Galen Stops talks to some veteran currency managers about generating returns in a world of reduced FX trends, increased regulation and evolving investor demands.
Talking to individuals that have been actively trading in the foreign exchange market since Profit & Loss was launched in 1999 – and in some cases before then – it is unsurprising that some of them highlight significant changes in the way that this market functions today.
“I think that in terms of generating alpha or positive returns in currencies, the big change that’s taken place in the last 20 years is that whereas in the ‘90s, trend following strategies were working well, they don’t anymore. That’s part of the reason that some people have been struggling with performance,” says Momtchil Pojarliev, head of currencies at BNP Paribas Asset Management.
This change, he contends, results from a structural shift in financial markets, caused by increased central bank transparency. Over the past 20 years, central banks have generally become much better at clearly communicating and signalling their moves to financial markets in advance, while steps such as publishing the minutes of their meetings have been taken to increase transparency around their actions. As a result, says Pojarliev, volatility has been suppressed to the benefit of importers and exporters, but to the detriment of trend following as a viable strategy.
“Trend following doesn’t work now, and I don’t think it’s coming back,” he says. “This doesn’t mean that you can’t make money in currencies, it’s just that you can’t rely on trend following because these strategies make money when you have only a large move in the market, but not when currencies are moving within tighter ranges like they have been.”
Pojarliev adds: “Now you have to be a lot more nimble. If you have a 2-3% move, then take the profit and wait for the next 2-3% move. It may sound very obvious, but you need to buy low and sell high, which is the opposite of trend following, which buys high with the hope of selling higher.”
Sticking with the Fundamentals
Van Luu, head of currency at Russell Investments, has a different assessment of this issue, however. He argues that the trade wars occurring right now will inevitably lead to a significant slowing of the global economy and, eventually, a recession. When this happens, Luu predicts there will be a big flight to safety and there will be a sizable increase in FX volatility.
“FX still reacts to the same fundamentals,” he says. “In the last seven or eight years we’ve been in much more of a reversal environment rather than a trending one, where if a currency has been going up a lot, those trends have rarely continued. Some of that is because most economies can’t bear a consistently strong currency, so everyone has been engaging in this currency war. I think that the next recession will change that behaviour and you’ll see huge trends in safe havens and the cyclical currencies. So momentum or trend has been a terrible strategy for the past five years, but I would expect that if you can stick with it and limit the bleed, then during the next risk-off event it will pay off again.”
He is quick to add though that perhaps trading firms need to be more thoughtful about how they construct trend following strategies. Given that these strategies will all be correlated irrespective of how they are designed, Luu says that what will distinguish the bad trend following strategies from the good ones is that the latter will “bleed” less in periods that are not good for trend.
For Adrian Lee, president and CIO at Adrian Lee & Partners, the secret to generating returns in the currency markets hasn’t changed over the past 20 years.
“A good, sensible process aligned with good, sensible clients is the answer to generating alpha,” he says.
In terms of the process, Lee says that sticking with fundamental factors such as interest rate differentials and technical indicators like momentum works over time, provided that you are able to trade a range of currencies.
“As long as we have a range of different economies globally in different patterns of growth with different rates of inflation, and you don’t need many, just a few divergences – then you can make money in currencies. People always underestimate the fact that monetary policies will never converge because the BoJ reacts to Japanese voters’ issues, the Fed to US voters’, the ECB to Europeans’, etc. As a result, there can never be complete convergence,” he says.
In terms of clients, Lee emphasises that it’s important to make sure they understand process and what sort of mandate is required to make currency trading effective.
Talking to currency managers about alpha generating opportunities and it’s clear that EM currencies play a bigger part in their thinking than they did 20 years ago.
“One thing that’s changed is that people accept that emerging market currencies aren’t flaky. They’re more liquid than they’ve ever been and less illiquid than people think they are, and by definition, as you would expect, those emerging markets develop, one by one. So Israel is now in the developed index, China should really be in there as it’s almost the biggest economy in the world. So there’s definitely been a drift in this regard,” says Lee.
Luu says that he is watching EM currencies much more closely now, partially because the compression of interest rates in developed markets has reduced the potential of the carry trade. He notes that while emerging markets can still be subject to idiosyncratic events that cause huge market moves, there is also generally a much greater interest rate and valuation spread in these markets. To emphasise this point, Luu highlights that the interest rate difference in G10 between the highest and the lowest yielding currencies is about 3%, while in tradable emerging markets it is about 30%.
“High yielding currencies have a lot of problems as well, some of that yield difference is maybe also risk premium, but there are some points in time when it’s really worth holding this risk. So I think the opportunities will possibly move into the emerging market space,” he adds.
Interestingly though, Pojarliev argues that if investors are looking purely for returns then the currency markets are not the best place to allocate assets.
“I think that currencies is one of the hardest markets to make money in because the central banks basically own the currency market. So if an investor is just looking for positive returns and a strategy with the highest Sharpe ratio, then that’s not going to be in currencies. The advantage of investing in currencies is that it’s a low correlated strategy to the other absolute return strategies and it’s unfunded. In other words, it’s an overlay, and so people can still invest in equities or other assets and almost get the currency piece for free, which is a big advantage,” he says.
