Written by European Pensions team
Chairman: Malcolm Leigh - principal, Mercer
Bill Dale - chairman and CEO, Cürex Group
Arnaud Gérard, CFA - senior vice president, Europe & Middle, Pareto Investment Management
Karlheinz Muhr - chief executive officer, QFS Asset Management
Klaus Paesler - head of overlay portfolio management, implementation services – EMEA, Russell Investments
Dmitri Tikhonov - managing director and head of portfolio management, Record Currency Management
Chair: We have had several years of low interest rates, debt overhangs and poor GDP growth. There has been a lot of uncertainty and this is likely to continue. We have also seen political uncertainty and this seems to have come to a head this year. During those few years we have seen declines in active returns as well and question marks around whether currency is a good place
to go to add value. So looking back at the economic climate, what are the panel’s thoughts on the links between this situation and active currency returns?
Paesler: One of the things that we have seen that has affected the active management environment in terms of currencies is the recent drop in volatility over the last 12-18 months, especially in the currency market. Certain currency pairs of course are more volatile than others, but generally the combination of low volatility coupled with the fact there is in essence a race to the bottom for interest rates, is making the carry trade less attractive, and is making other active strategies on the currency much less attractive.
We have also seen a large move out of active currency strategies and more into passive or investors going completely unhedged. Then, with the uncertainty of the euro, we have a lot of people who want to hedge the euro completely and not take any position whatsoever due to the fact that it is just completely uncertain at this point. There are still the rumours that Greece could pull out; and we recently heard rumblings that Germany themselves could consider pulling out as well. So there is massive uncertainty with the euro which is not necessarily positive for the active business, but it is more taking risk off the table.
Muhr: You mentioned the volatility as one, but we see three components of the challenges of the currency markets. First we have the current stasis between on one hand low volatility, extensive liquidity provisions, near zero rates for years imposed in many ways by the ECB, the BoJ and the Fed. On the other hand there is this dramatic structural risk in opportunities posed by the enormous fiscal imbalances in these countries. So we have this battle royale basically: on the one hand these massive opportunities from a macro perspective, from a currency perspective going forward, but on the other hand you have it muzzled by decree, short rates anchored at zero. That is very challenging.
The next one would be these bouts of risk on and risk off. These huge swings make managing the global macro themes very challenging as well. And then thirdly, which has also affected the currency market, is what is happening at the long end of the curve, the massive interventions in the fixed income markets around the world by governments and central banks.
Dale: Karlheinz mentioned something that is very important for us all to remember, which is the effect of intervention that we are seeing in the marketplace. We are living in interesting times. We are seeing the evolution of emerging markets, rapidly turning into developed markets and we are seeing the evolution of developed markets into mature markets. One has to take a very large step to appreciate this transformational view of the world. The good news is that the currency management industry is in the best position to tell this story to the broader marketplace, because traditionally equity managers and even bond managers have tended to focus more on domestic regions and domestic markets, whereas currency markets by definition reflect an international marketplace.
We are also seeing sizable movement of capital toward yield. Yield is what the developed markets are starving for and they are now finding it in emerging markets. What typically comes with higher yield 2is higher sovereign risk as well as new types of risk and I am not sure everyone who invests in these markets understands what they are buying. But currency overlay and the currency industry itself is in a unique position to tell a new story to the institutional investment world; that yield can be generated from spot or forward currency exposure. In addition, how currency management can separate sovereign risk from related currency yield or currency generated yield through term certain and overnight carries. It is a very interesting opportunity but it creates new challenges. On how best to package and distribute the solutions. This trend is opening the door for the securitisation of currency and currency overlay solutions.
What is a tremendous opportunity for the currency overlay business to communicate to the institutional world is this idea of separating sovereign risk from underlying exposure and the way to port that into a yield story – not just an alpha story. Yield and access to yield and new ways to source yield will be a big theme which is there for the devel-oped markets to take advantage of because we have a new carry trade which is short developed nation, long emerging markets.
