To think about this, we need to look in a bit more detail at the proportions of the market accounted for by its various groups of participants. Analysis of the BIS survey mentioned earlier, together with data from other sources such as the IMF, Visa, and the World Tourism Organisation, provides an indication of the proportion of the headline $1900bn daily turnover that is generated by currency-focused profit-seekers such as currency managers.
Figures three (see below)and four(see download file) divide up the headline $1900bn into its component parts. Figure three looks at the $1900bn, and apportions it using data in the BIS Survey. The actively managed (i.e. return-focused) portion of the market is almost exclusively formed from a sub-set within the ‘financial customers’ section. There will also be some proprietary position-taking within the Interbank section, but the vast bulk of this portion of the market is taken up with market clearing – the process by which orders from customers of the market are filtered through to equal and opposite requirements from other customers.
If we look to subdivide the Financial Customers section of the market, we have to rely on non-BIS data, but piecing it together we can create figure four, in which the active, profit-seeking participants can be seen to represent only $63bn (less than 5 per cent) of the headline daily $1900bn of activity. Given the scale of these numbers, there is scope for enormous revisions and/or enormous increase in active currency management before the market can be said to be dominated – or even significantly influenced – by the profit-seeking participants.
Hedge fund impact
There are almost certainly periods when the proportion of the market based on profit-seeking increases. Probably the largest such change took place in 1997-1998, when many hedge funds took large positions in the US dollar and Japanese yen. However, hedge fund activity in currency tends to be episodic, to take advantage of what are perceived as the most glaring inefficiencies. So it was in 1998. In October of that year, hedge fund risk management systems triggered a mass exit from the positions they had taken. In the process of closing out the positions they had taken, many funds lost a lot of the money they had made in the preceding period; and hedge funds were scarcely seen again in the currency market until 2004.
It is too early to be clear about the outcome of hedge funds’ recent currency market activity, but it is nevertheless clear that many took positions in the expectation of a significant fall in the dollar. Although the US dollar has fallen, it has also been through periods of directionless range-trading; and as this article goes to press, the US dollar is rising fast.
Hedging
While return potential is driving many investors’ interest in currency management, it is also true that unmanaged currency is a significant contributor to the risk of international asset portfolios. This factor has also received growing attention, as the movements of the US dollar and the euro in particular have highlighted its importance to investors’ total returns.
The risks of unmanaged currency in international assets are typically assessed by looking at the volatility of historic investment returns with and without varying degrees of hedging (also known as ‘passive currency management’). For UK investors, this analysis suggests that a 100 per cent hedge of asset-related currency exposures is ideal. However, hedging generates cash flow which at times of foreign currency strength and sterling weakness can be substantial, relative to the value of the assets being hedged. This often leads investors to select a lower proportion of assets to be hedged – 50 per cent is a commonly selected figure – particularly since the greatest benefit from hedging arises from the first 50 per cent of asset values hedged.
At Record, our recent experience is that many clients are keen both to manage the currency risk arising from their international assets, and to generate value-added from active management. Others, who have historically chosen only to hedge their assets, have now adopted active currency management as well.
The important point is that currency management can be tailored – both in pooled fund and segregated formats – to match the aims of each investor in terms of underlying risk management and return target. In reality, hedging and active return generation are independent of each other, meaning that combining them is a simple act of adding two products together.
Against this background, it is perhaps not surprising that currency management is receiving so much attention. With that attention, currency managers have also worked hard to make the traditional perception of currency as a ‘difficult’ topic as out-of-date as they can. Much of this has occurred naturally, as the focus has shifted towards return and away from complex risk issues.
The process has been assisted also through the development of pooled funds, which make currency management accessible in the same way as many equity or fixed income investments are. Other structures have also been developed for investors looking for segregated management, such as currency prime brokerage and ‘agency’ documentation, and these bring active currency implementation much closer to the implementation structures of other asset classes.
All these points suggest that currency is here to stay, and will surely grow further in investors’ alternatives allocations.
Peter Wakefield is director, head of portfolio management at Record Currency Management.
FIGURE THREE: FX MARKET TURNOVER BY TYPE 2004:
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