Currency overlay is not a new phenomenon, it has been a service used by forward thinking asset managers for some years; however, the world of currency overlay could be about to change irrevocably. For years, currency has been a by-product of other transactions in the financial and non-financial world, but shrinking (or non-existent) returns in other financial markets mean that investors are paying increasing attention to the currency component.
Colin Lambert looks at the shift in approach towards currency by asset managers, and how the currency managers are responding to this.
Despite the protestations of many in senior management on both sides of the market, there is little doubt that currency has always been the poor relation of the financial markets. Very swiftly after the authorities got control of the FX markets, especially in the post-euro era, banks tired of their own proprietary FX trading operations and moved to a customer service focus.
The picture was very similar on the buy side. Corporations that had previously run global treasury operations cut back their activities or closed them down and outsourced their operations, and asset managers frankly couldn’t care less about the impact of exchange rates on their portfolios. The argument being that if your equity and bond portfolios are returning 20+%, why bother with the tiresome process of currency hedging?
Of course, as the adverts say, “The value of your investments may go down as well as up”. Whilst participants in the FX market have been used to this phenomenon, those in other markets perhaps have not. Notwithstanding the long bull equity run which sustained many a portfolio over the past decade – even in times of falling equity markets, equity investing advocates maintain that if you hold your shares for the medium to long term, you will see good returns.
In the main, they are right, but if there is one overriding characteristic that the world has acquired in the past few years it is “short-termism”. In this environment, quarterly company results are pored over in more detail than the annual returns used to be and the “flavour of the month” has become the “flavour of the day, or perhaps week”.
This “what have you done for me lately?” attitude has resulted in investment managers no longer being able to hide behind a long term perspective, and this, allied to the sustained drop in equity values after the dot.com bubble burst, has led to a period of introspection and, more importantly, pressure from their investors.
Within this period, the role of the currency markets has reflected the ups and downs elsewhere. From being less than an afterthought to many managers, it became a by-product wherein they ensured they did not lose performance due to currency trends. It is now on the verge of taking another step up the value chain, becoming an absolute return asset class.
This change in attitude is reflected by Alex Over, senior vice president, European marketing at Pareto Partners, a London-based asset manager with $28 billion of currency under management. “Historically, currency has not been treated as an asset class by institutional investors – it has merely been an exposure created by an asset allocation outside of a client’s domestic currency,” he says. “Generally, our clients do not invest in a market to get currency exposure, they invest because they wish to own the underlying equity or bond.”
Now, however, interest is growing in currency, as part of a wider alternative investment strategy. “We are seeing disappointment in traditional asset classes from investors,” Over continues. “And a number of large pension funds and other institutional investors are, for the first time, starting to look at currency as a potential source of return rather than a risk which they may or may not wish to hedge away.”
Over believes that the currency management business will develop along two distinct paths. “We will have the traditional currency overlay business, where the client selects the benchmark and the overlay manager inherits a set of exposures and manages to that benchmark within predetermined guidelines, but we will also see the development of a new currency management business with a focus on absolute returns,” he says. “In the former model, the currency manager necessarily concentrates the active risk budget on managing the base currency risk; in the latter, the objective is to spread the active risk across a diversified opportunity set in order to enhance risk adjusted returns.”
Philip Simotas, president of New York-based FX Concepts, agrees. “Over the last two years the focus of the industry has moved to return generation, thus blurring the lines of distinction between currency overlay and absolute return programmes,” he says. “We have always focused upon returns and information ratio production, and while it was probably to our detriment four to six years ago, the recent lack of return in other areas of the market has justified our approach.”
The systematic approach to currency management has grown in credence over the past decade since the concept of overlay first made a serious impact on asset manager thinking. This reflects the thinking of many clients, according to Rashid Hoosenally, head of client strategy at Deutsche Bank in London. “Increasingly, we believe that the end users of the overlay product such as pension funds are unimpressed with the ‘finger in the wind’ approach. Rather they are attracted to a disciplined approach within a systematic framework or process.”
Perhaps the biggest factor driving the growth in the systematic approach is the increased level of data that is available to managers, as well as more powerful computers to conduct ever more in-depth analysis of the markets.
This is not to say that the discretionary approach has no value, according to Hoosenally, but the value appears to lie in a blend of both methods. “We are seeing an increasing use of a mixture of both styles,” he says. “This is the sweet spot for many managers – they can use quantitative techniques in conjunction with qualitative judgments and are clearly producing superior results.”
The combined approach to currency management is not gathering acceptance particularly quickly, mainly one suspects because successful managers are reluctant to change a winning formula.