Gerard: All of us agree there is a lot of uncertainty at present but at the same time we observe that amazing development where volatility has returned to levels that were last seen back in ‘06 and ‘07 when everybody felt that everything was fine, central banks were considered to have done a good job, and so forth. The key explanatory factor behind the recent environment is that we have seen the convergence of monetary policy around the world.
Secondly, there has been the effect of stimulus - we have seen through various QE (unconventional monetary policy) operations, markets have been tamed in a fashion. A by-product is that, under that deluge of liquidity, many of the signals or indicators that were used across all styles of managers have become less reliable because of those inter-ventions or manipulations.
All these interventions, if anything, have heightened awareness to the risks that are out there, but the market’s fears have not quite been realised. So when I am listening about that quest for yield which is genuine and valid considering the challenges that all our clients and pension funds face, I am very worried that greed will overcome reality or consciousness. And it is not scaremongering. It is just that we have been there before, and we know what the impact has been. The question is, is the current market going to continue for another two years? Is there going to be a great depression for the next 30 years? Most people expect some pay-back in the future.
Dale: I have been in Asia probably five times in the last eight months and one of the things that always strikes me there is how developed their economies and infrastructure are becoming and how relatively underdeveloped their capital markets are in relation to their economies and infrastructure. It is very difficult to go into these cities and see the massive infrastructure that has been built and then to recognise that they have bond markets that barely generate enough volume to be of interest to a trading floor in New York. We can be sure that will change.
I expect the development of these nations’ capital markets will advance very quickly from here on because they have to. This isn’t a cyclical trend like days of old. This is a secular shift. From my perspective, those markets that are currently more centrally controlled are committing resources to make this happen.
But when volatility tends to spike, when the coil is released; is usually when you have liquidity issues, when money needs to move from point A to point B and finds little or no market. What I think is wonderful about currency overlay and unique about this market is that an illiquid day in an illiquid pair of an emerging market currency is still highly more liquid than the most liquid day of that corresponding nation’s bond market. And so it is important that as investors look into new markets and look into new capital markets for yield; that they look at where the markets are more developed in terms of their currency markets and the corresponding liquidity that comes with more flexible monetary policy. I think this is a story we can promote to the institutional investment community because we still have low investor capital commitment into this space relative to other asset classes.
But this theme does relate back to the fact that the world is changing. What we don’t know is what amount of discipline will be imposed in the future on these capital markets. These countries are receiving large amounts of capital and we just don’t know if they are going to be disciplined in the deployment of capital and the management of their domestic capital markets. They may end up being better disciplined with their capital than developed markets have been, learning from the mistakes of the developed world. We just don’t know and so we have a form of risk that will be hard to gauge in the years ahead. And that risk will translate eventually back into currency risk and the need for currency risk management as volatility starts to pick up.
Tikhonov: You mentioned, Bill, that the cost of transaction in the currency market is low. I would mention one other theme that I think shapes the background of currency markets. It is the change in the regulations that govern transactions in the currency markets and the uncertainty associated with those changes. Those changes have been driven by the United States and a similar type of framework will be implemented in Europe. However it is not clear exactly what will be the impact on transaction costs, although it is more likely than not that these costs will rise. However the word ‘opportunity’ was mentioned a number of times and because there are elevated levels of uncertainty associated with both the economic and regulatory background, we are now seeing a greater degree of innovation. This innovation is expressed in the appearance of single currency ETFs or basket currency ETFs, for example. This innovation is also expressed in the way that the banking community will try to facilitate transacting in the foreign exchange market that is relatively easy but with different risks associated with it. We can see prime brokerage offerings that are developing relatively quickly across the banking community.
We can see other innovations as well. There were some conversations, especially when there was a greater degree of uncertainty around the eurozone crisis, that perhaps the euro that represents economies of different countries could actually be considered as a combination of different currencies. Thus contracts that do not just stand for the euro as a single currency, but for the legal tender of a particular country were discussed and actually designed and offered by some banks. I think going forward that this ability to innovate in uncertain market conditions will present even more opportunities.
