Challenging times

European Pensions currency roundtable

Chair: Malcolm Leigh, principal, Mercer
Alex Koriath, Director, Head of Manager Research, Investment Advisory, KPMG
Bill Dale, Chairman and CEO, Cürex Group
Gary Klopfenstein, CIO, Mesirow Financial
Klaus Paesler, Head of Currency & Overlay Strategy, Russell Investments EMEA
Roubesh Adaya, Senior Associate, bfinance
Tindaro Siragusano, Head of Private Banking & Asset Management, Berenberg Bank

Chair: On the face of it the current variability of economic environment should be great for currency managers. When there are differences in the phasing of economic cycles, then that would tend to create opportunity amongst the currencies that could be exploited. So given that environment, what do you see as having been the main challenges faced by currency managers over the past 12 months?

Siragusano: From my point of view the last 12 months could go as the last 24 months, with currency markets driven by political decisions. Then what we were seeing was more demand for emerging markets (EM) currency programmes. After the eurocrisis a lot of investors, especially institutional investors, tried to diversify their currency holdings by investing abroad. Especially for example in Germany where normally they were quite heavily invested in the euro, but now they try to diversify and now they get a little bit of the negative side of diversification. They bear some additional risk, like currency risk.

Klopfenstein: One of the interesting things, about a year ago now, was a move away from the risk-on risk-off world that we had seen prior to that. I think we’re out of the pure risk aversion paradigm, we’re more into one where currencies are being revalued according to some of their fundamental drivers, which I think is a good thing. Offsetting that is the overall pressure that we see from monetary policy keeping volatility down, and this doesn’t create the broader oppor-tunities going forward. When that pressure is lifted, there should be quite a bit of market movement.

Adaya: We have seen over the last 12 to 24 months a certain need for managers to adapt quite fast to changing market conditions. After the crisis, most central banks engaged in accommodative monetary policies, which brought interest rates and interest rate differentials across economies to very low levels. As a result, currency managers were less able to rely on carry-type of strategies to generate returns and focused more on trend-following and other momentum strategies. The importance of being able to adapt to changing market conditions was further emphasised by the fact that a few specialist currency managers disappeared from the market place, while a number of asset management houses closed down their FX business or limited the risk budget allocated to FX within their portfolios.

Paesler: The active currency management aspect of it has been a very strong challenge, especially with the interest rate differentials in developed markets being very small. We’ve seen a lot more requests for information on the passive side rather than on the active side. And then the question that remains is: what hedge ratio should be used? We have had a lot of discussions recently with clients about wanting to take all of the currency risk off the table and go for a 100 per cent hedge.

Koriath: For the industry it has been particularly difficult. Political risk has been material, particular interventions, so very hard to time, very hard to get right if you’re in the active space - if not impossible to get right. I think that the interest rate based systematic carry strategy has been absolutely destroyed, people have been waking up to that. Overall I think the industry is moving towards a more passive approach.

Dale: I’m certainly echoing the move towards passive. Diversifi-cation can actually dampen a significant amount of volatility that really does pull of the carry trade from time to time, especially with leverage on it. I think this is an evolution for currency managers that can adopt passive and active strategies and move in and out of these strategies.

Determining the hedge ratio
Chair: Going back to Klaus’ [Paesler] point, adjusting the hedge ratio is an open issue for lots of people. There are two question marks: one is when should you hedge, since ideally it would be when your base currency is extremely undervalued but delaying the decision incurs risk and so depends on your risk appetite, and the second is how to decide how much of it to hedge.

Klopfenstein: There are a few things that really point towards a need to make an active decision around the hedge ratio. One of them is you have to have a significant exposure to currency. What we tend to see on a global basis, those currencies that are near extremes tend to be where you see a shift from passive to active risk management. We’re not talking about going out and generating alpha, I’m talking about working through the portfolio, and asking what are the exposures in there, and do we want to be more hedged or less hedged? We’re starting to see the trend of having specialist managers make the tactical call once that strategic point of neutrality has been established, which is in my mind the definition of outsourced currency risk management.

Siragusano: Many of our clients have the 50 per cent hedge bench-mark. It is the optimum, but what is the reason for that? After lots of discussions I think it’s 50 per cent because you really don’t know what the optimal hedge ratio is. With 50 per cent you perhaps have the feeling that you’re not doing something wrong. We challenge this 50 per cent hedge ratio which a lot of passive mandates have in place. Perhaps it is a good starting point as a benchmark for active management and then to deviate the hedge ratio depending on market movements. More and more investors demand this time of dynamic currency management focusing more on the risk side. So our goal is to always have the optimal hedge ratio in place and not necessarily to generate a market neutral alpha performance. This is the big shift away from alpha to more risk management side.

