Increasing accounting and regulatory pressures on UK pension funds will compel them to at least consider including currency management in their investment strategy, according to James Binny, director of FX analytics and risk advisory at ABN Amro.
Pressure is likely to come from the new accounting standard, FRS 17 and its international equivalent IFRS 19, which becomes effective next year. Speaking at ABN Amro’s UK Currency Conference 2004 in London, Binny said that under the proposed FRS17 accounting standards the mismatch between assets and liabilities will be shown on corporate balance sheets. “Liabilities are discounted at a long term rate, and assets are marked to market, with no possibility of smoothing. So short term pension fund performance becomes important.”
Pressure is also likely to come from the credit rating agencies, he said. Ratings agencies increasingly view pension funds as part of corporate capital structure. Standard & Poor’s, for example, adds liabilities to corporate debt.
“This has a potential impact on a company’s borrowing costs, and some companies have issued debt specifically to covered pension liabilities,” Binny said.
“One solution is to match liabilities with fixed income investments. However, this means that the pension fund will not benefit from future equity outperformance, and it locks in the deficits. The alternative is to increase the return to eliminate the deficit. However, it’s unusual to increase return without increasing risk.”
Currency management can add return and reduce risk, he said. A simple passive currency hedge, with no currency alpha will remove all currency risk while active currency can add return.
Yet pension funds are still reluctant to ‘trade currency’. The Myners Report could change this attitude, said Binny. Principle 3 of the report says that “decision- makers should consider a full range of investment opportunities, not excluding from consideration any major asset class”.
“This means that currency management should at least be considered,” said Binny. “There should be an active decision made about whether currency is managed or not.”
Principle 7 of the report says that “trustees should consider explicitly for each asset class invested whether active or passive management would be more appropriate given the efficiency, liquidity , and level of transaction costs in the market concerned”.
Currency trading is the most liquid market in the world, he said with a daily volume of FX trades worth $1.2trn (E979bn). Active currency management has low transaction costs, with no commission or stamp duty and low spreads.
“Short term currency risk cannot be ignored, and medium term returns from active currency management cannot be ignored,” Binny concluded. “They help to reduce deficits and trustees should not ignore any potential source of return.”
Peter Eerdmans, senior investment consultant – manager research at Watson Wyatt said that research and empirical evidence supported the case for active currency management. Data from Frank Russell published in 2000, for example, which covered 241 currency overlay accounts and 21 managers over 11 years, showed an average information ratio of 0.63.
There are some caveats, he said. “The opportunity set of currency is more restricted than it is with equities, and with the euro’s advent, the opportunity set has decreased even further. There is also definitely a risk of survivor bias, and outperformance is volatile over time and across mandates.”
Harriet Richmond, head of the currency group at JP Morgan Fleming, said that active currency managers had a choice of choice of four management styles – fundamental, technical , diversified and dynamic – although she said there was a tendency for most managers to migrate to the diversified style.
The technical style – a quant-based style exploiting trends – had a heavy turnover and a low success rate, she said. “What you have to watch is that inefficiencies can be exploited by so many people that returns have been arbitraged out of the market.”
Carry trades, where managers buy and sell currency with the rise and fall in interest rates, have been very profitable in recent years. The technique is to buy currencies where forecast spot rate is persistently below the one month forward rate and sell when the forecast spot rate is persistently below the one month downward rate .
“Carry trades have been fantastically successful following interest rates over the past two years. However, they are prone to sharp drawdowns, and the drawdown of all drawdowns was October 1998.”
Writing currency options is also a possibility for pension funds, currency managers use straddles – a put and a call against the forwards price – to sell volatility. However, whether option writing would be profitable to a fund is questionable, she said. Between 1993 and 2003 looking at one month straddles the worst month showed a 17% loss and the worst drawdown a 35% loss. “It’s not very interesting as a raw strategy.”
Richmond said the inefficiency of the market made active currency management attractive, but this would not last for ever. “Currency markets are not efficient yet although inefficiencies will eventually be arbitraged away. More profit-seeking behaviour is creeping in and the market is getting smarter. So diversification is critical and research is needed to stay ahead.”