Muhr: I think the huge opportunity for currency - currency as an instrument, currency as an asset, whatever you call it – is its great liquidity. You made a good point that even in these more obscure regional markets currencies still have multiples of liquidity versus the local bond markets. Whatever view you have on a currency, at the end of the day you are long/short two countries. The way I try to position it to our clients when I explain what we do in running currency books is that we are long/short countries – there is long/short equities, there is long/short credit but investing in currencies, one expresses a long/short country view. And since you have tectonic plates rubbing against each other you will have these situations where for a long period of time the spring is coiling up until the energy will get released. Whether it is expressed via volatility or another path, that shock materialises, but expressing these views in currencies is so much more preferable than in equities because you can go long volatility in the currency market cheaper because you have no negative carry. This is a feature of the instrument [currency] that can be better utilised and it is still quite unexploited.
Paesler: I agree completely in terms of using it as an instrument. If you want to take a negative view on equities, you want to short, you have to have margin among other operational challenges. With currency, every currency pair has a long and a short embedded in the trade and with the amount of currency pairs that are available to trade, it is a very simplistic way, a cheap way, and an infrastructurally easy way to take long and short bets with whatever currency pairs you choose.
Chair: You mentioned earlier on that your clients were worried about hedging the euro for example, and Dmitri you mentioned that there is a question mark about what the euro represents. Is this something that your clients and you discuss?
Paesler: Yes. The problem is many of our clients are uncertain about the euro and they have come to us and said ‘we don’t know if it is going to be Greece and we don’t know if it is going to be Germany, the uncertainty around it is so difficult, what do we do?’ Well, even though volatility generally is relatively low, taking a put option or something of that nature to protect yourself on the downside is still incredibly expensive. The recommendation generally is that, if you are that afraid of it, then get out, because pure downside protection or insurance is still prohibitively expensive at this point.
Gerard: You need to ask, what makes a currency? Currency doesn’t exist out of thin air, currency has to be backed by economy, trades and financial markets and I think what has been a supporting element for the euro for the last few months or years is the fact that it is the second largest financial market in the world. You just can’t avoid it. Whether you call it euro minus or euro plus is irrelevant - what you are dealing with is a united group of financial markets and an economy of trades that people want to be part of. There are bumps along the way but until China (or others) completely opens up its markets and frees up its currency, Europe as a continent remains the second largest financial market. As long as that remains I think it will be very difficult to see the euro going down the drain. Whether it is the euro as we know it today, or euro minus some countries. And that is a big challenge that emerging markets are facing: to get to the next level of development and become less subject to speculative valuation, they need to open up.
Dale: Fifteen years ago we went through similar transitions in the commodities market. Fifteen years ago, to my mind, commodities were a hedging instrument. Today there is hardly anyone who doesn’t think of commodities as a section of their portfolio; an asset class. Currency will go through the same transition - and ironically I think it will be driven in this direction by regulation and by collective constraints on balance sheets.
We talk about innovation, but I think innovation needs to be checked, as innovation by itself can lead to systemic risks. Innovation that is small in its magnitude or has been built on previous, proven models is sustainable innovation and that is what we are focusing on. If you look at how commodities started to create ‘derivative’ instru-ments, it created new ways that risk could be managed. A market maker didn’t have to get ahead of a trade – he could now lay off his risk with a hedge using one of these new instruments. Those tools will become available for foreign exchange market making and it will create new intra-day volatility and the pendulum will start to swing again. When you have these tools you can consolidate your margins and draw new participants into liquidity provision.
One of the concerning things I see in terms of very recent developments is the fact that our regulation environment will likely become more fragmented globally. A year ago I was hopeful that we were going to see more homogenisation across borders which would have helped lower costs of migration. Now I think there will continue to be tremendous competition for capital and regulation will, at the end of the day, probably be used as a tool to draw capital into competing regions. But fragmented regulation will also lead to increased volatility. So one thing we can be sure of is that volatility will return. How it does is another matter. Hopefully it will be in a manageable, cyclical manner rather than a sudden abrupt event. Regulatory shifts and completion for capital are important influences on our markets and I see them as challenges. I don’t see consensus yet on how we are going to deal with them. I only see consensus that we are focusing on the topic. It will be interesting to see the effects of these influencing factors unfold over the next year or so as we gain more clarity on how this regulation comes in. As we start to see behaviours change, adapting to the new regulatory environment, we expect to see a lot of changes in capital flows and volatility.
