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Active, Passive, Or a Third Way?

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Active, Passive, Or a Third Way? FEATURE | THE NEW GEOGRAPHY OF INVESTING RETHINKING FOREIGN EXCHANGE IN YOUR INVESTMENT PORTFOLIO: Active, Passive, or a Third Way? By David Cohen ack in 2009 I was fortunate enough Perhaps it’s time we rethink foreign exchange U.S. dollar, but during the past 43 years the to hear a leading bond fund manager (FX). yen has appreciated at an average annual Bspeak about the future. As he held up rate in excess of 3 percent. In January 1971, a $1 bill, he prophesized that one day we Passive currency management is most often the exchange rate of the Japanese yen to the would be telling our grandchildren about the default strategy for the following reasons: U.S. dollar was 358:1, and as of December these little pieces of paper that people used 2013 the exchange rate was about 103:1. to exchange for goods and services. The 1. Short-term currency movements gener- Whether this type of change in fundamen- history-mindful manager had a theory that ally are difficult to predict and the man- tal valuation is the natural evolution for the currency devaluation was the central bank agement of domestic currency valuation currency of a country progressing from an elixir to the developed-market financial fluctuations relative to foreign purchas- emerging market to a developed market is crisis. At the time, it seemed like just a sim- ing power does not factor into portfolio beyond the scope of this article. The data, ple prognostication, but in reality it was a performance evaluations. however, suggest that currency valuations prescient forecast of the beggar-thy-neigh- 2. Active currency management strategies should not be considered a zero-sum game bor policies soon to be adopted by central are complicated and can be costly to over most investors’ time horizons. bankers—a systematic effort to kick-start implement. Accessing transparent, insti- economies and create inflation in an tutional FX markets requires expertise Multidimensional Pricing and the attempt to avoid a deflationary spiral. and a special credit facility, and best exe- Creation of Currency Beta cution requires forethought given the A currency’s price is presented as a rate of I began to study what this meant for portfo- unregulated nature of FX markets. exchange between two currencies, meaning lios and learned that, for most investors, 3. Relatively few options exist for tradi- currencies are priced in pairs. At any given currency management is passive—in fact it tional investors to implement active cur- time all currencies also are being priced is so passive that it is often ignored. The vast rency management strategies through against myriad other currencies. A euro is majority of investors’ currency exposure is a traditional brokerage accounts. priced in terms of U.S. dollars but it is byproduct of portfolio construction, pas- 4. The predominant, yet factually incorrect, simultaneously quoted in yen. The influ- sively defined by international allocations to belief that FX is a zero-sum game; i.e., ence of one currency valuation on another stocks and bonds. I also found that even that relative price fluctuations between can simultaneously affect the prices of a astute institutions with active currency pro- currencies and yield differentials third currency in which it is also being grams generally take a passive approach to between countries generally iron out quoted. Such a circuitous route to deter- what they consider active currency manage- over time. To that I say, “Tell George mining a currency’s true value typically is ment, simply hedging out a portion of inter- Soros that currencies are a zero-sum not engrained in those of us whose exper- national currency risk in favor of the cur- game.” Mr. Soros made more than $1 bil- tise generally has focused on cash assets rency denomination of their liabilities. Many lion in 1992 as the result of an invest- that generally are measured in basis points. plan sponsors benchmark 50 percent of ment thesis predicated on the funda- international allocations to indexes hedged mental valuation of the British pound The added dimension of simultaneously to the currency of domicile, creating a non- and an understanding that it was unsus- quoted, multilateral pricing obfuscates the committal hedge that dampens volatility but tainably overpriced. true performance of a currency as its fun- trades foreign currency risk for increased damental value begins to change. When domestic currency exposure. At first this The Japanese also are cogently aware of the one asks, “How did the euro perform may seem like a reasonable approach, but in potential impact mispriced currency valua- today?” there must be a follow-up ques- an environment where monetary policy is a tions can have on an investment portfolio. tion: “Against which currency, the U.S. weapon of mass stimulation, does this kind The currency story of 2013 was the yen’s dollar, the Japanese yen … the Hungarian of passive approach remain prudent? 