Galen Stops takes a look at why active currency management could make a comeback this year……..sort of
Institutional investors have long understood the value of diversifying their portfolios, and this usually means investing internationally.
But when they buy foreign equities, they’re actually buying two portfolios, the first being the long equities denominated in their base currency, and the second is that they’re shorting their base currency against the foreign currency they need to purchase the equity.
This presents institutional investors with a choice: they can do nothing and accept the risk of holding this foreign currency, hedge that currency exposure passively or manage it actively.
Many firms choose the first of these options for a number of reasons. Some take the view that holding the foreign currency actually provides diversification.
Another issue is that FX is an entirely different market structure and trading environment compared to equities and therefore investment managers are reluctant to trade it unless they absolutely have to.
Further, there are some scenarios where having unhedged exposures can be beneficial – for example, between 2000 and 2011, the weak US dollar environment meant that US investors enjoyed a windfall as the foreign currency return contributed positively to the performance of international equities.
Other firms choose to hedge their exposures passively, the advantage of this approach being that it enables firms to reduce the currency risk of their portfolio without needing to hold actual views on the currency markets in order to do so.
“We don’t have an FX strategy, we don’t have an FX strategist and we don’t develop models. In our view, FX is more of an operational necessity,” explains a senior figure at one US pension fund.
This particular pension fund doesn’t hedge the currency exposures from its stock holdings and passively manages its currency exposures from its natural flows of income, capital calls, and distributions and rebalancings.
“We’re very plain vanilla with regards to FX. When we have what we consider to be a reasonable amount of currency exposure, then we eliminate it, we repatriate it to US dollars,” says the pension fund manager.
Questioned about why the fund does not hedge the exposures from its stock holdings, the source replies: “Our benchmarks are not hedged and so, given that we are cognisant of our tracking error, if we hedged we would actually be adding risk compared to our benchmarks. Could we hedge and change our benchmarks? I suppose we could, but it’s not something that’s being pursued at this point.”
Ultimately, funds like this prefer to passively manage their FX exposures simply because trading FX isn’t their core focus or competency.
“We create these internal mandates and they’re designed for you to focus on what everyone thinks you’re best at,” says the pension fund manager. “Most of these firms are probably not equipped to actively manage FX, it’s not in their DNA.”
It is worth noting, however, that passive currency management is not risk-free. Because as Momtchil Pojarliev, senior portfolio manager, currencies, at BNP Paribas Asset Management, points out, there is still an important market-timing component to this approach.
He explains: “Let’s say a firm decided to move from being unhedged to passively hedging their currency exposure – that’s a market timing risk. An example of this is what happened to many people in 2002 that were implementing passive hedging programmes because the US dollar was strong in the ‘90s during the dotcom boom, but then saw the US dollar weaken for the next 10 years.
“So they put the passive hedge on at the worst possible time and then suffered losses for the next 10 years because when the foreign currency appreciates and the USD depreciates, you have to put up cash every time the hedges are settled. Many investors actually liquidated their passive hedging at the worst possible time, essentially at the bottom of the US dollar in 2011. So ultimately they paid a high price for hedging and then failed to benefit when the US dollar finally rebounded. We saw a similar demand again for these hedging strategies when the US dollar was very strong in the 2014-2015 periods, and again the US dollar has depreciated since.”
Therefore, according to Pojarliev, many firms get the market-timing component wrong because they have the most pressure to put on a hedge when they’ve already lost money and then they’re essentially locking in the losses.
Shift towards passive
Whereas passive currency management effectively treats all foreign currencies the same way, active currency management looks to reduce risk, while simultaneously generating alpha where possible from the unmanaged risk positions that institutional investment firms naturally accrue.
The downside of this approach, is that it requires the firm managing that currency risk to have a view on the FX market and if that view is wrong, it means that it will underperform a passive hedging equivalent.
“In the US, the board isn’t really monitoring your currency return, they look at your global index return, they don’t break it down into currencies and as a CIO you’re stepping out on a limb by actively managing your currency exposure and I think that causes a lot of hesitation,” says a market source.
Further, because many of these institutional investors will not have any particular background or expertise in the FX market, to be effective in actively managing their currency risk they will probably need to hire a currency manager, which in turn can prove problematic in some instances.
This is because anecdotal evidence suggests that some investment managers are reluctant to get up in front of their boards and say that they need to hire a currency manager, given that this means additional fees and, should that currency manager underperform, it could reflect badly on the person who hired them.
As the source put it: “It’s not the most career enhancing problem to solve.”
According to Adrian Lee, CIO of Adrian Lee and Partners, some investors are also skeptical about the size of the returns that can be generated in currency markets.
“The intuition is that no one can make money in the currency markets because they’re so liquid, but they’re confusing liquidity with efficiency. If you go through the 101 of what makes an efficient market, it’s having many buyers and sellers with common information sets, no barriers to entry and common objective functions. And actually, all of these are not really present in the currency markets, which is why you can find inefficiencies,” he says.
While each of these are more fundamental deterrents in terms of beginning to actively manage currency exposures, in recent years there has actually been a sizable shift amongst institutional investors that were practicing active currency management towards a passive approach. This change has been driven by a number of factors.