Gerard: The challenge that most currency managers has been facing is one where the currency market has been manipulated. Currency managers want currencies to be floating freely so that everybody can use their own style to capture opportunities, whether it is using fundamental or systematic methods. After the credit crisis, the currency market has been manipulated to avoid pain, whether it is kicking the can down the road or fixing problems is not important. I am just saying there has been a long list of manipulations, for example with the pegging of the Swiss franc, with Central Bank intervention in the Japanese yen; the Fed quantitative easing. We know manipulations have less of an effect, so the day of reckoning is approaching. This level of manipulation presents peculiar challenges for currency managers. So what we prefer is free floating currencies and the instruments to express our ideas effectively.
Chair: Dmitri, in the past you have used carry as a very significant factor in your strategy, do you see political manipulation as a major issue for that style of management?
Tikhonov: Yes, we do. What we see is artificially compressed interest rates that do not allow for the clear generation of signals as to which currency pairs to choose and where to allocate positions. In the absence of market forces that dictate the exchange rate and the level of interest rates, naïve models may become blind as to how to allocate capital effectively. The success of allocating capital may turn into a random outcome and therefore, in this environment where the interest rates are set artificially low and at a homogenous level, naïve models may not generate value. That is what we have seen during the most recent period.
But generating return by ‘carry’ is just one of the ways managers attempt to create value. The word ‘volatility’ has been mentioned a number of times today and volatility is a measure of variability in the daily price path. It doesn’t take into account the direction of that path; if you look at the volatility indices, they show a low number, but even away from currency you see other low volatility levels. If you look at government debt for example, that also showed a remarkably low level of volatility but the valuations have been going in just one direction. Therefore with currency, in the same way as is recognised in other asset classes, carry is one element but there are other elements that capture the deviation from an equilibrium valuation point and there are models that can capture the direction of this trend.
Chair: Is the issue of reduced availability of capital at investment banks an impediment for those clients looking for increased returns from active management?
Tikhonov: Thinking about those participants who demand currency management, if we look at the world of institutional investors, clients have different objectives. It is important to recognise that there are clients who appear to be return seeking, there are clients who are looking to match their assets and liabilities and there are clients who are focused on more optimal or balanced portfolio construction. If you think from that angle, currency exposure that is the side-effect of acquiring overseas assets does not necessarily represent the desired currency position for the institutional investor. So therefore if you look at the demands of the institutional clients for currency management, it has gone beyond just purely looking at the return and risk management in the form of currency hedging. It is probably entering into the space of seeing to bring the currency allocation that I have as a result of my other decisions in line with my desired currency allocation in a coherent model that is consistent with my thinking about strategic and tactical asset allocation, and that is also implementable in such a way that it is effective and efficient.
Muhr: I think you have made such an important point that we are, hopefully, moving from managing first order risk, looking at sharpe ratio and volatility, to looking much more carefully at second and third moments of risk, such as skew and kurtosis which in the end are much more important.
You might look at returns that are uncorrelated but if you don’t look further, if they are positively or negatively skewed, you will not incorporate the effects in your portfolio correctly. So I think looking at higher moments of risk will become an important factor in the overall management of portfolios.
Dale: Certainly, the whole concept of separating one’s currency exposure from the embedded currency risk that one has inherent in their portfolio, is a big part of the next generation of risk management conversations and will lead to new methods of managing currency exposure. Currency hedging is natural when it comes to bonds, because you can see you are buying a single country with each bond, but when you are passively invested in an international equity index, what is your currency exposure at any moment? It is changing because the index constituents are changing, and the market valuations are all changing your currency exposure.
Chair: We are talking about compression of interest rates and political intervention being a problem, trends in naïve forms of adding value don’t work very well and we are all waiting for something, waiting for the spring to uncoil, to uncompress. We don’t know what the trigger for that is going to be, but the question I want to pose to the table, while we know these things don’t work so well in the current environment, while we wait for this decompression to occur, should investors simply be avoiding active management altogether and going into some form of passive hedging instead? Because we all agree that it is difficult, so why do it?
