Is Active Currency Management Making a Comeback?

A new report finds that institutional investors are taking a
more active approach to managing portfolio-wide currency risks, and in
particular there is a greater appetite for active currency overlays.

The report, by investment analytics firm bfinance, says this
change is being driven by divergence in European and US interest rates,
geopolitical unrest and greater scrutiny of costs. 

The report also recommends investors look beyond the
headline fees and look closer at transaction costs, stating, “Although front-end fees receive column inches,
transaction costs have been the subject of serious reappraisal from investors and
regulators alike. The days of prop trading scandals may have ended; the days of
investors accessing more cost-efficient trading are only just beginning.”

While
bfinance acknowledges that 2017 is far too early to predict a return to the
heyday of active currency management, it argues that, “…more active or tactical
approaches to managing portfolio-wide currency risks do appear to be
experiencing a revival in popularity.”

The
backbone of the new research is a case study The DNA of a Manager Search, which explores one pension fund’s
recent hunt for appropriate currency management solutions.

The firm
says the case study reveals a universe of providers that has changed
significantly since that investor’s last search, key distinctions in strategy
and massive disparities in both visible and invisible costs for active and
passive elements. It adds that transaction cost analysis (TCA) formed?a “particularly
vital” aspect of the process, and was conducted with input from New Change FX. “Far
from being a dry technical afterthought, smart execution is increasingly
recognised as one of the most significant areas where providers can add value,”
the report states.

The report
observes that in spite of hopes of a revival in active currency manager returns
since 2015, these have yet to be realised. That said, bfinance argues that the
most significant decisions surrounding investors’ FX exposures – whether to
hedge them, how much to hedge, whether to hedge passively or tactically – have
been challenged by?events since 2014. “In Europe, a phase of dollar
strengthening has seen investors with a large hedge ratio looking over their
shoulders at potential gains that they could otherwise have obtained and could
ill-afford to miss given the low-return environment,” the report says

It adds,
“In the US and countries with USD-pegged currencies, the same period has harmed
endowments and pension funds that had kept international investments unhedged.
That, after all, was a relatively mainstream approach underpinned by
diversification and the expectation that the dollar would weaken over the long
term, not to mention aversion to cumbersome liquidity calls.

“Globally,
investors with little or modest protection from currency volatility have seen
Sharpe ratios suffer from more frequent macroeconomic or geopolitical events,”
bfinance states.

Although
the firm accepts that active currency management is playing a key role in other
parts of investors’ portfolios, it argues, “One?key message is clear: while
pure active currency managers have not really returned to favour, the question
of tactical currency management and its role in institutional portfolios is
more pertinent than ever.”

Manager Search

In the DNA of a Manager Search part of the
report bfinance explains that between late 2016 and early 2017, it assisted a
European pension fund in the search for active currency overlay managers.

While this
investor had run an active overlay programme since 1996, it was convinced that
a refined approach could deliver better results. Over 20 years, the active part
of the overlay had delivered just 20bps per annum in excess return, which
bfinance says is “a somewhat disappointing figure, even though the overlay had
succeeded in its primary objective of reducing volatility”.

The new
remit was not markedly different: passive currency hedging of the pension
fund’s non-EUR investments, with limited discretion to employ active currency
management “when there is a compelling case for superior risk-adjusted
returns.”

The new
return target for the manager was, however, considerably more substantial than
what had been achieved in the past, at 100bps per annum above the passively
hedged benchmark. “This 1% return would, in theory, offset the costs of hedging,”
the paper states. “Historically, an active overlay arrangement has also
provided the benefit of reducing cashflow pressures, although this will change
shortly under new regulations (EMIR) which will require the collateralisation
of forwards and force cashflows to be reset regularly rather than at the end of
contracts.”

The
research highlights two distinct active currency management styles – the pure
trend-following dynamic hedging model and the more fundamental multi-strategy
model. The paper says that while trend-followers have struggled in “somewhat
directionless markets, with precious little momentum to exploit”, the advent of
a ‘two-speed world’ in rates should lend greater support to the strategy.

It also
notes that multi-strategy approaches, on the other hand, should in theory
deliver excess return regardless of whether currencies ‘trend,’ applying a
range of more fundamental models alongside momentum signals.

The due
diligence process on the managers in the selection process involved them being
assessed and scored on a range of elements including the strength of their
investment and risk processes, the quality of execution, fees, reporting
capability, reputation, experience and more.

