Currency overlay

Pension funds and institutional investors have been globalising their portfolios for many years, yet a majority of these investors have typically ignored the currency risk inherent in these investments. For example, euro-based investor with US assets has seen a reduction in returns from investing in the US since 2001 (close to 50%) purely from the movement of the E/$ exchange rate. As a former pension plan sponsor who struggled to find a single source of information on the topic of currency management before I implemented the currency programme for the World Bank’s pension plan, I have to commend Neil Record for his book, Currency Overlay.
As Record points out, at the time of writing the book, a comprehensive analysis of this investment activity did not exist in a single book, but interestingly enough, there have been a recent spate of books mainly from professionals at investment banks (see for example, the multi-contributor book from Jessica James at Citibank or the offering from Hai Xin at UBS). Record needs to be commended for having produced what is the equivalent of an encyclopedia on this topic, and it is no surprise that someone who has been at the helm of a successful currency management company since the inception of the industry in 1985 has managed to address both the high level issues as well as those one might consider mundane. His experience is his strength, but also unfortunately his weakness as we will discuss later. While the book is probably targeted to institutional investors, this book is an absolute must read for professional seeking t make a living working for in the currency management industry.
The book lays the ground work for the reader in great detail by highlighting how an investment in foreign assets engenders currency risk and what clients can do to manage the same. The chapter on the instruments in the currency markets touch on instruments not used by the average currency manager and provide useful reading for the interested reader. This is complemented by sections on valuation of these instruments that are not shy to go into the technical detail often found lacking among professionals marketing such products. After a brief history on the currency markets and the various players that lend their balance sheet to active currency managers through their not-for-profit currency trades, Record lays out the theories of currency hedging and even the mechanics of passive currency overlay, currency overlay benchmarks and overlaying different asset classes. Thereafter, the book shifts gears to make the case for active currency management followed by a description of the active currency management styles and a summary of the evidence on whether currency overlay has been successful. The book closes on some practical aspects of implementing currency overlay programmes as well as some thoughts on what the future might hold. Surprisingly, the chapter on the future was probably the weakest given the innovative approaches that many clients have taken to an activity that requires limited funding and generates meaningful alpha, and where managers have had to react to a significant reduction in the opportunity set given that the euro removed 11 currencies from consideration.
As an individual who implemented a currency programme for a pension fund, evaluated many currency managers, and worked for two (I am also fortunate to work with a former colleague of Record), I am glad to see such a book finally work its way into the literature on the topic of currency management as it raises awareness to the fact that a potential currency risk in portfolios can be converted into a source of excess returns by creative clients. However, where the book comes up short is that Record is biased by the style adopted by his firm and the instruments that they use and takes pot shots at competitors that are unwarranted in an otherwise fine book. The book is very supportive of technical models and somewhat dismissive of approaches that use fundamental economic analysis (“the key shortcomings are instability of explanatory relationships, and the unresponsive nature of fundamental models” – pp 218), but such comments reveal a set of blunders that are unnecessary. There are two things missed by such a comment: (i) that the assets under management in overlay for fundamental managers far overwhelms those of technical managers suggesting that either the comment is wrong or clients are foolish and missing something – performance of such strategies as good as any; and (ii) a smart manager or a client will find these styles are not highly correlated and hence will diversify the risk of being wrong by including both. Further, there is a suggestion that asset managers that are affiliated to investment banks/custodians may engage in unethical behaviour with their parent firm and execute trades at rates disadvantageous to the client. Having worked for one such firm, I can testify that this is far from the truth. Such accusations or suggestions should be backed up with evidence to show that this is endemic (as opposed to one-off examples that Record may know about but does not reveal) or else they should not make their way into print.
Further, the market is moving away from the type of activity that the author writes about and which can be called the 20th century approach to currency management. Clients realise that the true risk management provided by currency management is in generating a positive return stream (or alpha) uncorrelated with other assets in a complete portfolio rather than simply modifying the return pattern from a single asset class through the traditional overlay that Record writes about. As clients search for higher returns in their portfolios, currency management today seems entirely focused on generating the highest return per unit of risk (or information ratio) and the future for this industry where diversification is limited in developed markets using forwards to just 10 currency pairs, will come from three key areas: (i) use of additional instruments such as options – typically ignored by currency overlay managers, but a good source of alpha and a useful risk management tool; (ii) extending such activities to emerging market currencies to add as many as 22 more currencies; and (iii) improving portfolio construction through a dynamic allocation of risk (or what Record calls a top-down approach). Record does not touch on these three possibilities in the sort of detail one would expect in such a book. The explosion of interest from hedge fund funds of funds in active currency management and pension fund clients who realise that currency management is a pure cash generation strategy will lead the industry in the direction of raising information ratios (above 1 and closer to 2) and the fees in that space are more lucrative than those paid in the types of mandates described by Record. Hence I think his estimate on the fees earned by the industry is dramatically understated, especially in a year like 2003 where currency managers had banner performance (with excess returns above 3% and often information ratios in excess of 2) and many of the players had performance fees.
In summary, the book provides incredible detail and information for the interested reader on the theory, practice and mechanics of currency overlay and is worth the read for anyone wishing to make a career in this area. However, the market is innovating faster than the currency managers are, and the future for clients and managers will be more exciting than the past has been or that this book anticipates.
Arun Muralhidar is managing director of FX Concepts in New York