Paesler: Beta is the risk and return of the market index. I think we are all agreed on the definition of that. However, the majority of currency exposures tend to be seen in a beta sense, or in a passive sense, as the currencies and weights are driven by the other investments. A benchmark in a beta investment should be representative of the market as a whole, but having your currency exposure driven by your exposure to your other asset classes is not representative of the currency market.
So what we suggest is separate the two. Hedge out all of the currency exposure derived from the other investments and then deliberately put on the FX exposure that you feel either defines the currency market or take active bets in the currency market. One way or another it needs to be separated and then put on deliberately. Whether you want to invest, say, 33 per cent in three different currencies or what have you, it shouldn’t necessarily be driven by your other exposures. So does one define that as active or passive? In essence any currency exposure that is driven by something not descriptive of the currency market is active. So there are ways of taking on those bets passively. That said, we have seen a lot of clients move from active management to more passive or pure hedges. At this point we are not necessarily seeing the trend going the other way, and I think part of that is because of what is driving the currency markets, your momentum, your value, your carry. As mentioned when you have manipulation as well, those signals that would drive currencies are in a very challenging environment. But I would suggest that I would challenge what is actually active currency management.
Gerard: A different way to express it is to look at it from a conviction perspective. Now the degree of conviction will clearly have an impact on the efficiency of the active manager to deal with a currency move. The lesser conviction you have in the manager ability, the more you would tend to go down the passive route. If no manager can deal with those markets, then passive may make more sense. In the present environment, what are we dealing with? We know there is a lot of uncertainty, we know there are some market manipulations, the risk is no longer whether the manager can deal with the markets or not efficiently, it is more about when the current market environment is going to change.
We are having conversations with our clients along those lines. Is now being passive such a bad idea – you are having an insurance that costs you for a tail risk that is not occurring, how long are you going to bear that cost? It becomes not a call on the manager and his ability; it becomes a call on the environment. So for clients that make the call that the environment is there to persist for a long time, I think a bias towards passive makes sense, it reduces their costs. But it means in return they are exposing themselves to have made the wrong environmental call – flying without insurance.
Chair: Dmitri, you have an active currency product and you have style index strategies as well as hedging products. What are you seeing from your clients in relation to how these issues drive their preference for different types of products?
Tikhonov: In our opinion, a currency manager needs to have an open dialogue with the client in order to fully understand the client’s objectives, particularly the balance between their focus on the risk reduction and the additional return generation. The type of offering a currency manager prepares for this client may change, and traditionally Record has been very systematic in the way we implement our models. We have recognised that in an environment where the interest rates are artificially compressed, completely systematic models may not respond in the way that they have done under a ‘no manipulation’ scenario. Therefore a certain degree of discretionary oversight of the models should be permissible.
But whether we talk about passive hedging, dynamic hedging or return seeking currency strategies, either in the form of a carry product or a multi-strategy product, it always comes back to the same questions: what is the risk you are trying to eliminate for the client and what is the risk you are using to substitute in the risk budget that has been freed up? The approach should be fluid and responsive to the environment that is constantly changing, but it has to be consistent with the manager’s philosophy and understanding of the currency market, and with the philosophy of the asset allocation that the client is sharing. In our opinion, a good currency manager is a manager who has congruence and consistency in conceptual thinking and implementation, who is an expert prepared to contemplate and be the person who is prepared to answer the question why something has happened, and offer a solution irrespective of the environment we are in.
Dale: I think people are moving to passive right now. I am not so sure they are giving up on active managers, I think it is because most active currency managers have a bias to short-term trading and many of these models are challenged in a low volatility environment. One way to change your time horizon is with a change to a passive strategy. If this is the only alternative, the client is forced to create their own time horizon. There is room for a different type of asset management inside currency that I think is coming. There are a lot of equity managers that typically trade slower but are having a pretty tough time of it as equity mandates move to predominantly passive indexing. Some looking for new niches are actually getting a handle on currency as an asset class. I think new entrants will bring in slower, more trend-following or different types of models that have different time horizons, and I think the marketplace will open up.
