Currency alpha management is not only well-suited to turbulent markets, argues Jay Moore. It also responds well to stress testing against extreme scenarios
Global markets today are being buffeted by sovereign credit brinksmanship, stumbling economic growth, broad risk aversion and herding in equity markets. With investors redoubling their focus on liquidity, transparency and diversification, many are looking to currency management to reduce long-term volatility and deliver diversified, less-correlated returns amid rising levels of turbulence.
Institutional investors around the world have steadily increased their international portfolio exposures for many years. With every incremental increase in cross-border investment activity, the relative significance of currency risk edges up a notch. As investors who once chose to ignore currency volatility look to manage the impact of currency fluctuations on their portfolios, many are interested in much more than simply hedging away currency risk.
The goal of currency management for many global portfolios has evolved from a simple desire to mitigate currency risk, to a calibrated balance between risk management and alpha generation. Each investor, and each mandate, brings to the challenge a unique definition of risk management. For some, currency management might simply mean minimising overall portfolio volatility or minimising the tracking error of a passive hedging policy against a chosen benchmark, while others seek to maximise alpha using active currency management as the tool.
Currency risk management programmes turn on passive (strategic) hedging policies that bring with them no expectation of returns. But today, with macro-economic tensions and enhanced sovereign risk exerting extraordinary pressure on currency valuations, investors undertaking passive risk management often begin to consider directional views on the dollar, euro and other currencies. Moreover, investors often have an appetite for the cash inflows that they derive from hedging depreciating currencies, while at the same time wanting to avoid cash outflows from the alternative.
Investors with forward hedges that result in cash outflows (losses) know that there must be an offsetting gain in the underlying asset. Many investors fail to acknowledge these offsets, calibrating their hedging decisions solely through cash flows. This suggests that investors are interested in both risk management and return enhancement, and that there is therefore a need for active as well as passive currency management.
Decisions around currency risk management and the use of currencies to generate alpha don't turn on a simple binary choice. Rather, investors face a graduated spectrum of strategies that allows for degrees of market risk commitment. For example, currency overlay/hedging programs are designed to manage currency risk as a means of adding value to the portfolio. By manipulating ratios of existing hedges, investors can achieve moderate return enhancement by actively tilting passive currency hedging in anticipation of currency fluctuations.
Active overlay is less than ideal from a return-generation perspective because the currency mandate is typically limited to hedging (or not hedging) only those currency exposures within the portfolio. In consequence, most active overlay decisions are centred on major currencies such as the US dollar, euro, British pound sterling or Japanese yen, with less importance given to decisions regarding smaller, but still important currencies such as the Swiss franc and the Australian, Canadian and New Zealand dollars. Overlay constraints usually exclude most emerging market currencies altogether.
A second limitation of active overlay is the influence of the specified benchmark imposed on the manager. For example, a single manager may have two clients, one with a fully hedged benchmark and another with an un-hedged benchmark. Because active overlay mandates are typically constrained to hedge 0-100% of the exposure (no over-hedging or net long positions) the same investment strategy will perform very differently for each of those investors, depending on market direction.
Pure or ‘portable' alpha strategies provide managers with full discretion over the positions within the currency portfolio, provided that the aggregate portfolio risk stays within mandated parameters. This approach permits clients to address the strategic investment decision of a passive hedge as a risk management tool, while treating active views on currencies as part of a diversified alpha program. Often, investors redeploy the risk reduction achieved from the strategic hedging policy directly to an unconstrained portable alpha strategy to boost returns.
Currencies and crisis
Currency management might seem somewhat exotic to investment committees and fund trustees accustomed to traditional asset allocation mixes of domestic stocks and bonds. But over the course of several years of financial crisis and market upheaval, currency investment has been revealed to possess several stabilising qualities.