“A manager
assessment framework tailored to the client can prove particularly relevant in
this space,” the report says. “Reporting capabilities were just as critical for
this investor as the investment process itself, as was the ability for managers
to work effectively with their custodian.”

Interestingly,
the report observes that assessing the past performance of?these providers is
by no means simple. “The manager’s return stream combines the passive with the
active component: separation of the return streams is vital?to understand
whether the active returns are adding value. Not all managers?were able to
identify and attribute with sufficient granularity: in many ways this is a
“reporting” issue as much as performance assessment challenge,” the report
states.

Another
interesting aspect of the report was the wide diversification in the fee
structure of managers. “When it comes to fees and costs, manager pricing is
widely dispersed,” the report finds. “The more expensive management fees were
twice as high as those of the cheapest, while transaction costs varied by more
than 400%.

Further analysis
revealed that those with lower headline charges often proved to have higher
average transaction costs and vice versa, “making it even more vital not to
take fees at face value and consider the overall package of expenses”.

Bfinance
says these differences are strongly correlated with the type of provider. Banks
tend to offer principal relationships, executing all trades through their own
institutions; others operated on an agency basis with open architecture
execution. In addition, there were substantial savings to be gained with larger
mandates, since the majority of providers offered tiered rates depending on
assets under management.

Pushing
deeper into the costs incurred, the report stresses the quality of execution is
highly significant. “This can be a major source?of value erosion if not done
with care,” the report argues. “Given the importance of transaction cost
analysis for provider selection in both passive hedging and active currency
overlays, bfinance brought in the expertise of independent currency TCA
specialist New Change FX for searches in this space and ensured that TCA
represented a meaningful component within the overall manager assessment
scorecard.”

In the TCA
analysis, Andy Woolmer, CEO of NewChange, uses the example of a UK pension fund
with 60% of the fund in non-sterling denominated assets. He cites data from the
UK Investment Association which indicates that around 63% of this offshore
portfolio is hedged back to sterling and says, “Those hedges are rolled once a
month. We calculate that passive execution at the 4pm fix (the most common
practice) costs approximately 8bps per transaction, which means that this
pension portfolio loses a staggering 15% of its value in FX fees over its
entire lifetime.

“Switching
away from periodic benchmarking to a live benchmark should reduce costs to
around 1.5bps, or less than 3% of the pot,” Woolmer continues. “Good asset
managers can have FX costs as low as 0.5bps, while we have identified schemes
whose custodian executes for the asset managers where the investor pays more
than 10bps per transaction over and above a non-defined market spread. The
costs could reach a quarter of the entire pension pot on that basis.

While
FX usually contributes the highest volume of trading of any asset class within
a portfolio, it is almost always the most neglected,” he adds. “FX flows are
treated as a back office function rather than an important component of cost
and an asset which can be sold to the market.”

Kathryn Saklatvala,
global content director at bfinance and the report’s author, says, 
“Today’s
investment climate raises new FX-related headaches for investors, provoking a
rethink of previous decisions to hedge currency exposures, leave them unhedged
or delegate such decisions to fixed income and equity managers.

“2017 is far too early to predict a return to the heyday of
active currency management – a sector which experienced a dramatic cull after
the financial crisis when the return of volatility undermined widely-used carry
strategies. There was a large shift towards passive currency management
strategies. But this uptick in appetite for active currency overlays is
potentially very significant.

“After 2010 many consultants appeared to have determined
that active currency management had no place in a risk-reducing hedging
programme; this attitude is now clearly undergoing a rethink,” Saklatvala continues. “The question of
more tactical currency management and its role in institutional portfolios is
now more pertinent than ever.” 

Meanwhile, Toby
Goodworth, head of diversifying strategies at bfinance, says, 
“This
paper gives considerable insight into the re-emergence of active currency
management and the strategic choices available to investors when considering
active currency overlays. Investors are now looking to take advantage of the
divergence of interest rates and we have seen a significant increase of
interest in active overlays in particular. Fees and transaction costs should
also be scrutinised closely.

“We have been very pleased to work with New Change FX to
provide clients with independent, rigorous transaction cost analysis in this
sector. We also found that a highly tailored manager assessment framework is
essential in the active overlay sector due to portfolio-specific performance outcomes,
regional reporting requirements and the fit with other providers such as
custodians.” 

Colin_lambert@profit-loss.com

Twitter @lamboPnL

Twitter @Profit_and_Loss

Colin Lambert

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