The best way to allocate across mandates is to look at relative risk and relative returns and what diversification means at any given point in a business cycle when you are assessing portfolio performance. I think the introduction of new tools that incorporate currency into more sophisticated analytics are coming and will help the asset class evolve and the industry grow. Hopefully we can get beyond passive versus active discussions and look at how we bring them together to create a better portfolio solution for clients.
Chair: So is there still a case for active currency management? You said that, if one has a global macro product then, at the moment, why wouldn’t one just offer that? The corollary question to that has to be why, even if the environment changes, would you want to come back to currency again? Is currency still an attractive asset class in its own right?
Gerard: In many cases the emerging market has become like the developed market and some of those markets are actually more liquid than some of the developed ones. Just look at the liquidity of the Mexican Peso versus, the Swedish kroner/sterling for example. We have witnessed a good run from emerging market currencies, will this continue.
More broadly, the case for active currency management is more fundamental, and as alluded to by Dmitri, comes down to the client’s objective and the various distinct missions that can be given to a currency manager.
The first mission that most people tend to consider is one seeking absolute return – you want an active currency manager to generate some alpha, to make money, to generate returns. Currencies access some very specific factors. Our clients are very sophisticated/large pension plans, they already have a multitude of investments. Do they want more carry, do they want more trend? They often already have these somewhere in their portfolio but they may want to have a currency specialist that can exploit some original factors like long/short, or pure volatility base opportunities for example. Such a focus role comes with some potentially episodic return or some strategy specific characteristics/limitations, but our clients understand that. What they are after is a diversification and the currency manager may have a role to play in providing it.
We have touched upon the advantage of using pure currency volatility strategies for tail management risk or volatility bets, as these could offer a cheaper implementation method to these ideas than a more traditional a equity base products that exist. So there is a place for pure currency managers in an alpha seeking role.
The second mission of a currency manager is one of hedging where we are looking at existing currency risk – it is all about risk management, the return generation comes as a secondary effect.
The irony is that in these somewhat manipulated markets, where it is very difficult to manage currency as nobody knows exactly where the currencies are going to go, it is a market in which the currency risk has not been significant (lack of tail event – maybe with the exception of the euro move during the second quarter of 2010). In such an environment, passive and active which are competing against each other are not delivering such a different outcome. The key aspect of hedging to keep in mind is - like a balloon - if you remove currency risk passively through hedging, you effectively replace a return uncertainty with a cash flow uncertainty. Now what is preferable, return uncertainty or cash flow uncertainty? Well, for most of our clients that we talk to that are long-term investors and are fully invested, cash flow risk is no better than return risk, or return uncertainty. To effectively manage currency risk (reduce return uncertainty but control possible negative cash flows) one needs to adopt an active process. This role for currency managers will persist as long as currencies are floating and as long as investors investing outside their own country have a sizeable foreign exchange exposure. Risk manage-ment is by definition an active process.
Paesler: I would agree with that, I think the needs are going to be there one way or another for currency. First of all currency is still seen as a diversifier. Although there is a correlation with other asset classes. It is a desirable exposure to have in one’s portfolio. However, there are other needs, not just from an investment standpoint. For instance infrastructure needs; if a UK-based company is buying trains from Switzerland, you are going to need currencies to transact that. As more global investments and more global purchases and sales are going to take place, there are going to be currencies needed for those transactions alone.
Even something as simple as tourism creates a need for currency.
Because of its size and its low transaction costs, currency is generally seen as a relatively efficient market. However, given that there are going to be structural needs for currency, it is not necessarily efficient. Whether to hedge or not is going to be a debate that will not necessarily be resolved one way or another. There are always going to be those that feel they need to hedge their currencies. There are always going to be those that feel the FX exposure should be embedded. How one goes about that remains to be seen – active, passive, creating a new index to describe a new currency market – I believe there is a definite case for it and I think the market is always going to change where it is putting its bets, but it will always be a desirable asset class.