Currency: Managing the risk
Written by European Pensions team
European Pensions Currency Roundtable
Miller: The benefits of investment in currency are well known. It has deep markets, with good liquidity, low dealing costs and a high proportion of not-for-profit players. Even though this year has been difficult, over the last five years, the median manager has achieved an information ratio of 0.5. That means that if they were targeting 10 per cent risk, they achieved a five per cent return before fees. That sounds like a pretty good argument for active currency management to me.
Roberts: I certainly agree that currency is quite a good harvesting ground for alpha. But let’s split the opportunity set into absolute return currency managers and currency hedging strategies. With respect to absolute return currency managers, we would typically say that it is not the most efficient way to extract that currency alpha. Whilst we recognise that there are some really strong managers in that area, we would normally access that alpha through a broader hedge fund strategy. So it might be a global macro approach or a global tactical asset allocation approach; something that includes currency as an alpha source, but is not necessarily the only alpha source. Comparing that to the passive currency side, hedging should be thought of as an opportunity to help reduce risk for pension schemes. Separately, currency also works as a smart beta or alternative beta idea.
Siragusano: As a euro area member, Germany stands under the impression of the euro crisis. We see many pension funds diversifying their currency exposure. Five years ago it was important to be in the eurozone: in this large currency area and its currency market. But today diversification is king: in hard and emerging market currencies. But diversification means that you buy additional risk: pure aesthetic hedging is not the solution if you want to diversify risk. There is much demand for overlay mandates as a source of alpha to bring in some performance but also to reduce the risk of investing in foreign exchange markets.
Miller: In the last five years or so, we have seen the emergence of currency funds as well as the more traditional segregated currency overlay mandate. Trustees often prefer the simplicity of investing in a fund. They are prepared to give up some of their control over the investment in return for a stand-ardised product with limited liability. It is much easier to buy and sell investments in a fund. The largest investors are best able to implement segregated overlays, although many of these also prefer funds.
Roberts: If you think of a funded currency mandate as a hedge fund strategy and it is long, short, it is usually leveraged and most of those strategies tend to charge hedge fund-like fees. Some of the fees might be slightly lower than hedge funds, but in general it has a lot of the characteristics of a hedge fund. Perhaps the one thing that is different is that you typically get very good transparency on holdings and process. And you also get very good liquidity in most of the currency markets.
Miller: Should we move on to looking at the risk and rewards in investing in currency - especially given the current environment?
Tikhonov: Whilst looking at the risk and reward of investing in currency, it is helpful to recognise various investment styles, each of which has distinct properties. Firstly, there is an observation that high interest rate currencies tend to outperform the low interest rate currencies. There is momentum in currencies; there is a convergence between the wealth of the developed and emerging economies which is reflected in appreciation of the emerging market currencies. There is also an observation that over time as certain currencies become overvalued, they tend to revert back to their fair value, whichever measure is taken. Once we have defined broadly the boundaries of what are the sources of the return – high interest rates, convergence to some valuation measure, exposure to emerging market currencies or the more technical ability to see the trend dimension; then you can think about risks and rewards. In order to measure risks and rewards, it is helpful to create indices - something that is very simple and transparent but can capture the opportunity in its broadest sense. For example, Record established a partnership with FTSE and FTSE now publishes a family of currency indices that capture returns from exposure to high interest rate currencies – FTSE FRB5 (FRB stands for Forward Rate Bias) and FTSE FRB10 indices that capture returns from the forward rate bias in currency pairs from G5 and G10 currencies universes respectively.
Siragusano: Currency movement is quite uncorrelated to equity and to bond markets. But what are the risks? One risk is the risk of the manager, when the strategy is not working properly, but I want to bring another risk to our attention: central bank interventions. In this market climate, which is quite volatile but determined by many political issues, the currency market is always one of the first markets where policy makers and central banks make interventions: I think this is something like a threat to us as currency managers and for currency investors.
Shilling: The whole risk on, risk off trade has meant that the assumption that we would like to make about currency, that it is uncorrelated to other asset classes, is to some extent undermined. So we have to look at the next sort of derivative of currency management, which is the generation of alpha and the way alpha is generated within the currency markets, which is uncorrelated with the way alpha is generated in other markets. When the active currency manager wants to move out of the carry trade and into a trend following strategy or another style because they see risk increasing; that exactly is what the other hedge fund managers and other asset managers want to do, as they want to move out of equities and into bonds at the same time.