Koriath: What do your clients end up in then? Do you move them away from the 50 per cent? How do you determine that?

Siragusano: We determine this with our quantitative model frame-work that generates signals for each currency pair and the starting point is 50 per cent. The clients have the flexibility to restrict the overlay by giving us a maximum or minimum hedge ratio, e.g. 25 to 75 per cent or leave the overlay unrestricted between 0-100 per cent. And then it’s changed depending on the market movements. A purely trend-following strategy.

Paesler: I agree that 50 per cent tends to be the standard and it’s really down to regret risk. As you say, it’s one extreme or the other: 100 to zero. Go 50 per cent and then you reduce your regret risk. However, you mentioned a lot about benchmark and I think that’s an interesting thing that’s happening a lot with currency. We’ve done a lot of research on what should drive a currency benchmark and for most of what we’ve seen, it’s carry, trend and momentum, but how do you weigh those drivers? So in essence what we’re saying is, don’t necessarily have your currency weights driven by your equity weights. Rather look at what’s driving the currency market and that should be your passive benchmark, rather than focusing specifically on the hedge ratio.

Klopfenstein: We tend to have a little bit of a different view on that. Generally we find there’s a couple of different ways our clients look at it. One is on an asset class by asset class basis, so they pick a different hedge ratio for each asset class. So it’s almost a waterfall effect by asset class, and then by total currency view. At the end of it, it’s what’s your residual currency risk that is important, because you could end up with a very different outcome than what you would expect if you take a strictly asset class view. But the point Tindaro [Siragusano] was getting to is that, whatever you start with, you can then actively position to be more or less hedged. I like your concept, and clients think about this the same way. Many times the currency component of your investment is a by-product of your asset allocation decision as opposed to the intended currency exposure.

Dale: We talk a lot about hedging, always getting out of foreign currencies and coming back to your local, but what about your local currency? We’ve seen interest in a very passive strategy, in the sense of just an equal weighting of currencies, as an absolute beta comparison against which all of these decisions can be measured. Going back to what our clients’ objectives are, we have portions of our capital there for capital preservation, we have some that are there for inflation protection. One of the by-products of currency management that we shouldn’t lose sight of is the fact that when you’re moving out of your local currency, you’re in many ways creating inflation protection for yourself in case of a local currency. And it can create a really interesting manner in which you can actually create coincident inflation hedges in your portfolio with the use of active currency management as opposed to just looking for tips or other sorts of currency-linked investments.

Siragusano: A further question to this is if you have active equity managers and they start to change countries, what should your currency programme work on, on which allocation? The benchmark allocation of your equity investment or on the real exposure allocated by your equity managers? It’s a question on the approach of the active equity manager, is he also looking at currency performance and against which benchmark is he performing? Is the currency investment itself the main driver of investments, like emerging markets, or is it just a by-product, like with hedge fund investment or private equity investment.

Paesler: The overlays we put in place, we look at it manager by manager to make that determination: do we hedge the benchmark or do you hedge out the actual currency exposures? It really comes down to what the individual managers are doing their research on. So you really have to dig in to the managers themselves and see what goes into their research and their stock picking.

Siragusano: That’s the reason why every overlay management is very individual. There is no standard solution for currency overlay, because you have to take everything into consideration. The asset allocation process of the client, the manager’s selection criteria and is your manager benchmarked against S&P500 or benchmarked against in sterling denominated MSCI North America, where you have to take consideration of the US dollar-sterling development.

Chair: Do you agree that when we advise clients, we should be looking at currency exposure in a more general perspective, taking account of the broader portfolio and objectives?

Adaya: It raises some interesting questions, especially on where currency management should sit within the investment framework of each client. If each manager selected by the client performs active currency management, and has currency exposure that varies significantly from their benchmark, it is not simple for the client to include a currency overlay in their programme. Furthermore, I would like to stress that unlike other asset classes, currencies are pretty much a zero-sum game. A currency will always gain or lose relative to another currency. As a result, the long-term appreciation of the ‘asset class’ is pretty much zero. It is important to make sure that you are actively positioned to not only achieve good performance, but to be able to attain a reduction in volatility compared to the client’s unhedged portfolio. As portfolios become more customised, currency overlays become more difficult to implement. This raises the question: is it worth having an interest rate overlay programme across the broad structure of the client’s assets, or is it better to actually leave diversification to play, and allow selected managers within that asset allocation programme to run their own active currency exposure?