For example, financial academic theory has long understood that unmanaged covariance (the co-movement of returns in different assets or asset classes, as measured by correlation and volatility) has a potentially corrosive effect on portfolio returns in the short run. It is well understood that in times of extreme market turbulence, correlations across traditional portfolios surge to one almost instantaneously. Research by State Street Associates, the research partnership between financial academics and State Street Global Markets practitioners, suggests that over the past 10 years the correlation of global equity, bonds and real estate returns significantly increased during periods of market turbulence. But during these periods of turbulence, the average correlation of currency strategies with those asset classes actually decreased, providing diversification when it is needed most.
Furthermore, during the financial crisis of 2008, as investors discovered massive correlations and herding with regard to portfolios that they had previously thought to be diversified, they also discovered their investments to be highly illiquid. Amid turbulent trading markets, many positions could not be unwound, with ruinous effect on valuations. Foreign exchange positions, by contrast, could be unwound with less traumatic impact on asset prices. The extraordinary properties of currency markets during crisis can be attributed to the fact that on the most turbulent trading days, the foreign exchange markets trade with minimal disruption, giving currency managers the ability to manage portfolio risk on a much more continuous basis.
Taking advantage of market turbulence would be difficult if investors were to enter choppy markets blind. Fortunately, research has revealed how turbulent markets evolve, how they persist, and how investors can reallocate their portfolios to manage risk more effectively or enhance alpha by taking advantage of volatility.
Quantitative financial practitioners have long sought to understand the frequency and duration of market-changing turbulence and its impact on investment correlation. More frequent bouts of financial market turbulence have taught us that market outliers that were once thought to be rare have become more common, with greater impact on the correlation of asset classes and on the risk profiles of diversified portfolios.
Turbulence can be defined as the arrival of these market outliers — statistically anomalous events that represent substantial divergence from normative models. Extreme political and financial scenarios such as the 1987 stock market crash, the first Gulf War, Russian default, the bursting of the technology, media and telecommunications bubble and the financial crisis of 2008-09 are examples of this.
True turbulence is not the manifestation of investor opinion or behaviour. Rather, it is a simple statistical expression of unusual price changes. Sharp departures from normal pricing — on the upside and the downside — define turbulence. Turbulence measures can be applied objectively across any market or asset class, including currency markets.
The study of market turbulence reveals that traditional quantitative expressions of risk, which place equal significance on normal and non-normal markets, significantly underestimate the impact of turbulent events. Covariance estimated from market outliers, by contrast, provides a model of portfolio risk superior to those derived from full-sample analysis.
The study of turbulence has proven particularly applicable in tactically managing the impact of market turbulence on currency strategies. For example, the forward rate bias strategy, which exploits the difference in interest rates between currencies, performs well in times of minimal volatility and underperforms during market turbulence that changes the correlation structure of various currencies. In times of market turbulence, the swings in currency valuations are even wider than those in other classes, often dwarfing interest rate differentials. Market turbulence affects various currencies in different ways, wreaking havoc on correlation assumptions and breaking apart the covariance matrices at the heart of investor risk models.
If asset owners and their managers can understand the way that their strategies will perform under times of high turbulence, they can effectively insulate their strategies. This is possible because of the well-documented persistence of turbulence in currency markets. Once turbulence arrives, risk positions can be scaled back and positions reduced as a hedge against future turbulence, thereby defending portfolios.
One of the single greatest lessons of the recent financial crisis might be that traditional and non-traditional asset classes are increasingly intertwined, with correlation accelerating as volatility erupts. But when markets grow turbulent, while other asset returns herd into massively aligned defensive positions, currency returns tend to go their own way.
The use of turbulence measures to hedge against the breakdown of persistent market inefficiencies and currency relationships may go a long way to preserving portfolio values. For example, currency strategies (in the aggregate) generated strong returns through the challenging markets seen since 2008, and also provided diversification when it was needed most.
Increasingly, currency is viewed as a viable asset class that can be considered a critical element within alternative portfolio allocations. Investors using turbulent covariance matrices to stress-test asset allocations may find that currency management strategies informed by this research can provide a shelter in both good times and bad.
Jay Moore is a managing director at State Street Global Markets