“I think that some firms were a little bit too simplistic about how they approached currency management and also there was more money to be made in other asset classes. The investment management fees for currencies are not huge, they can’t be because firms are paying them on top of the equity portfolio that they’re already concerned about. So I think that some people morphed into other asset classes because currencies weren’t generating enough profit for them,” says Lee.
Meanwhile, Pojarliev says that in the past, some firms were perhaps unclear about exactly what they were paying their currency managers for. “I think that some people made the mistake of confusing currency alpha with active hedging. Usually, if you have skills in the currency market, what you’d like to do is not just hedge but have an unconstrained absolute currency program. So basically, you want to speculate in the FX market and then the idea is that because you’re unconstrained, you’re going to have the highest information ratio. But absolute returns programs don’t actually address your foreign currency exposure,” he says.
Pojarliev continues: “Let’s say that you have an active manager and he’s a very good currency manager, but he’s buying or selling EM currencies and while that might be a good call and might work for a while, if you don’t have those currencies in your portfolio, then actually what the manager is doing does not address what you need, it’s not a solution to your problem.
“So I think that there was some disappointment with active currency management because people invested in absolute return currency programs rather than in active hedging programs. Active hedging isn’t so much about speculating and generating profit as it is about providing a different approach to passive management in the sense that it minimises the market timing risk.”
However, there are signs that attitudes towards currency management amongst institutional investors are changing. In June, Profit & Loss reported on research that suggested that investors are taking a more active approach to managing portfolio-wide currency risks, and in particular noted that there is a greater appetite for active currency overlays.
One reason for this, according to Aaron Hurd, managing director, senior portfolio manager at State Street Global Advisors, is that a number of investors got hurt by the USD bull market and consequently learnt lessons about the need to manage their currency exposures effectively.
“Attitudes towards currency management are definitely evolving and changing. The US is a tough market in the sense that it traditionally hedges and manages currency the least, but even here I think that eyes were opened by the US dollar bull market and there has been a lot of education going on since then.
“The dollar bull market was very rapid, most of the returns happened from mid-2014 to mid-2015, but that was the first time US investors ever had a dollar bull market when they had 20-25% overseas assets, they had never seen losses like that. Back in 1995-2001 US investors maybe had 10% invested in overseas assets, so it wasn’t that big of a deal when the dollar appreciated. But now it really hurts them and there’s been an education cycle that’s happened as a result,” he says.
Another reason why there is a growing appetite for active currency management amongst institutional investors is the growing interest rate differential that is currently opening up.
“Let’s say you’re a Europe-based investor, in this period where US rates are higher than in the Eurozone you’re paying almost 3% carry by hedging the US dollar exposure. So some investors might decide that instead of just doing a passive hedge and locking in the negative interest rate differential, maybe they should do something different. Essentially, the higher interest rates in the US right now are creating a demand for active hedging strategies outside of the US,” explains Pojarliev.
Similarly, Lee notes: “It’s hard to argue that divergent monetary policy in the US, Europe, Japan and other certain jurisdictions won’t show up in the currency markets. The impact is often disappointing because the markets don’t move as much as people expect, but the a priori view is that currencies should adjust because of the de-synchronised nature of monetary policy. This creates momentum at a time when I think that investors are becoming more sophisticated about currency management. And with yields so low and alpha so hard to find, if there’s 2% or 1.5% alpha available no-one can afford to say that they don’t need that.”
Another factor to consider is that as more investors shift towards passive management, the opportunities increase in the active space because it becomes less crowded. According to Hurd, this naturally creates a pendulum-like effect between the two approaches.
“I like to imagine an active/passive pendulum. So as we get more passive management that actually increases the opportunities in the active space because it’s not as crowded. If you think of active as really just trying to get good returns and passive as purely trying to shape exposures in a portfolio, for example reduce them by 50%, then that pendulum swings between the two,” he says.
A new approach
Interestingly, Hurd sees a more aggressive emergence of a third category that sits in between these other two approaches. In this category is active risk management, where the goal isn’t just to generate returns, but rather to use currency expertise in the market to better understand the risks in a portfolio and adjust the hedging with the goal of both generating some returns, but also mitigating the currency risk.
“This is where you get into “smart beta” or “factor investing”, which is where you look to get 60-70% of the returns active currency managers are producing by just following other strategies. So you get these basic, beta-like structural factor positions – this is common across multiple asset classes, but specifically in currency markets active managers historically tend to be overweight on carry trades, they have a buy and hold to value or a lot of people use momentum strategies,” explains Hurd.
The logic behind this approach is essentially to replicate these simple strategies, but at a fraction of the cost, with the aim of developing a better long- term return profile, while also satisfying the desire to reduce management fees.
“So I don’t think that we’re going to see the pendulum swinging completely back and forth between active and passive because of the increasing growth in this active risk management and smart beta factor investing space,” says Hurd.
He adds: “I think stand-alone active management, where you hire your alpha overlay manager and he runs absolute return or you have a standalone hedge fund that you actually put cash in, I think those firms are going to have a tough time.
“I think what you’re going to see more of is alpha programmes tacked onto hedges, I think you’ll see more emphasis on generating return through currencies in other asset classes. For example, you might see global rates managers becoming more aggressive with currencies.”
Ultimately, there is no one best solution for managing currency exposures – the approach should clearly be tailored to a given institution’s portfolio. However, it is certainly no bad thing that investors seem to increasingly be taking a more thoughtful approach to currency management.