Dale: I think it’s a choice. I think it comes down to how you want to view currency. I think there’s an appreciation of the isolation of currency, what it can add in terms of portfolio advantages. For many passive investors and even active investors, currency sits there as a passive component of the portfolio. And I think there’s a choice of whether one wants to remove that currency and capture some of the carry that is inherent. What we find quite interesting is when you equally weigh across a very broad section of currencies, it dampens volatility tremendously. But you have to capture carry, because you construct to pick up the yield in currencies you wouldn’t normally have exposure to or wouldn’t certainly overweigh on any sort of a market cap basis. So currency I’ve always felt is this amazing pick up in beta, it’s just additional pennies far away from the steam roller, because it’s an additional yield that you can start to add into these asset classes but it does take an approach and it does take a decision.

Koriath: It’s probably intellectually very sound. But I think what happens in practice is much more blunt. In practice there is often a 50 per cent hedge ratio used or some other crude hedge ratio. And very often EM exposures in particular aren’t hedged. They aren’t hedged because A) it’s costly, no one offers it as a reasonable price, and B) there’s the prospect of or the hope that EM currency goes up. It hasn’t worked for the last couple of years, but maybe it will.

Klopfenstein: We see very specific hedge ratio discussions based on what is in the underlying asset mix. We do that on the passive portfolios all the time. I think it depends on the client’s objective. Understanding the details of the underlying assets is less important as active returns will overwhelm the nuanced variation of portfolios. On the active risk management you have to understand governance, and where your returns are going to come from. Active performance tends to dominate those decisions, in the sense that returns are generated by the active deviation from the benchmark as opposed to the selection of the benchmark itself. That being said, the benchmark selection should correctly and exactly reflect the client’s view of risk neutrality. The client needs to understand where their starting point is.

Dale: It’s a starting place from which you can add alpha and when we have these we can start to employ very common programmes of these and equities which is short the benchmark, long the active manager and finding ways to actually reduce volatility but present some of these types of returns. I think it opens up a whole new sphere of ways the market can embrace the ‘asset class’. And I call that asset class with parentheses, because I have this view that currencies attribute to all asset classes, so we have something to offer everyone, but at the same time when we get into these types of discussions we end up having very asset class-like discussions and I think that we have a lot to bring to this discussion around, taken from that point of view.

Active vs passive
Klopfenstein: I think there is a shift to managing risk in portfolios whether it is the active or passive portion and away from pure alpha.

Chair: I totally agree. But in some ways, managing risk by changing the hedge ratio is already what every active currency manager is doing, albeit usually in currencies individually rather than across the board.

Klopfenstein: The question there is, is it a strategic change, because we think that should reside with the client. If they want to change strategically what they’re doing, typically that decision is maybe once every year or two or three. Our job is to be active around that.

Chair: That raises a number of questions. How is the success of those tactical decisions going to be measured? Should it be performance against the strategic benchmark or are there other objectives such as volatility reduction or cash flow management? How do you make these decisions? Most ways of determining the strategic long-term currency exposure is based on variance or some other measure of risk or liquidity or growth views. But for the tactical rebalancing, the key thing for me is defining its objective. We’ve mentioned here, on occasion in the same breath, reducing volatility and adding alpha. Reducing risk and adding value do not normally go together. Do you really believe that this is the case, that you can both reduce risk and increase returns as well?

Paesler: Yes, you can do it passively, but you can also get in essence active returns out of it, just like you would by using smart beta strategies in equities.

Koriath: I don’t buy it unfortunately. I don’t buy it at all. I think it is very difficult to achieve two objectives of adding alpha and reducing risk at the same time. And a couple of strategies that sound quite similar to what you’ve just described have performed horribly over the last six years. There were a number of these strategies that were popular with UK pension funds that performed very poorly, and a couple were semi-passive strategies that didn’t work very well. I think to evaluate these, it comes back to this: how long does it work with small gains? I think you have to look at this over a long period of time, and see whether they are really robust, because strategies can work quite well for quite a number of years and then go sensationally wrong. I think it’s very dangerous to just give a very short history and people can make the mistake of looking at a too short history of strategies that look en vogue and quite nice now, for the last two, three years or for the last four years, but haven’t been tested through several cycles. Some strategies in this space were not hedging at all anymore, they were actually risk increasing, tremendously increasing risk on the downside through a skew with many small positive returns but some huge negative returns.