17.7-percent decline in value relative to the forint?” MAY / JUNE 2014 47 © 2014 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved. FEATURE | ACTIVE, PASSIVE, OR A THIRD WAY? Most currency transactions are priced rela- tive to the U.S. dollar, which serves as the Table 1: 2013 Currency Performance through December 2013 (%) world’s reserve currency. Cross-pairs, a Currency vs. USD vs. G20 currency pair that does not include the Return 0.00 2.03 U.S. dollar (such as pound sterling/Swiss USD franc), may have dissimilar performance Volatility 0.00 5.57 Return 4.52 6.26 relationships from what is implied individ- EUR ually between each constituent currency Volatility 7.21 4.54 and its value relative to the U.S. dollar. For Return –17.71 –19.09 example, the Russian ruble may be down JPY Volatility 7.70 8.90 against the dollar and the Polish zloty may Return 1.89 3.85 be up against the dollar, while the zloty is GBP down against the ruble—yes, this is Volatility 8.65 7.09 entirely possible. Return –6.29 –4.54 CAD Volatility 6.87 3.45 Meanwhile from the perspective of a Return 1.29 3.28 domestic investor who is invested in a SEK domestic security denominated in the local Volatility 7.04 3.77 Return 2.92 4.81 currency, the local currency never seems to CHF change in value and thus appears to have Volatility 6.55 3.49 no impact on the valuation of the domestic Source: Cürex Group security. But is this really the case? If cur- rency can change the relative value of that pricing methodology using a standardized tional commercial transactions. When one security in the eyes of the world, how can base-currency valuation model gives inves- considers that trade weights can change there be no impact to the local investor? tors a new tool for comparative market substantially over time and that actual analysis at any moment in time. commercial trade makes up less than 5 per- To address these complexities, our firm cre- cent of FX volumes, one can conclude that ated a currency beta basket index series to Other currency valuation benchmarks do trade-weight currency baskets are not an normalize performance of all currencies exist; the best-known is the U.S. Dollar optimal approach to measuring the overall versus a passive selection of the world’s Index (DXY), which is a basket established value of a currency. most liquid deliverable currencies. using a fixed weighting of the U.S. trade- weight as it stood in 1973. The basket is cal- The establishment of a beta-base currency To further simplify the complexity of multi- culated by taking the geometric average of basket allows for an easier understanding of dimensional currency pricing for the invest- price changes in a basket of currencies the relative performance of currencies. More ment community, we partnered with a lead- using a weighting of 57.6-percent euro importantly, it allows any domestic investor ing index provider, FTSE Group, to create (EUR), 13.6-percent Japanese yen (JPY), to understand how the domestic currency is the FTSE Cürex G20 Index1, a basket cur- 11.9-percent pound sterling (GBP), performing relative to the rest of the world rency index that can be used as a beta for 9.1-percent Canadian dollar (CAD), and potentially take action to hedge away currency valuation. The FTSE Cürex G20 4.2-percent Swedish krona (SEK), and from domestic currency exposure. Index is an equally weighted basket of 20 3.6-percent Swiss franc (CHF). While this spot currencies, with allocations approxi- has proven to be a consistent weighting The Third Way: Passive Application of mately one-half to developed markets and methodology, one might think the weights Systematic Strategies one-half to emerging markets. This basket aren’t particularly relevant today given the The concept of active currency manage- could be considered a reasonable proxy for a evolution of U.S. trade weights over the ment traditionally involves taking a view of beta benchmark for the currency market as past 40+ years. a currency’s direction based on a model or well as a performance measurement bench- the overlay manager’s skill (alpha). I would mark for active currency overlay managers. In theory, trade weighting seems like a sen- assert that there is a third option. Similar to sible approach to building a currency bas- alternative beta strategies in equities, active At its core, G20 offers the market a stan- ket given its seemingly parallel logic to the currency management can be delivered dardized formula for calculating the value concept of market-cap.
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