If they are looking at the same information, then that correlation of alpha starts to come back as well. So it becomes more difficult to argue for it and that may be a good argument for a broader global macro strategy.
Miller: What has been unusual is that there was a prolonged quiet period before things blew up, when things were more stable and quantitative managers were able to build models and find factors that worked for a while, and discretionary managers often seemed to struggle in those conditions. Discretionary managers might have the edge if we are now going through a regime shift. We have had regime shifts before and if this is another one, the industry will have to adapt to a new reality.
Siragusano: I completely agree with the regime shift: central bank interventions became ‘socially accepted’ and fundamentally de-couple the movement of the exchange rate from free market behaviour and therewith change the way you can trade the currency.
A Tobin tax or something similar will do the same. We aim to react on that systematically. We need to identify when is the point of change and do we need to change our models or is there a complete shift that some currency pairs are not tradable anymore as it happened with the CHF in September.
Miller: Shall we move on to the economic climate. We have talked about various things, including the Tobin tax and currency interventions and so on. So how can investors take advantage of all this?
Siragusano: What we see is that people try to diversify out of the eurozone and to invest in different currency pairs. This is investors’ reaction to the economic climate. But this brings some additional risks. We have learnt currency is a diversifier but also an additional risk that is different from the underlying asset, e.g. overseas equity so people need good currency managers. I think it is more obvious that you need specialised managers for different types of risk.
Miller: We have been pushing the idea of hedging the currency risk that comes with overseas equities and other overseas investments for many years. Investors often think that overseas currency exposure provides diversification, so we explain how it usually increases risk instead and that hedging the overseas currency exposure can reduce the volatility of these invest-ments, and hence reduce the overall risk as well.
Siragusano: But then very often currency management becomes overlay management, and therewith becomes risk management and not anymore purely alpha seeking. Using a dynamic hedging approach opens the door for alpha against your benchmark over time. However our objective is to manage currency risk systematically.
Roberts: The objective of that kind of programme is to minimise risk, so you should review your strategic policy periodically, but what you don’t want to do is just replace investment or currency risk with counterparty credit risk and actually at the moment, there is a reasonably significant chance that is exactly what you are doing. If you look at a lot of the currency hedging agreements that are in place between asset managers and counterparties, they just haven’t been satisfactory. There has been work done over the last few years to improve that, but I still think there is a lot to do.
Shilling: I think it is very important to manage your counterparty risk properly, but there is a kind of logical aspect to look at as well. You are not actually replacing your currency risk with counterparty risk if you put a hedging programme in place.
The reason is when you undertake a hedge with a counterparty, you are only exposed to the profit of that hedge. If the hedge goes into loss, then you are not really worried about your counterparty exposure because you owe them money, you are only concerned when you are making a profit.
Tikhonov: Perhaps another item, as counterparty risk is so important, is the collateral management. A two-way margining is becoming a market standard for over the counter transactions for prime brokerage relationships. One should also consider the implicit cost of hedging: how much does it cost to run a currency hedging in terms of interest rate differentials that could be paid or received.
Miller: Clearly if you are going to put in a hedging strategy you have got to look at all these operational issues. Some managers talk about avoiding counterparty risk using currency futures. Does that help?
Siragusano: You have a cashflow risk on a daily basis requiring higher cash amounts because you settle p/l-swings of your position daily. If we use one or three months OTC-forwards your cash settlement is reduced accordingly. We see currency futures trading as a possible option, but still the highest liquidity is in the OTC market. Furthermore, you have the volume flexibility of the OTC contracts to do an optimal hedging of the underlying portfolio.
Miller: The other area to talk about is the euro. You can try and diversify away from the euro because you are worrying about what is going on, but if your client benchmark is still euro denominated, that seems to be taking on another risk?
Siragusano: That is the reason why they are trying to use currency overlay manager to have a real tracking area for their euro benchmarks and their liability and that is the reason why we know German or eurozone pension funds will have a large diversification account without managing this risk. But there is no doubt that it really makes sense to diversify. But it only makes sense if you are looking and not passively hedging the currency in the foreign exchange currency pairs because then of course the diver-sification effect is zero and that is a reason why a lot of people will use their own active hedged benchmark approach to a low tracking error, to have a positive performance impact on their pension fund.