Siragusano: Yes, and that’s why it is really important to look at how the strategy behaves and what the investment strategy itself is doing. On the risk side against a 50 per cent hedge benchmark I’m extremely confident that even a simply structured currency overlay programme will reduce risk.

Adaya: As an active manager, you should predominantly look at reducing the risk of an unhedged portfolio. That’s principally what you’re looking to achieve. We do believe that any incremental performance you get on top is a bonus.

Dale: It’s a very good point. When we look at this as an asset class in isolation, the drawdowns I agree can be dramatic. But what we need to remember is that FX, I’ve never met anyone in my career that has 100 per cent FX in their portfolio. The drawdowns that are happening in currency are also in the equity portfolio, are also in the bond portfolio. So the question is, are you creating some diversification, some dampening, and I think that speaks to, again a layer of diversification which in itself is a very passive strategy to have, but requires a lot of action to actually keep you diversified. You end up undiversified pretty quick if you don’t do anything. I think it’s a very interesting point: can you add alpha with a reduced risk and add return? I think you have to answer that question in the context of your entire portfolio.

Klopfenstein: That’s the whole point of currency overlay. All our clients we’re talking about have equities. We manage the inherent risk of currency that is imbedded in global equities, that’s what we do.

Dale: Exactly, and that’s a conversation that needs to expand more broadly. But it’s inherent. I think we have to keep that in focus more.

Klopfenstein: If you have currencies imbedded in your equity portfolio or bond portfolio or whatever it happens to be, you’re taking risk, because currency is risk to that, without any expected return. So as a rational investor why would you do that? And if you’re able to successfully and actively manage that, you should be able to reduce risk at the same time. As a by-product of that, there will be some alpha that comes through.

Chair: I tend to be sceptical about the ability to reduce risk and add alpha. I think if you have a benchmark, it’s simpler, if you define risk by tracking error, to reduce risk completely. You go a benchmark and stay there, because every time you step away from the benchmark, you’re taking an active risk.

Klopfenstein: It depends on what your benchmark is. We’ve been talking about your benchmark with unhedged currency. What’s does risk reduction look like versus a 50 per cent hedge? I would find it generally difficult to reduce volatility of returns to currency against a 50 per cent benchmark actively. I think you can reduce the downside risk, but that’s different than what you’re talking about doing. You’re adding an active decision process to a benchmark, when you do that, you increase active risk.

Chair: Would you say that that’s an indication that the benchmark is not well constructed? A correlation between the currency and the underlying assets, which you’re dealing with on a tactical basic, should instead be dealt with on a strategic basis.

Paesler: I think the big question is what is a passive currency mandate, what is a currency benchmark? We’re not suggesting someone should either be in currencies or should not be in currencies, but if you’re going to be in currencies do it deliberately and invest in those currencies that describe the currency market. I think you were saying, one of the things that’s critical is the manager’s expertise, not only in investing in currencies as part of their research, as part of their chosen securities, but how they invest in currencies.

Siragusano: That’s a very good point, because we’ve got two goals as a currency manager. Not only determining the best current hedge ratio, but also to ensure a best execution process to reduce transaction costs.

Adaya: Currency has been slammed for contributing little in terms of performance for a number of clients. However, I believe there is room to add value through currency management. When you look at fixed income managers for example, currency is often used as a source of alpha and allocated a risk budget in most of their portfolios. What I do not agree with is the constant use of carry strategies to which high risk budgets are allocated, irrespective of the market condition. Scaling up your risk to take advantage of lesser opportunities within carry strategies, for instance, is not a wise choice. Some trades are likely to work better in some economic environment and other trades are likely to perform better on a risk-adjusted basis in other instances. In the last few years for instance, the risk-on risk-off environment was a good example; if the manager focused more on trend-following strategies than on carry strategies, he would either be long the USD or to EM currencies, rather than just being overweight to countries/currencies with positive interest rate differentials. Adopting the right strategy, or using the right models, at the right time and according to specific market conditions has been key to how successful a manager has been. At the moment, we are seeing investors coming back to carry strategies. Forward guidance by central banks as well as a possible decoupling of monetary policies across countries has meant that the correlation between the expected interest rate differential and the valuation of a currency pair has increased, rendering carry strategies attractive again. From an investor’s perspective, this brings up the question of how to add value with a currency overlay programme, especially if the underlying managers of the client’s overall portfolio are taking active positions on the currency markets? How do you actually monitor all of this, and try to add value without significant ongoing knowledge of the client’s underlying currency exposure?