Pojarliev claims that the focus on absolute return currency strategies is misplaced because no major investor is going to allocate 20-30% of their portfolio to such a strategy. Because of this, he says that even an exceptionally good currency performance is unlikely to have a significant impact on the overall returns of such investors.
“If an investor has a 60% allocation to equities, then what’s going to move the needle for them in terms of value added? Let’s say they allocate 2% to currency alpha, it’s honestly almost not worth the due diligence time for the effect that this will have on the portfolio. What people are missing, however, is that out of that 60% equities allocation probably half of it is allocated to global equities, which have currency risk. So they’re already investing in currency, but are not compensated for it and this is where the focus should be when they think about currency strategies,” Pojarliev explains.
Unfortunately, he says that message has not widely permeated investors over the past 20 years and that in fact, attitudes towards currency management have not changed significantly during this period of time. Pojarliev partially attributes this to some currency managers tending to push products that are ill-suited to investors’ needs.
“If you’re a currency manager, an unconstrained product where you can buy and sell whatever you want is the easiest way to generate alpha,” he explains. “For example, I could claim that there is a great opportunity to buy Russian ruble because it’s a high yielding currency and will make money over time, but that’s not what the client needs. So I think there’s been a big disconnect between what people have been pushing in terms of currency investment and what investors actually need. People need positive returns, but maybe investing in the Russian ruble isn’t the easiest place to do it.
“Another thing that currency managers pitch is that it’s actually very easy to make money in currencies because there’s a lot of price takers that have to transact without actually caring about the price, but that’s not true,” he adds.
Lee, meanwhile, points out that there have been cyclical waves of scepticism regarding the value of currency managers over the past 20 years, but says that the consensus now is that there is a benefit in having a specialist handle currency exposures.
Or as he puts it: “We no longer have to explain why currency overlay makes sense to people.”
Evolving Investor Demands
As for the investors that do decide to employ a currency manager, it seems that their level of sophistication and, subsequently, their demands from these managers has evolved significantly over the past 20 years. One area where this is particularly apparent is in the growing demand for currency managers to utilise transaction cost analysis (TCA) tools to demonstrate the effectiveness of their execution when trading in the currency markets.
“I did my first TCA study in 2001, and back then TCA in the FX markets was unheard of,” says Joe Hoffman CEO, currency management, at Mesirow Financial. “But since 2008 there’ve been a number of new TCA providers that have appeared on the scene and now investors are demanding FX TCA and they’re becoming much better educated around transaction costs.”.”
The obvious question to ask here is: if TCA has actually been around that long in FX, why has it only just really come to prominence in the past few years?
“Back when I did that first TCA study the data wasn’t as robust,” Hoffman responds.
He adds: “I think that the rise of TCA now is due to a few things. Obviously, people want to have more transparency and understand what they are paying on their FX trades. Then with some of the other scandals in the industry, people are trying to demonstrate that they have better governance and better oversight of their FX transactions. Other asset classes were already widely using TCA tools and it’s extremely beneficial that the FX industry has extensively adopted it as well.”
Luu echoes a lot of these points, saying that lower expected returns following the financial crisis have driven increased cost consciousness amongst end investors, while the scandals in the FX industry have led to an increased focus on transparency and good governance. In particular, he cites the developments of timestamping trades, TCA, currency managers acting as agents rather than principals or being affiliated with brokers and improved benchmarking of currency trading following the change in the methodology of the 4pm London Fix in 2015 as symptomatic of these trends.
Luu also notes that regulation has played a part in this, with Mifid II requiring asset managers to provide explicit cost statements to investors when it comes to managing currency risk, or currency strategies in general, ex-ante and ex-post.
“It’s a big burden on us to compile these, especially the ex-post cost statement, but I think that it’s a very good development for the industry because it’s increasing transparency for investors,” he says.
Hoffman also highlights regulation as a key factor that has changed the role of currency managers and their relationship with their investors.
“Over the past 20 years as a currency manager we’ve had to become much more of a partner and resource for our clients, especially because of the regulatory landscape. Because of this changing environment a lot of our clients have come to rely on us more, which has inspired us to evolve and offer many new services: We’ve integrated regulatory reporting, provided TCA reporting, collateral management and documentation management – 20 years ago these services weren’t as relevant, and maybe even before the financial crisis, they weren’t as prevalent. Our clients at Mesirow Financial are looking for us to be a resource and a long-term trusted partner as opposed to only providing a product,” he says.
Despite this, currency managers will, ultimately, be judged on their performance. This means, says Lee, that the person responsible for hiring them needs to be confident that their performance will meet expectations or they could face difficult questions internally.
“The biggest obstacle to using currency managers is that you explicitly see the performance of the currency, otherwise it’s just muddled up with the equity manager’s performance. So clients need to have the confidence that they’re doing the right thing and the currency manager is going to make money, because if they don’t, they can’t really hide behind the equity portfolio anymore,” he says.