Shilling: I think we have to be careful when we are talking about a hedging mandate as well as an active hedging mandate. We have to be careful about the alpha word, because alpha is about looking for opportunities to take risk to make money and active hedging is about managing the pre-existing risk and primarily to manage the tail risk that is there already. If you start thinking about that added value as alpha, then you start arguing for relaxing the constraints of hedging and allowing new risks to be taken and all of that activity belongs in the separate alpha space. So with active hedging you have to be careful because you are not going out to take new risk to generate alpha.
Siragusano: The measurement of the effectiveness of the actual hedge can be done by looking at the tracking error which is the more traditional way as you rightly say. It doesn’t always give you the complete picture. Another way of looking at it is by considering what is the extent of the currency movement in the underlying exposures and how much of this movement has been compensated by having a hedge in place.
Roberts: I struggle to see how this isn’t alpha. I think that if you assume that the currency manager is skilled and takes a position away from the strategic benchmark, then there is almost as much likelihood that that position is likely to go wrong as it is to go right.
Shilling: If you have a fully hedged benchmark and your base currency is strong, then the currency manager will not add any value, because the best thing to do is to be fully hedged. That means you have a benchmark, and within a hedging mandate you can’t increase the hedge beyond that and you can’t take on other currency exposure that doesn’t already exist. So you won’t add value against the benchmark, you will probably underperform the benchmark, because you undertake some activity, and there will be some costs in maintaining the hedge, but the client may be very happy. But if he is thinking of it as an alpha strategy of course, he would have to be unhappy because you haven’t generated any alpha, but that wasn’t actually the objective.
I do agree that an actual programme does want to add value and I think you want to take it over a sufficient timescale that you have had the opportunity against an extreme benchmark. So there is an objective certainly to add value – but it isn’t the only objective. I think that just managing the tail risk and what we rather technically say is reshaping the distribution of return is in itself a benefit. By reducing the downside, and leaving some of the upside, even if the mean stays at zero, that is still a better profile of return, even if it doesn’t add value. And in fact if you look at the world at large, people will pay money for that. People will buy insurance. They don’t expect to make money out of it, but they understand they are getting rid of the tail risk and therefore they have a better profile, so they will actually pay for it. They accept negative expected return. What we are trying to do in currency is to produce that insurance, but also have a positive expectation, so it is a double benefit.
Miller: It is hard enough with a broadly based currency strategy to generate alpha (or to add value) consistently. So when you start narrowing it down, there is an opportunity cost. There is a risk when you have got such a narrow investment set that it becomes that much harder to add value, to get those positions on average right because you have got fewer chances to take decisions. It looks like this debate is going to run and run. What about the euro, is it going to shatter; how are you preparing in case it does collapse?
Roberts: There has not really been any change in our advice to sterling based clients. Minimise risk through currency hedging has applied still. If you are a euro based client, there hasn’t really been any change either, although in all honesty we don’t get asked by many Greek pension funds. If a Greek pension fund did come to us and say ‘how would you advise us to hedge our currency currently?’, then that would be quite a difficult question to answer, because there must be a probability that something happens with the Greek participation in the euro and you might have to attribute something to that in your risk management.
Tikhonov: Probably another question, more a technical than a philosophical one, is when we are transacting in currency pairs where one of the currencies is the euro, if the eurozone changes its shape or the format, what is going to happen to the contracts that are outstanding at that moment in time? Probably there are two questions to consider – firstly who is the counterparty to this transaction, and secondly, if the eurozone were to change its shape, what would be the obligation on the contracts already outstanding. We have been thinking about the idea that perhaps, one way of removing part of the uncertainty would be to introduce contracts where the obligation is to deliver the euros or the legal currency of a particular country. If you are dealing on behalf of a German client, you are transacting the euro, and by the euro you mean, either the European currency or the legal currency of Germany in case the eurozone changes.
Shilling: How do you define at what exchange rate you have contracted at if that currency as yet doesn’t exist?
Tikhonov: You don’t need to define the exchange rate at the outset, because the exchange rate will only be defined when the euro changes its format, but you have in fact defined the legal obligation. As I said, it only partly removes the uncertainty.
Roberts: And I think that brings up the topic of contingency as well which is interesting. The euro is purposely designed without a contingency for it to fail because if there was a contingency for it to fail, then everyone would divert to that in an attempt to avoid trouble.
