Should I actively invest in currencies?

The last couple of years have seen an unprecedented rise in interest from the institutional investor community in active currency management. Mandates are being issued to managers with increasing regularity, and the size of those mandates is increasing all the time. Active currency management is often cited as being a genuine source of ‘alpha’, and it is this property of currency management has been the main fuel for recent growth. The vast majority of investors however still appear to question if currencies can even be defined as an asset class, and if so, is there really any opportunity for a manager to extract alpha from that asset class? The currency managers insist of course that they are the best and cleanest available alpha source, but the reality is naturally much more complex. So is it sensible to invest in currencies at all?

Can currency be defined as an asset class?

The first step in the process of understanding currency is to establish if it has any claim at all to be seen by investors as an asset class…so what is an asset class and what features does an asset class have? Of course it is possible to say that anything can be an asset class, for example, all the shares in the FTSE 250 beginning with ‘F’ can be defined as an asset class, but I would suggest that this rather ‘over-defines’ the case. Asset classes should have boundaries in terms of the underlying investment, that is to say, it should be broadly certain what general properties all of the assets in the class have. Individual asset classes should, in general, move up and down to some extent independently of other asset classes, presenting the opportunity for an investor to make a return from the price movement in the asset class as well as any risk premium. Each asset class should also have access to independent, transparent pricing liquidity, so that it can be considered something investable in the first place, and in general there is a risk premium related to this pricing. Finally in this day and age there is usually a benchmark for the asset class which reflects the effect of buying every security in a certain asset class.

So how does currency as an asset class actually measure up against this yardstick? Well, certainly all currency transactions can be grouped together successfully, be they executed in the cash markets or in the options markets (or in fact via the futures markets too). Secondly, the currency markets certainly go up and down quite a bit, and this price movement is generally somewhat independent of other asset classes. The opportunity to make money is present. Thirdly it is quite certain that currencies are priced in a deep, liquid and transparent market, although there is clearly a question mark over the presence of a risk premium. Finally, we have the question of a benchmark. This is tricky, as there is no benchmark that accurately reflects the experience of investing in a currency manager, leverage is not being taken into account and so on, but it is generally accepted that as currency is cash, then a cash benchmark is appropriate. As most managers of currency have USD denominated products, a 3 month USD Libor benchmark works well as a benchmark against which to compare currency returns.

So in summary it is possible to see the currency market as an independent asset class, sharing the features of other asset classes. The issue now is what to do about it?

The currency conundrum.

The problem currently being faced by institutional investors the world over is that of whether to do anything about the currency risk in their portfolios. It has always been there, so why worry now?

The reality is that any sensible investor has decided to diversify into foreign equity and bond markets in order to access the valuable risk-premium associated with doing so and has as a result of this investment strategy decision, introduced currency risk into the portfolio. The choice made by the huge (but shrinking) majority is to do nothing at all about this risk, but why is this, and why are things changing?

The reason for ignoring currency risk is rooted in two ageing facts: Firstly trustees of investments have been very reluctant to touch what is seen as an unregulated, highly leveraged and highly volatile market, with no long-term benefit, but plenty of short-term costs. This approach is diminishing over time as trustees become more confident that accurate risk management techniques help them to control the risks being taken in the portfolio, and secondly the emergence of currency managers with long and stable track records is evidence of value in the asset class, if correctly managed.

Secondly, there has been a perception that currencies tend to mean revert over time, and indeed the theoretical return from currency over time is zero. This of course remains a theoretical proposition, as anyone in Europe who bought US equities in 2001 and left them unhedged will tell you. Not even pension trustees can wait for this to come out in the wash! Acceptance that the theory and the practice are two separate issues means that the risk must now be examined properly.

As these two key issues have now been exploded, and more advanced risk-budgeting techniques have become available to trustees and other institutional investors, it is now no longer a question of whether to do anything about the currency risk, but rather what to do about the currency risk.

What to do about currency risk: alpha and beta. We have established that currency risk can come as a by product of cross-border investments, and that it can be considered an asset class in its own right. This creates two categories of opportunity, firstly that presented by the ‘unintentional’ risk stemming from the underlying investments, lets call it beta, and secondly the opportunity to add ‘alpha’ through strategic currency exposure. An investor may choose to lump the two things together and appoint an overlay manager, but perhaps a more sophisticated solution would be to pull the two issues apart and look at them independently.

Managing the ‘beta’ portion of the risk should be a reasonably simple operation. Most banks will happily identify the risks relating to currency in a portfolio, and will offer a cheap and simple solution to its elimination. One possible approach would be to implement a hedging benchmark of perhaps 50% of the portfolio in order to reduce but not eliminate the currency risk. Investors can also rely on the expertise of independent consultants if they need help setting the hedge benchmark for the bank to follow. This is a passive approach to the currency risk, and must be considered by a portfolio manager, but it does not address our central question of taking active currency risk in order to extract alpha.

The tricky part though comes when we start considering alpha. Does it really exist? Where does it come from, and can the manager who found it for me yesterday find it again tomorrow?

Digging up currency alpha.

Whilst you may be somewhat ‘Alpha weary’, it is obviously very important to understand what we mean by alpha in the currency area, and where it comes from. Opinions of what alpha actually is vary wildly, but for our purposes, we can define it as a value indicating an excess risk-adjusted rate of return relative to a benchmark. That is to say, the manager’s ‘value added’ expressed as a number. The value of this figure lies in comparing manager performance rather than in itself…after all investors in currency should still be drawn to absolute returns rather than the index-based returns one finds in the long-only world, but of course we now need to identify where this ‘alpha’ comes from in the currency world.