There is also the need for currency managers to recognise developments in the market and respond by offering a comprehensive range of products and services to meet their clients’ demands in what is a very competitive market. Pareto’s Over stresses the need to be able to differentiate by product, but equally he feels that investment style, assets under management, the experience and the quality of the investment team are also critically important. “I think there are maybe six serious players in the currency management market,” he says. “Five of these are more or less regulars and each year you find that one loses influence – because the environment does not favour their style perhaps – and one is elevated to the top group because they have had a good year performance-wise or have an interesting approach that has attracted mandates.”
Pareto’s own style is aimed at managing downside risk and reducing the volatility of client returns. “In traditional currency overlay, the job we perform for our clients is to avoid losses in adverse environments and to capture return in favourable environments through a process of active hedging,” says Over. “Our investment strategy is model-driven, where the insights of our investment team are encoded into computer-based models and the models run the money. Our philosophy is less a question of forecasting returns but more of forecasting and managing downside risk.
“Empirical and academic work on the distribution of currency returns has shown that they tend to be peaked (leptokurtotic) and exhibit extreme values (fat ‘tails’),” he continues. “In currency markets, three standard deviation events are not as uncommon as you might think. Also, currency as an exposure has no long-term expected return as no capital is invested in it – when losses occur there is no mean reversion. If we could consistently forecast returns we would focus on the positive tail of the distribution, but as we believe this is extremely difficult to achieve, instead we focus on the negative tail and try to avoid losses. “This is how we have added value of approximately 1% per annum over the 11-year period we have been managing money.”
Deutsche Asset Management (DeAM) also uses a quantitative model to set the constraints on their trades and manage the risk; however, the input to the model is perhaps the most varied in the market. The currency operation has been set up very much in the model of a bank, with five teams in Tokyo, Singapore, London, Frankfurt and New York contributing quantitative, qualitative and technical ideas.
Paul Lambert, global head of currency at DeAM, explains that the currency group was established as a standalone unit three years ago. “We have a reasonably unique structure,” he says. “We were able to create this because we had a lot of resources from which to pick and were able to start with a clean slate as far as the business model was concerned.
“We combined teams that were relatively successful – with information ratios [the ratio of extra performance to extra risk] between 0.4 and 1.0 – and found that we could raise that ratio to 1.3 or 1.4 which put us in a different league,” he continues. “We reinforced that by structuring with a low correlation across the units. This enabled us to raise the ratio above 1.5 because we could lose duplicated resources and spend these in more productive areas such as emerging markets. We have a dedicated emerging market resource, which is relatively rare in this industry.”
The argument against currency overlay in emerging markets normally revolves around the lack of data, thus the inability to model. Lambert accepts this but believes that the DeAM’s emerging markets capabilities not only is one of its strengths, but also justifies its approach to currency management. “It is very difficult to run a system trading model in the emerging markets, but by integrating a qualitative approach we can do this and add alpha,” he says.
FX Concepts also manages currency risk in emerging markets, applying an absolute return approach in those markets, according to FX Concepts’ Simotas, and this is an area that investors seem keen to investigate. Hoosenally believes that the key to avoiding the worst excesses of emerging market volatility lies in a sustainable and diversified strategy. “Currently the emerging market currencies tend to trade around economic fundamentals,” he says, “But as they become more tradable I think we will see more process-driven dealing. In the big picture, there is no doubt that including an element of emerging markets in a core G10 programme – provided it is sensibly proportioned – enhances the potential for return.”
Not unlike the banking industry which supports currency managers with its services, the latter also has clients to satisfy. Over acknowledges that clients have different objectives – Pareto offers tailored programmes according to those needs, therefore, it is important for the manager to explain its investment philosophy and process. “We apply our philosophy consistently across all of our clients,” he says. “If we are successful in avoiding most of the loss and capturing a significant part of the gain, we, and our clients, are happy. Everyone needs to be realistic when setting objectives. We tell our clients that currency returns are episodic and environmentally dependent – sometimes there may not be an opportunity to add value against their selected benchmark. In those environments our job as overlay manager is to limit losses to a pre-agreed “floor”. In more favourable environments, typically where currencies trend, we look to capture return. By adopting a tight risk of loss floor, the results of the strategy may occasionally offer disappointments in the magnitude of upside capture, but there will never be surprises in the form of large losses – I think this is important.”
The argument against currency overlay in emerging markets normally revolves around the lack of data, thus the inability to model. Lambert accepts this but believes that DeAM’s emerging markets capabilities is not only one of its strengths, but also justifies its approach to currency management. “It is very difficult to run a system trading model in the emerging markets, but by integrating a qualitative approach we can do this and add alpha,” he says.
DeAM uses what Lambert terms a simple algorithm – within established bands – to ensure that all teams have influence in the portfolio construction. “Typically teams with a low correlation tend to be up-weighted and vice versa,” he explains. “This ensures we are running a truly diversified programme.”
