative movement in the currency then the gap needs to be settled in cash with the FX counterparty, hence the need for liquidity. “A dynamic hedge either opens or closes the hedge depending on market movements to protect the underlying assets,” explains Berenberg investment adviser, overlay management, Maria Heiden. “The dynamic hedge refers to individual currency pairs so each pair is looked at in isolation, so it is not a blanket approach across the portfolio.”
It is however important for investors to understand the circumstances in which these dynamic strategies work best, which is usually when there is a clear trend in place.
“Although it is inexpensive to trade in futures because they are liquid, if you get choppy markets you will hedge and unhedge the pair more than would be optimal to deliver the performance,” adds Berenberg UK institutional business director Matthew Stemp.
“And in those markets you would not benefit as much.” Smart currency Recently consultants and investors have recognised there are sustainable returns to be generated in currency markets using a more systematic, index-based approach. Broad consensus has identified three such strategies for currency in which investors can gain from taking long and short positions in: carry, momentum and value.
According to Record Currency Management chief executive James Wood-Collins, before engaging in these strategies investors need to be satisfied they have a track-record of generating returns and will continue to deliver in the future. Once comfortable with this, systematic currency strategies can offer an appealing amount of return per unit of risk and diversification, while they are unfunded and highly accessible given the depth and liquidity of currency markets.
Towers Watson has been a proponent of such smart beta approaches to take advantage of factors, among them foreign currency carry and emerging market currencies. In a paper published in August last year, Understanding smart beta, it explained: “For example, with 10 liquid developed market currencies, there are 45 currency pairs an investor could potentially take positions in. A simple smart beta approach would weight each of these pairs equally, with the higher interest rate currency being bought against the currency with the lower interest rates using forward contracts.”
Wood-Collins says: “The tremendous depth and liquidity offered by the currency markets makes these returns widely accessible, with little or no capacity constraints on investing or liquidity constraints on exiting – in sharp contrast to many other alternative strategies.”
After taking a battering during the financial crisis, active currency management has had a tough time trying to nudge its way back into institutional investors’ portfolios and five years on from the crisis people would be forgiven for thinking the perception had changed.
Recent global monetary policy and the divergence in global interest rates has made its comeback difficult, but also created pockets of opportunity for certain managers, particularly those of a fundamental or smart beta persuasion.
However, institutional investors need to be convinced of the merits in terms of past and future performance. UBS Global Investment Solutions team strategist Matt Bance says he felt a “little disappointed” that more pension funds have not utilised currency management since the crisis because it can be a “significant source of added value but also diversification”.
However, Bance sums up the general sentiment with: “Utilising blindly strategies like carry and momentum can have unintended consequences, particularly when overleveraged positions are unwound sharply.”
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