Foreign exchange (FX) is closer to shedding its label as an ‘alternative’ investment and becoming a major player within a traditional investment portfolio, according to industry sentiment.
Though the endgame is generally agreed upon – improving the weight FX has within the tactical asset allocation of an investor – how this asset class arrives at the lofty positions fixed income and equities are currently at is a matter of discourse for the investment banks selling FX products, and for the specialist currency managers buying into FX on behalf of pension funds and corporate investors.
With few exceptions, the typical institutional investor will allocate no more than 5 per cent of an investment portfolio either actively in managed currency funds that invest in a basket of currencies, and/or using currency overlays to smooth out residual volatility from exposure associated with their global equity investments. But the last two years has seen a flattish performance from active currency managers, according to figures from Mercer Investment Consulting that found a median manager recorded an information ratio of 0.3 over a three-year period to June 2006.
Slumping active currency management has lead a number of investment banks to up the ante, claiming pension funds should actually consider placing a fifth of their investment portfolio in FX, and in doing so, put currencies once and for all on par with bonds and equities as a source of beta, and if managed well, potentially alpha.
Enhancing alpha
At Deutsche Bank, Bilal Hafeez, global head of FX Strategy, has been putting the finishing touches to what he claims is the first investable currency benchmark, where investors can gain exposure to a benchmark index with a series of yield-enhancing FX strategies such as ‘carry’, ‘momentum’, and ‘valuation’ and in principle replicate the added value of an active currency manager.
The new product, the DB Currency Returns (DBCR) index, is based on the theory that currency trading rules can be exploited at a relatively low cost to the investor and with correlation to fixed income and equities at a minimum. Mr Hafeez explains: “FX has often been viewed as an alternative asset class, rather than as a comparable asset class to bonds and equities, due to the absence of a widely followed benchmark and ignorance of the return characteristics of FX. Yet we feel FX has shown long-term systematic returns or ‘beta’ which are comparable, if not better, than bonds or equities”.
According to Mr Hafeez, asset allocation to FX should be in the order of 20-30 per cent, “in that way, the quality of returns can be significantly enhanced, not least by considerably reducing the duration and magnitude of bouts of underperforming returns”. A ‘dry run’ of the DBCR last month showed that since 1980, risk adjusted returns of 4 per cent were achieved, compared to 5 per cent for equities and 2.5 per cent for bonds over the same period.
A number of databases exist that aggregate the performance of currency managers, such as Barclay Currency Traders Index, Parker FX Index, and Stark Currency Trader Index, however Deutsche’s Hafeez says this method is fraught with problems associated with manager composites and peer-group analysis, including survivorship-bias, selection bias of managers, and lack of representation of strategy types. “Existing databases of currency managers, used by investors to measure their performance, is inadequate: there are many biases which could often give a misleading picture of manager performance,” he adds.
More information
His research also found the information ratio higher than both bonds and equities, and correlation very low, suggesting allocations to currencies should be high. FX ‘carry’, where managers buy high interest rate currencies and sell low interest rate currencies, delivered annual returns of 13 per cent since 1980, the best performing strategy.
Active currency managers, such as Investec’s head of currency management Thanos Papasavvas, recognise the introduction of sell-side FX products, like the DBCR index, as bringing “transparency and innovation into the currency investment industry”, but recommend alpha-chasing strategies for benchmark beating returns. “The banks are going for beta, where we are going for alpha,” he says.
Mr Papasavvas believes allocating 20 per cent of a pension fund’s assets to currency, as recommended by Deutsche Bank, to be too high. Instead, an investor should consider the positive residue from an aggressive currency fund, albeit with a smaller proportion of assets invested. “The big advantage of FX as an asset class is that you can allocate a smaller proportion of assets in a highly geared fund. You don’t need a big allocation in FX because you can buy a highly geared fund to do this,” he says. “From a risk/return viewpoint, it makes no difference whether a pension puts 5 per cent in an aggressive currency fund or 15 per cent in FX overlay with one third of the risk; the former strategy uses less cash and is more economical.”