If you do build in contingencies, then you run the risk of people relying on those contingencies and using them if necessary. Also, the more people that talk about the euro, the more people have these kind of discussions, the more likely it is we will have some kind of euro change. I think there are obviously a couple of extreme outcomes where you either have a complete breakup in one form or another; or if you want a sustainable euro as it currently stands, then you need proper fiscal and political union. That is extremely difficult to predict.
Shilling: You could see how the euro could cease to exist if the reverse of the process that formed it was put in place. So you would have all those currencies, and you would have an exchange rate at which each would be converted. That process could in theory be reversed. And for everybody that holds a euro, they would get in return a certain number of Deutschmarks, Drachmas etc. You could also see how it be replaced by a new euro and peripheral currencies. So in return for your euro, you would get a certain number of new euros and a certain number of Drachmas. So you could see how those major changes could be managed in the same way that the euro was created. And that may not be a catastrophic event.
Siragusano: What we are more looking at are technical issues. What happens with the contracts, ISDA agreements and so on. We really have to look at the technical side, for example collateral management. But up to now, we do not think the split of the euro is a highly probable scenario, although I agree it won’t be a thing from one day to the other. There will be a structured process like the intro-duction of the euro and it will be done in a very smooth way. Nevertheless, the political impact has some impact on the euro and how it behaves to other currencies, e.g. the USD. This is something that is much more interesting for us. Look at the behaviour of the exchange rate EUR/USD: it has changed, making us to take steps and change our philosophy by diversifying into emerging market currency pairs which will substitute the high por-tion of EUR/USD.
We are bringing emerging markets currencies into our currency overlay programmes to reduce the risk of being EUR/USD sensitive. And this is something that we as currency managers have to deal with: reduce the Euro/US dollar or Euro/Yen importance and diversify over currencies not effected by the eurozone.
Shilling: I think there is a case where for most developed market currencies we would say that this would be another situation that needs to be managed, but I think you can make a case for the emerging market and that there is an expectation these markets will grow and the wealth will be generated there and that will be reflected in the currencies. So there is an argument again for not hedging emerging market currency risk and taking it as part of your portfolio.
But we would say that within that emerging market currency exposure, there is a dollar component. And maybe you should strip out and hedge the dollar component but leave what you might call the pure emerging market growth opportunity unhedged.
Tikhonov: We produced an analysis to demonstrate how much of the return generated by exposure to the emerging market equities is contributed by the currency element. There is an emerging equity market appreciation, but about a half of the return over the long term comes from currency appreciation. Now, if you are exposed to emerging market equity, the most typical way of doing so is to buy some kind of recognised index. Then if you look at the index composition it will be dominated by the countries with established local equities markets and exposure to certain countries is very small. Generally we think that keeping emerging market currency exposure unhedged is a good idea, but perhaps another good idea is to re-weight allocations to different currencies. You cannot change exposure to equity markets just because you are holding an index, but you can put an overlay programme that reduces exposure to the countries that dominate equity index and increase exposure to underrepresented currencies. By doing so, you will achieve a much more balanced exposure to both emerging market equities and currencies, which bring a substantial amount of the overall return.
Roberts: I think there are a couple of risks to highlight. The first one would be a period of over-boughtness or technical pressure in the market where some of the those emerging market currencies appear expensive, and the second one goes back to the eurozone, which is that a number of the emerging markets are reliant to some extent on funding from some banks in the eurozone and so if you were to get those, hopefully small, probability events where you do get complete chaos in the eurozone, and that there are some serious issues with some of the banks, that could impact on the emerging market economies and you end up with a more global issue that just Europe. Now some of the emerging market economies are more reliant on those types of institutions than others and so that is why I would say that having a diversified exposure to a emerging currencies is important so you might get some of those impacts at certain points in the future but if you are diversified then that is reduced.
Miller: It is interesting that many managers are expanding their investment universe to include emerging markets. Obviously, it gives them a whole new opportunity set. They do have to be careful about liquidity, but developed markets can have liquidity problems as well, as you know. New Zealand is a particular case in point.
Siragusano: For us emerging markets currencies are became much more favourable. Liquidity is good and gets better quickly. Especially for Equant, with its high trading frequency, increases it. Transaction costs decrease, which was in the past five to 10 years a reason why we said no, it is not possible for us with our approach to manage emerging currencies profitable. For an absolute return product being benchmarked against a total return benchmark we don’t hear clients saying “I don’t like it”. They want to have the return from emerging currencies and so we increase our emerging market quotas to deliver them higher diversification.