Dale: I think you always have to look at those types of comments in the context of the time horizon of your investment. The reality is that there’s very few of us that are going to be zero-sum game over our lifetime. We’re either going to be positive or negative effects by currency, that’s something you have to pay attention to.

Koriath: A lot of our clients are in the pension fund space and they are long-term investors. For pension funds it’s more about avoiding permanent loss or permanent impairment of capital. The interim volatility in theory you can ride out, if you are a 30-40 year investor, you should be investing for the long term. Are you not then just paying commissions, trading costs, investing fees to overlay managers?

Paesler: I would agree. I wish more of the industry would look at it that way, but in fact, you have to report to the trustees quarterly, annually, etc. And if they see a 5 per cent drop in the value of the assets due to currency movements, they’re going to have a lot of explaining to do. Whether in the end that’s going to revert itself in the next year or two, unfortunately those that are going to see the reports are going to take issue with that.

Emerging markets
Dale: I think you tapped on something I believe strongly in as well, and that is a look to the emerging markets. Even in some cases frontier markets. Not necessarily what’s in everyone’s portfolio but when you have a very long-term time horizon, you can ride out significant volatility. I think there is some fundamental about capital being injected into economies where they don’t have the monetary policy to handle the infusion of capital that net results are an appreciation of a currency, it’s obviously difficult for those countries to deal with those appreciations in currencies but they have them nonetheless.

Chair: How would you all recommend playing the emerging markets?

Paesler: Generally, how we see people do it is you hedge developed and you leave the emerging markets unhedged. In that sense practically it’s still better to do that portion unhedged. If you want to have some currency exposure and you don’t just want to remove 100 per cent of all currency risk, it is probably at least operationally easier to leave the EM unhedged because of the costs, the spreads, the operational difficulties around that. That said, that is changing. For example, in China it’s becoming a bit easier to trade now.

Siragusano: Of course our recommendation is benchmark with EM of course unhedged. Because the benchmark decision determines the sensitivity of the currency overlay programme. With an unhedged benchmark, our currency overlay programme is more fat-tail protection instead of continuous dynamic hedging starting at 50 per cent. So at the very end, the other alternative is to be long EM and to buy a put option on the EM. But we all know it’s quite expensive, implied volatilities are quite high and if there’s a better solution to have this asymmetric fat tail or shortfall event hedging style and dynamic hedging instead of buying a put option then this is something that is quite interesting and perhaps delivers the possibility to let investors participate in the appreciation of the EM.

Adaya: Leaving your exposure to emerging markets unhedged, without active monitoring, is a risk. Quantitative models have not tended to work so well in emerging markets historically. We believe the exposure to EM currencies should be left to a manager who is able to take judgmental positions based on the fundamentals of such countries. Often, managers in emerging market debt or equity may take an active position through both a bond/equity trade and a currency trade, with one leg acting as a hedge for instance. With the assumption that the manager has had experience managing EM currency, we tend to believe that the management of EM FX should best be left to the manager of the underlying asset class, be it EM bonds or EM equity.

Klopfenstein: A couple of years ago, five or seven years ago for sure, very few people would even consider actively managing EM currency risk. Today we see a lot more hedging of emerging market currency risk, so it’s becoming more common place.

Koriath: Do you see costs coming down for EM currency trading?

Dale: In the long term I think we’re going to go through a transition. The market is going to learn to adapt to a new world. There are very few true liquidity providers in non-deliverable markets who had to take real risk. These aren’t guys who can lay off the risks in five seconds, they hold the position for weeks. You actually have relatively few real liquidity providers. There’s a lot of decisions that need to be made and people are going to make mistakes, they’re going to learn about the new market place that they’re moving into. Ultimately that will lead to more transparency, but what will have to happen is, we’re going to have to see in combination of an evolution of that market place, an evolution of the countries under which they are linking themselves to learn ways in which they can actually increase liquidity. Because ultimately this is an unsustainable path, it is a stepping stone in emerging markets’ evolution to an open and more mature monetary policy and these countries are growing so quickly now and they require the tools that are a bit more sophisticated. I think they’ll come quicker than they have in generations past. We live in a world where information is shared much more openly and where technology is much more freely available and where many of these countries are willing to trade, they’re willing to bring in new trading systems, new platforms that will create more transparency. I think there’s a great amount of hesitation and apprehension but also at the same time there’s a big stick behind them in terms of domestic inflation and a requirement to move into the new environment. I think the push towards electronic trading will eventually move this to more deliverable currencies.

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