Tamiso & Company is a smaller currency manager, based in New York. Robert Tamiso, president of the company, believes that transparency of returns is the key to client satisfaction. Tamiso has what is a relatively unique approach to currency overlay in that it does not perform against a benchmark and does not offer a single currency programme.
“Our belief is that a speculative trading approach is the best type of overlay programme,” says Tamiso. “This will alarm some people who see the traditional hedging process as ideal, but in reality that is exactly what they are trying to do – the difference is leverage. Our programme returns are directly related to that leverage, unlike our risk/return cycles.”
Tamiso uses a portfolio rather than a protection approach. “We try to achieve consistency with a portfolio of currencies that is run in an entirely systematic fashion,” he says. “The problem with a specific currency approach is keeping the client satisfied. If you are protecting against a euro fall, for example, you have been doing very little lately, which raises questions about the value you are providing for the client.
“You also have to stay on top of your exposures, which can be difficult and create unnecessary volatility and trading in the programme. I think there is a real danger in being overactive, you have to maintain discipline,” he adds.
The key to Tamiso’s approach is volatility. The programme includes the seven industrial currencies, plus the Singapore dollar. “We included that because we were underweight in that region and it is not typically a very volatile currency,” he says. “Our programme rates the volatilities of the currencies so that, over time, we are balanced in terms of risk. Our model is very simple: volatility is our proxy for risk.”
Changing the Model
It is widely assumed in the wider financial world that, harking back to this article’s opening sentiments about the status of FX, that if the equity markets commence another sustained bull run, FX will once again shrink into the background. This is unlikely to be the case, however, primarily because many asset managers (though not all) have finally understood the need to squeeze every point of return possible.
Should it be the case however, some forward-looking currency managers are preparing to diversify their product range to take FX into the realm of absolute returns. Over notes that Pareto is starting to see significant demand for such an approach, indeed it is close to rolling out such a programme itself. “We are working on delivering a Currency Absolute Return (CAR) strategy that utilises the same investment philosophy, process and models that we have used so successfully in a hedging context, but configured for absolute return generation,” he explains. “By eliminating the constraints of a traditional hedging mandate (ie, benchmark, inherited exposures and hedge ratio range), we can expand the opportunity set for adding value and deliver an Information Ratio approaching 1.0.
“In effect, we are creating a long/short currency product using currency as an alpha source,” he continues. “As the alpha source we are exploiting is consistent over time, we feel confident that a modest amount of leverage can be applied – say up to a maximum of three times notional exposure – without any significant degradation of the Information Ratio. We believe that such a construction could deliver a return of 10% to 12%, net of fees, over a market cycle. Due to the observed lack of correlation of currency risk with other asset class risk we believe this would be a very interesting product for fund-of-funds, high net-worth individuals and other hedge fund investors.”
Tamiso is equally unconcerned at the thought of an equity bull run diluting interest in overlay, but if it does, he is also prepared to act. “There is a possibility that a sustained equity bull run will impact on overlay,” he says. “But in terms of a speculative programme, if we are moderately successful with a low leverage programme, we can make the argument for turning it into a currency speculation programme – in effect another asset allocation programme with higher leverage.
“We would not get anywhere near the level of interest we do in traditional overlay programmes, but we would probably benefit in revenue terms,” he adds.
DeAM’s Lambert believes that the asset managers’ need for diversification will ensure that currency overlay is sustained as an industry. “I don’t think that a sustained equity bull run will detract from the market, however it may prove difficult to attract new clients,” he suggests. “Asset managers are now looking to invest in areas with low correlation to their existing markets, however, and not only does currency provide this but it is very scaleable and is not subject to liquidity crunches as other markets are.”
FX Concepts’ Simotas believes that the current bear market in equities has given the currency overlay industry the opportunity to demonstrate its value. “There are a number of plans that have experienced good returns in their currency strategies,” he says. “As a result, more and more institutional investors are looking to add a currency component to their portfolios, whether via a currency overlay or an allocation from their underlying portfolio. Even if the equity markets show an upturn, the non-correlated returns provided by currency management make a valid argument for active management no matter what the format of the programme.”
Survival of the Fittest?
Although as Pareto’s Over notes, the currency overlay market is dominated by six firms, there is little doubt that overlay has been a growth industry over the past few years. Whether it can sustain this growth in terms of the number of firms depends to an extent not so much on the performance of the equity markets, but rather on the growth of cross border investment.
Asset managers are likely to maintain, if not increase, their interest in overlay from here, however. Hoosenally feels the potential for growth is enormous. “The percentage of pension fund assets is growing, as is the percentage of those assets held offshore – in fact, it is growing more rapidly. The level of cross-border assets is therefore likely to grow strongly and these assets are likely to be actively hedged. Everything points in the right direction for the overlay market.”
