Carry on recovery
Uncertain economic recovery and the global rebalancing to a ‘new normal' argues for volatility and directional emerging market FX trades, but Lynn Strongin Dodds finds that it's too early to write off the carry trade
The financial crisis scared institutions away from any investments tinged with risk, but the tide is slowly turning. Investors are becoming adventurous, albeit cautiously and exploring alpha generating opportunities across the asset class spectrum. Currency is no exception: it is well documented as being the world's largest and most liquid market, with $3,200bn being globally traded, according to the latest figures from the Bank for International Settlements. Currency is also known as a zero sum game played by a variety of market participants ranging from non-profit orientated central banks and governments to profit-seeking traders and hedge funds.
The active approach has been a firm feature in investment management circles but it has gained a following over the past few years as part of the alternative asset class movement. The carry trade, which involves selling lower-yielding currencies, such as the yen, to fund the purchase of higher-yielding assets elsewhere, has been one of the most popular strategies during the past decade but it fell from grace when Lehman Brothers collapsed. In the early part of the century, momentum held sway. Investors rode the technology wave based on crowd sentiment but failed to jump off in time.
Although the carry trade has made a comeback in recent months, investors are looking to widen their horizons. Henrik Pedersen, chief investment officer at Pareto Investment Management, a subsidiary of BNY Mellon Asset Management, says: "Two to three years ago, currency as an asset class became part of the alternative allocation of an institutional investor. Investors are still looking at different and more liquid sources of return but they are increasingly turning to managers who run multi-strategy funds because they provide consistent returns over the long term."
Elizabeth Para, a currency investment strategist at Overlay Asset Management (OAM), part of the BNP Investment Partners group, agrees, adding: "Looking over a long-term horizon - 20 to 30 years - the carry trade has definitely generated alpha but many investors do not want to wait that long. They also do not want to be exposed to dramatic blow-ups which is what happened after the collapse of Lehman. We are definitely seeing more interest in our multi-strategy products. I think last year people were sorting out their core assets and are now turning their attention to other sources of uncorrelated returns such as currency."
Jaco Rouw, senior investment manager, global fixed income at ING Investment Management, also believes that investors will continue to keep their options open due to the mixed global economic picture. For the past few months, economists have been debating the different scenarios - ‘V', ‘W' and even ‘L-shaped' (where growth bumps along the bottom). Rouw says, "Looking ahead, the main questions revolve around the timing of governments' tightening their monetary policy and addressing their huge fiscal deficits. The carry, which has performed well since March, will still be played but I think it is more important to keep an open mind and not focus on just one style. We use a top-down, theme-driven, alpha qualitative approach that looks at all markets and strategies to identify alpha opportunities."
Thanos Papasavvas, head of currency management at Investec Asset Management, adds: "There are several uncertainties next year, including when inflation will start to rise and when the Federal Reserve and European Central Bank will raise interest rates. Although we are not experiencing the extreme volatility of 2008, volatility remains high and whatever happens it will not be a smooth ride. Our philosophy is that multi-strategy funds are better at diversifying risks and capturing returns across different styles as well as markets."
Investec recently launched an absolute return emerging markets currency fund that has a return target of LIBOR-plus 10%. Based on quantitative and qualitative analysis, the aim is to exploit the inefficiencies in the emerging markets and reward governments with strong fiscal policies, while avoiding those with unsustainable ones. In a recent research note, Investec stated its positive stance about the future of emerging market currencies (only Turkey and Brazil look potentially overvalued, it reasoned). It advocates taking a much broader analysis of factors like improvements in terms of trade and GDP per capita, instead of looking only at nominal or real effective exchange rates which incorporate inflation differentials.
Diane Miller, principal at investment consultant Mercer, is also witnessing a move towards trading emerging markets currencies. "There is a general view that these countries as a group are stronger than they were, so provide a good alternative to the developed world," she observes. "Overall, though, the main emphasis is on active currency managers who can manage risk and capture alpha without losing it."
In fact, there has been a spate of offerings that use options to better control risk and improve the consistency of return. For example, OAM recently launched two - the SingleHedge Currency Options fund and the SingleHedge Multi-Strategy Currency fund. The former aims to achieve capital growth by taking active positions on currency volatility in addition to the direction of spot foreign exchange rates. The latter is a feeder fund that seeks to deliver strong risk-adjusted returns through exposure to three OAM underlying currency programmes - developed markets diversified, emerging markets currency and the currency options strategy. Pareto, on the other hand, already employs options and recently launched a long/short emerging markets strategy under its multi-strategy banner. The fund takes dynamic allocation among strategies based on a systematic risk-control framework.
Despite the movement towards multi-strategy, proponents of the carry trade argue that the style can more than hold its own, provided that the proper risk control tools are in place. Henderson Global Investors employs a proprietary risk filter in its carry trade-based global currency fund, which invests across G10 and emerging markets. Mitesh Sheth, deputy head of fixed income, notes: "I know there are a lot of arguments surrounding carry but in my view it is one of the strongest risk premia in global markets and in many ways similar to the equity risk premia. A carry strategy can provide long-term risk-adjusted returns. However, we feel it is important to have an effective risk management structure in place to ensure the fund continues to perform well even during the dramatic sell-off regimes, like those seen in 2007 and 2008."
"The perception that the carry trade has little to offer is not true," says Buford Scott, global head of the alternative asset group at Standard Chartered. "Our analysis of 20 years of data has shown that when the difference between high and low-yielding currencies is minimal, as now, profit probability rises dramatically as any fresh divergence creates opportunities. We have two products - FX Global Yield Model (GYM) and FX Yield Differential Accrual (YDA) Model - both of which are offered as principal-protected structured notes. We have made money on both strategies by exploiting the FX forward discount anomaly, and minimising downside risk by applying proprietary risk filters, which enable us to identify specific risks and enhance returns." The FX GYM five-year principal-protected structured notes, which returned 9.5% year-to-date as of October, covers select emerging market and G10 currencies. The FX Yield Differential Accrual 5 year principal-protected structured notes, which boasted a 12.7% return, aims to capture yield differentials among a basket of G10 currencies.
Just as the right time to buy equity risk is when equity is oversold, so the right time to buy the carry trade ‘risk premium' is when it has been oversold - or so the argument goes. Moreover, there is, by definition, always a carry trade available for those nimble enough to switch from one to another, as this year's many US dollar-funded examples attest. Although the economic recovery and the evolving ‘new normal' might argue for FX volatility trades and directional long emerging market positions, it is too early to write off carry as a strategy for the coming months.