The main arguments against the existence of alpha opportunities in any given market are usually pretty similar, and run as follows: markets are efficient, with participants maximising their return at all times and removing the opportunity to beat the market. Markets represent a ‘zero sum’ game which necessarily means that one player wins and simultaneously another player loses, and so, on average, players can only hope the break even before costs. The final arguments which are peculiar to the currency markets are that central banks make money on their management and intervention activities and so are not sources of alpha, and secondly that FX rates cannot be forecast.

Lets take these one by one, starting with the question of market efficiency. The argument here is that because the spot and forward FX markets accurately reflect both supply and demand and forward interest rate differentials, so there is no point in seeking alpha here as an investor would be no better off in one currency or the other. This assumes that over time the currencies will move to eliminate any gain made by buying the higher yielding currency and selling the lower, and therefore that forward FX rates are an accurate predication of market prices. This is quite easy to knock down as it is historically true that investing in the higher yielding currency and selling the lower would result in a profit being made. This flies in the face of economic theory, but of course also presents an opportunity to produce additional return, or alpha.

Secondly, there is the question of FX trading being a zero sum game, which is to say that if I win, then you must lose. The problem with this statement is that it ignores the fact that a great deal of currency trading is done not to make profit, but rather to reduce risk.

Imagine if a Swedish investor with a USD exposure were to trade directly with a US investor with a Swedish exposure. The Swede would sell USD to the American, and buy the American’s Swedish Krone position. By doing a deal both parties would have kept their underlying exposure to assets, but would have eliminated their currency exposure and therefore have reduced risk. They have achieved a valuable goal through the currency markets, but have not maximised their profits. It is this risk management flow which provides a large portion of global currency transactions (usually undertaken by central banks, investors and corporations) that means that FX is not a zero sum game, and provides the opportunity for an intelligent alpha manager to extract value.

Thirdly we have the question of central banks making money. As I outlined above, central banks have very often got other imperatives rather than profit to fulfil their mandates. The role of the central bank is in fact almost anything other than maximising profit! They take an active role in national monetary policy and generally have responsibility for ensuring stable economic conditions in which growth is able to flourish…these goals may actually require that currencies are not managed with maximum profitability.

Finally we have the question of forecasting FX rates, which would appear to be central to the proposition that currency management can produce alpha. Again, economic theory tells us that currency prices are a random walk, but there are two key indicators that point to currency as an alpha source. In point one above I noted that forward prices of currencies are in fact anything but a good indicator of forward value, and that yield is a key component of forecasting. Secondly it is apparent that the actual price action, if not overall direction, in the currency markets is reasonably predictable. Daily volatility is within fairly stable ranges looking back over long periods, and it is also apparent that shorter-term strategies which are implemented according to rule based systems manage to add value or alpha. The combination of these two facts means that there is in fact a rich seam of alpha available in the currency world as prices are not completely random.

The theoretical conclusion that alpha is available in the currency world is supported by a great deal of anecdotal evidence that currency managers do indeed add value, but, as with anything, the question of how to find the right manager is key.

How do I find Mr or Mrs Right?

Finding the right manager means taking two key decisions. Firstly, is currency as an asset class generally a good fit for my portfolio (a decision I shall take as read), and secondly which manager or combination of managers is the right one?

The key benefit of currency management that hasn’t yet been discussed is that of diversification. Currency managers tend to be very slightly correlated to traditional asset classes (e.g. SEB Universe to MSCI World = 0.26, to Russell 3,000 Large Cap = 0.15, to Merrill Lynch Treasury = -0.09) which means that they provide one of the finest sources of portfolio diversification available. This means that in the long-term, a portfolio with an active currency element will carry less risk but generate more return than a portfolio without active currency. This means that the starting point for manager selection must be the existing portfolio, and a careful analysis of correlation.

Having done the correlation work, it will be evident which managers are able to provide returns of the right kind, in these terms. This subset will then be discoverable according to statistics such as return, volatility and various statistics stemming from these basic figures.

The statistical work will take the potential investor a long way towards a successful outcome, but in our view and experience, successful investment still requires a very careful consideration of qualitative issues as well. To ignore these issues in pursuit of alpha is likely to result in tears! Independent research is a very good idea at this stage, and well worth the effort as good managers will stand out. This should also weed out any bad apples.

SEB FX MAP

In order to both identify the right manager and then invest through an investor owned structure, SEB have created SEB FX Managed Alpha Platform. The platform is a comprehensive access point for investors looking for the right currency manager. We have commissioned research by Mercer and Watson Wyatt on all the managers and we have worked with Mellon Analytic Services to create an index of the managers in the universe. All of these tools as well as correlation information is available through the product so that managers can be selected quickly and easily.

Once a manager is selected, SEB helps to facilitate the investment through a variety of structures according to the investor’s needs. This ensures transparency, adhesion to strategy, limits being observed and complete liquidity in the product, all of which reduce the key concerns voiced by investors.

Conclusion.

It is quite clear now that currency is an asset class in its own right which cannot be ignored by serious institutional investors. Having established the hedging (beta) needs of a portfolio, investors can implement an alpha strategy which will allow participation in a rich and durable source of alpha. By working with SEB this can be achieved through an information-rich, secure, transparent and liquid structure.

Contact: Seppo Leskinen Head of Hedge Fund Services Global Foreign Exchange

SEB Merchant Banking 2 Cannon Street London EC4M 6XX Tel: +44 (0)20 7246 4282 Fax: +44 (0)20 7236 3542 Mobile: +44 (0)7887 711471 Email: [email protected]