Miller: Are there any last points that anyone wants to make?
Shilling: We haven’t talked about the regulatory changes which are pretty important because there is a real risk that trading in currencies is going to become much more expensive and much more onerous. And that makes even passive currency management a lot more expensive and I know a number of us have been campaigning actively against some of the effects that this would have, particularly on the pension funds and other investors.
Miller: The other area that I am concerned about is the level of fees. One of the things we would like to see is a more sensible approach to fees so that managers charge fees that are more in line with the returns being generated.
Siragusano: Looking from Germany, looking from the investor’s point of view, they are willing to pay for currency managers something like they pay for a fixed income manager. This is how they look at it, like it is similar to a fixed income investment, and therefore we don’t have this debate about hedge funds style fees. We have more income orientated fees although I would love to have hedge fund fees. Nevertheless, it isn’t possible in continental Europe or Germany.
Shilling: There might also be a move in the other direction, not so much for alpha strategies, but I think there will be a realisation that services such as passive hedging cannot be provided for free, it never was free, and now that is going to become much more explicit. So there will be fees for that kind of activity, and that kind of activity will provide a baseline for all currency managers, and active management will have to justify a higher fee on top of that base, which is no longer zero.
Chair: Diane Miller, Principal, Mercer
Diane is a member of Mercer’s Alternatives Boutique, a unit within Mercer’s investment consulting business, and is lead researcher for active currency. Her responsibilities also include researching strategies from other product groups, in particular global macro and CTAs. Diane joined Mercer in 2001 and is based in London. She has over 25 years of experience within the pensions and investment industry. Before joining Mercer, she was at Morley and its predecessor companies, General Accident and Provident Mutual, where she worked as a fund manager, specialising in UK equities and asset allocation for pension fund clients. Diane has a degree in mathematics from University College London, and is a Fellow of the Institute of Actuaries.
Matthew Roberts, Senior Investment Consultant, Towers Watson
Matthew joined Towers Watson (then known as Watson Wyatt) in 2005 having graduated at Bristol University with a BSc in Economics and Finance. Within Towers Watson, Matthew is a Senior Investment Consultant in the Manager Research team and leads the multi asset diversified growth and multi strategy hedge fund research teams. The multi strategy hedge fund research team covers a wide variety of different strategies including systematic macro, active currency, event driven, broad multi strategy and some alternative beta hedge fund ideas. He is responsible for driving the research agenda and concluding on manager decisions in those asset classes.
Mike Shilling, Chief Executive Officer, Pareto Investment Management
Mike joined Pareto in September 1998 as Director, Portfolio Services. In this role he took responsibility for client service and day-to-day delivery of all Pareto’s products. Having spent some time in Pareto’s New York office, Mike returned to London to assume the position of Chief Executive Officer in October 2004.
Tindaro Siragusano, Head of Asset Management, Berenberg Bank
Tindaro joined Berenberg Bank in 2006 and has headed the Asset Management business unit since February 2009. In this role, he is responsible for the development of innovative overlay and investment solutions for professional investors. In October 2011, he additionally assumed leadership of the Private Asset Management department and thus overall responsibility for the management of institutional and private assets. Siragusano has more than 15 years experience in the Asset Management industry. He holds a master’s degree in quantitative finance from the Frankfurt School of Finance & Management (formerly known as Hochschule für Bankwirtschaft), a leading private business school based in Frankfurt, focusing on financial mathematics and financial engineering, and was active in various positions at HypoVereinsbank in Munich. In 1999 he developed a quantitative trading trading model for currency management, which was awarded with the Paul Julius Reuter Innovation Award in 2002.
Dmitri Tikhonov, Director – Head of Portfolio Management, Record Currency Management
Dmitri Tikhonov joined Record Currency Management in July 2002, straight after his MBA programme at University of Cambridge (Judge Business School). His responsibilities initially included research and development of investment processes. In October 2006 he was appointed a Director and is now Head of Portfolio Management responsible for the day-to-day management of existing portfolios. He has been awarded a CFA charter in 2005. Prior to his MBA programme, Dmitri was awarded a PhD in mathematical modelling and worked for Austrian Airlines being responsible for business development in the Russian market.