Consultants hope that a healthy volatility is returning to FX markets to lure back pension funds, writes Angela Henshall. But does the strategy debate still need to move on?

Statements from the Fed about the unwinding of quantitative easing have sparked anxiety and indecision among institutional investors over rising interest rates. While this will inevitably see some capital re-allocated away from bonds it’s not yet clear where these funds will be reallocated, with a large volume thought to be waiting in cash.

One asset class that will welcome the end of zero rates will be active currency management, which has been all but killed off as a strategy for pension funds during the long period of ‘risk-on, risk-off’ markets and low-interest-rate differentials. However, pension consultants face an uphill struggle selling currency as an asset class to clients who remember the heavy losses experienced in 2007-08. Assets under management in active currency funds are thought to be just a fraction of the $2trn put to work in hedge funds, despite the $4trn-per-day FX market being the world’s largest and most liquid.

Malcolm Leigh, principal in Mercer’s investment business explains that active currency management began to gain ground in the early 2000s as sterling-based investors started to increase their exposure to overseas equities and, with that, their currency exposures.

Managers adopted a range of approaches to try and add incremental value to both absolute-return investment portfolios and hedging overlay programmes, but there was considerable focus on carry-based strategies – which involve selling a certain currency with a relatively low interest rate to purchase a different currency yielding a higher interest rate, and leveraging that interest rate differential.

Paul Lambert, a currency fund manager at Insight Investment, says some managers argued strongly that the carry trade made sense and were very successful at convincing consultants of this. “A lot of carry managers raised a lot of capital in the run-up to the crisis and received quite a lot of support from consultants,” he recalls.

While the gains from carry can be large and persistent, the big risk is, of course, in the uncertainty of exchange rates – a collapse in a higher-rate currency can wipe out years of gains from rate differentials. After initial strong performance, the strategy was hit by the extreme currency volatility of the credit crisis, leaving numerous pension funds badly burnt.

Becalmed

Why was carry so popular? Some suggest that the strategy was sold as a market return to a systematic risk, a kind of beta, and that this fit better with consultants’ understanding of how markets work and how asset classes could fit into asset allocation models than the other, more obviously alpha-driven strategies. Consultants are less willing to concede this.

Roubesh Adaya, senior associate at Bfinance, instead suggests that the focus on currency carry enjoyed popularity in the early 2000s because during becalmed markets, “with fewer dislocations to take advantage of”, it becomes harder for managers to deliver excess returns. Carry worked because interest rate differentials were sufficiently large to generate income (in particular Japan’s rates were stuck at zero) while exchange rates were sufficiently stable to encourage the application of greater levels of leverage. The financial crisis was particularly disastrous because not only did exchange rate volatility pick up sharply in general, but capital fleeing to safety ran into carry-funding currencies like the US dollar and Japanese yen, in particular.  

“While, with hindsight, it is easier to spot such periods of volatility, they are much harder to predict,” says Adaya. “Consultants, as well as asset managers, were certainly reactive rather than proactive in recommending that their clients reduce the risk budget allocated to such strategies.”

Nonetheless, by 2006-07 consultants say many clients were already diversifying their alpha strategies – a process that has continued through to today. Mercer says that, around this time, it saw a rotation of client exposure from pure currency to broader global tactical asset allocation or macro strategies. Currency carry remained a common source of value within these portfolios, but it was better diversified alongside other active management strategies and asset classes.

Matt Roberts, senior investment consultant at Towers Watson, points out that active currency is not all about carry: there are many other different styles, with the chief among them being value and momentum and variations on those that focus on fundamental supply-and-demand dynamics.

“We think there is merit in some of these strategies and that they may become more or less attractive over time,” he says. In particular he feels that due consideration should always be paid to things such as “crowded-trade risk and leverage”.

He adds: “We think that currency can act as a valuable alpha source. However, we believe that this is often best accessed through broader strategies.”

Herded

Q1 2013 from Parker Global Strategies showed improvement in performance from currency managers for the first time in several years. The Parker FX index measures both the reported and the risk-adjusted returns of 42 global currency managers running around $43bn in assets. Despite a positive start to the year, however, the index fell 1.33% in August as the US dollar had a very strong month against most emerging market currencies – underlining that bouts of volatility remain a risk and that managers are still really struggling to identify trends with sufficient strength.

As global markets and economies become more diversified, however, most consultants feel there will be greater opportunities for active currency. Some make a specific case for carry.

Adaya at Bfinance emphasises that while carry strategies are often demonised due to their tail-risk, he argues that, as geographically diverse emerging market bonds and currencies are integrated into portfolios, the underlying country risk associated with the strategy can be reduced.

“If and when we do move out of this risk-on, risk-off mode, carry strategies offer an attractive way of generating excess returns,” he says. “Investors should, however, be mindful of the tail-risk inherent to such asset classes.”

Tapan Datta, head of global asset allocation at Aon Hewitt, also feels carry is likely to remain an important part of most currency strategies and that we will see increased investment in strategies focusing on emerging-markets currency. Re-visiting the theory that carry represents a systematic beta, he warns that any move away from carry will lead to more dependence on strategies that rely on manager skill rather than identifying attractive interest-rate differentials. Even relative-value trades between currency pairs, for instance, focuses more closely on macroeconomic views of the underlying countries.

Leigh at Mercer believes the ability to produce returns is related, among other things, to the size of the opportunity set – how many markets are moving against each other and how much they are moving. So, when many currencies are stable against each other, because they are being primarily driven by the same factors, the opportunity set reduces.

“As this situation dissipates, currencies start to vary more and the opportunity set will increase,” he suggests. “Currencies should start to respond more to fundamental economics, rather than political decisions, and this plays more to the strengths of currency managers.”

Insight’s Lambert feels that the active currency debate needs to move on from the sterile ‘carry-versus-the-rest’ terms.

“[Discussion should focus] more closely around whether currency managers can make money,” he says. “People involved in the FX markets are hedging, doing corporate transactions, buying and selling reserve currencies. If you’re in there the question is, can you access the alpha?”

He has a point. For the reasons he states, currency management ought to be a very rich source of diversifying alpha for a broad portfolio and, moreover, macro conditions seem to be turning much sunnier for its practitioners. Investor appetite is so low only because the conversation has focused on the least alpha-driven strategy of them all for too long – a strategy that they already saw themselves herded into once before, at exactly the wrong time.