Benchmarking has been greatly influenced by the positive carry environment of the last decade, i.e. holding currencies with high yielding interest rates such as Australia and New Zealand dollars and being underweight on low yielding interest rate currencies like the Japanese yen. “If this was to change in the short-term, then those indices would start to demonstrate negative returns,” claims Mr Papasavvas.
“The upside to an active currency manager is that they would exit the carry trade or go against the carry trade,” he says.
It isn’t just Deutsche Bank pitching for a sizeable chunk of investor business from traditional buy-side managers. Merrill Lynch announced last month, and a week before Deutsche Bank’s DBCR launch, an “FX Clone” methodology designed to replicate FX strategies such as carry trade, momentum, and US dollar (where investors take a view relative to the value of the US dollar).
Alex Patelis, head of global foreign exchange and local currency strategy at Merrill Lynch, says there has been a rapid growth in both the demand and supply of FX investment products, echoing the trend displayed by the equity markets three decades earlier. “The introduction of products that replicate the strategies of active FX managers is part of the natural evolution within the marketplace; the market becomes more competitive and you try and strip things you can easily imitate,” says Mr Patelis.
ML FX Clone gives different weights to FX strategies over time, depending on the success of the time varying weights. Following back-testing, it achieved an annual return of 9.1 per cent, with a 0.82 sharpe ratio, with one year of negative returns since 1989.
“In time, investors will flock to the most obvious replicating indices, and then move on to exotic ones, right now we are at the very early stages of FX indexation,” adds Mr Patelis. Supporting his claims, Merrill Lynch research recently found that justifying paying higher fees for active management “may be increasingly difficult if similar strategies can be mechanically implemented at a lower cost”.
Buy-side backlash
 | Ken Dickson, investment director of currency at Standard Life Investments, describes the growth in FX mandates as “phenomenal” and is not surprised that investment banks want a piece of the action. Despite active, alpha-centric, currency managers going head-to-head with sell-side index makers like Merrill Lynch and Deutsche for investor business, Mr Dickson, who oversees Standard Life’s currency overlay and FX funds business, notes: |
“There is more happening now in the FX industry than has been in the past 10 years: the market is growing rapidly and there is certainly the capacity for the types of services we see provided by the sell-side.”
Mr Dickson believes as long as inflation does not rear its ugly head, then FX, with its low correlation characteristics, will continue to flourish as part of an investment portfolio. But what of the double figure allocation mooted by the likes of Deutsche Bank? “In theory this is a possibility, but practically this is unlikely to happen: pensions are wary of changing at the wrong time and the way they allocate risk may change overtime,” he says. Instead, the small to medium-sized pension fund will be the more likely to up its stake in FX than funds where managing liabilities is of an immediate concern.
Mike Victoros, FX and tactical asset allocation (TAA) global products specialist, ABN Amro Asset Management, oversees $32bn (£23.6bn) in currency overlay and $1bn in a currency as an asset class. He says the inefficiency in the FX market “with many different market participants with varying motivations”, doesn’t detract from the upside of currency investing. “Currency is an important alpha source in an underlying portfolio because of the good information ratio it delivers, the de-correlation with other asset classes, and translation of skill into profit because of the cheap execution,” he explains.
Pension funds looking for a source of alpha from FX are faced with a “two birds with one stone scenario”, according to Investec’s Papasavvas. “They can bring the FX managers in to manage the underlying risk exposure held by the equity managers, and secondly add alpha uncorrelated to the returns of their other investments by investing in a highly geared currency fund,” he says. Investec has a conservative currency fund going back to 1981 as well as a “quite aggressive” fund, as described by Mr Papasavvas. The manager is to launch a middle of the road fund in the near future, he adds.
The industry view is that more benchmarks replicating FX strategies will come on line in the next two years, increasing transparency and lowering costs for investors. Merrill Lynch’s Alex Patelis says these will complement the activity of active currency managers in the same way passive investing in equities hasn’t negated the need for active management either. “A similar situation will happen in FX overtime,” he comments.
Mr Papasavvas forecasts the trend of indexation will continue “until one or two become the standard”. “It is positive for the industry, adds transparency and for the good currency managers it will be a very clear way of differentiating,” he says. “The issue of FX benchmarking has finally been addressed after years on the sideline.”