The key to attracting mandates is, of course, providing value for money and keeping the client happy. Tamiso notes that managers have to contend with the impatience of the client on occasions and that many expect hedging operations to make money. “There are times when clients can get a little over-exuberant,” he says. “They want to see greater returns without accepting the greater degree of risk.
“Notwithstanding that,” he continues. “To attract mandates you have to offer a precise model and transparency of results. We report quarterly and monthly to our mandates and if the programme works, they get to see the majority of the benefit. If it doesn’t work, you are gone. Clients are not locked into a programme, we are simply hired help and if we do not perform, we suffer the consequences.”
As to the question, “Is size important?” Pareto’s Over believes it is. “Institutional investors can gain comfort from dealing with an organisation that has the resources to commit to the business. The barriers to entering currency management are rising – and I think they are already high. It is no longer enough to have a robust investment process, you must also be able to demonstrate to your client that you have the necessary infrastructure in terms of trading expertise, middle and back office, client service and general infrastructure. With high profile scandals concerning rogue traders and ineffective internal controls, you have to be able to convince your clients that your risk management practices and systems are leading edge.”
DeAM’s Lambert agrees, and suggests that the research resources available to DeAM’s teams, as well as the flow it sees is a differentiator. He also believes that the smaller independent firms could face a challenge from their larger brethren. “The reason independent firms established their footprint was because more traditional multi-asset managers created a restricted environment for their currency units,” he suggests. “Our comparative advantage is that we were able to create a standalone product; our teams have to think of nothing else but currency.
“If multi-asset managers had done this in the first place,” he continues, “The independent managers may have struggled to establish their business models. In time I think the smaller operations will face a stiffer challenge from operations such as ours.”
There are minor concerns about the future of the currency overlay industry and, outside the problem posed by an equity market surge, the biggest issue could well come from the banking industry. Currency managers need liquidity and liquidity is an area of growing concern in the FX market. The headline numbers show that FX remains the most liquid market in the world, however the reality is that liquidity is increasingly being isolated in pockets throughout the (predominantly European) day.
“Despite the fact that the currency market is the largest and most liquid market in the world, access to liquidity and the ability to execute in all market conditions is becoming an issue for managers with significant assets under management,” says Over. “Following the introduction of the euro and the recent introduction of online trading platforms, liquidity in the currency market is becoming more concentrated in the hands of a relatively small number of banks. These banks have clearly demonstrated their commitment to the FX business but such concentration could be a risk to the industry’s development. Our model looks to identify and exploit trends – not create them – by definition when markets are moving we need liquidity in order to trade.”
Notwithstanding this, FX is likely to remain of interest to asset managers, increasingly from an absolute return perspective, and this should ensure the medium term health of the currency overlay industry. Deutsche’s Hoosenally is confident over the outlook. “Asset managers must accept that FX is a good place to spend some of their risk budget,” he suggests. “One of the big trends we are seeing is that the less a manager’s hands are tied by the mandate, the better they perform. This advocates greater flexibility for currency managers, and hence, better returns.”
An Added Option?
The use of currency options by the overlay industry is relatively rare. Some of the more sophisticated programmes have an option element, for example FX Concepts has an approach based upon options and implied volatility; however, in the main they are rarely used as products.
This is likely to change along with the renewed focus upon absolute returns rather than hedging in the industry, and is a development that Rashid Hoosenally, head of client strategy at Deutsche Bank, suggests is timely. “We believe active managers should be given the ability to use the options market,” he observes. “There are negative connotations surrounding derivatives due to a few high profile events, but they offer choice and help to finesse the risk/return profile.
“As people become more educated in their use and the historic legacies are broken down through greater transparency and better risk and reporting systems, we feel people’s objections will no longer be valid,” he adds. “There is a lot of value to be released – the first layer will be vanilla options, but some structured products such as barriers can add a lot of value because handled correctly, they allow managers to fine tune their views.”
Another currency manager agrees options will be used increasingly with the move towards absolute returns rather than straightforward hedging, noting that as such, many managers are likely to be on both sides of the market – effectively trading volatility as they look to tweak their models.
Not all are in agreement, however. Paul Lambert, global head of currency at Deutsche Asset Management, acknowledges there is a debate about the use of options, but suggests that the nature of the options market works against the currency manager. “There is a bias in the options market for implied volatility over historical and actual volatility. Therefore you want to be a writer of options, which raises regulatory issues for the currency manager. If you are a buyer of options, in effect you are taking a bet on the markets and paying above the odds. This is not the job of a currency overlay manager.
“Our information advantage is in our research and flow through our company,” he adds, “We have no advantage in predicting volatility – that is the preserve of the banks.”