Do not be surprised when today's immense macroeconomic stresses find an outlet in global currency markets, writes Anthony Harrington. And if you can, ready yourself to take advantage
With advanced economies teetering on the brink of a double-dip recession, the FX world is experiencing sharp intra-day currency swings.
This has been highlighted in recent weeks as investors have, apparently paradoxically, fled to the US dollar as the world's deepest pool of liquidity, despite loud warning bells from the US economy. Even a controlled currency like the Chinese renminbi is not immune, having seen a real annualised appreciation of some 12% over the past two months.
Equity and bond fund managers - not to mention their pension fund clients - cannot avoid squaring up to the fact that currency movements can have a massive impact on returns from foreign currency-denominated asset classes. They face three choices. As Morgan McDonnell, head of FX markets and products at RBC Dexia explains, managers can ignore the currency risk - and this should be as much an active decision as any other that they make; they can try to hedge some or all of the currency risk away; or they can try actively managing the risk in pursuit of a better return.
The second option, hedging, itself offers
three further choices. The first is passive hedging, where the investor seeks to offset either a fixed percentage or as much as possible of the risk.
The second involves treating the hedged component as an actively-managed element, moving the hedge up or down to take advantage of beneficial or adverse currency movements.
The third choice involves a fully-active overlay which retains the option of trading currencies where the fund has no exposure against others that are not the fund's base currency - treating FX as a potential alpha generator in its own right.
As McDonnell points out, there is no one-size-fits-all strategy. "You have to ask yourself as a pension fund manager what approach to currency best aligns with your investment policy or objectives," he says.
Choosing to leave currency risk unmanaged might seem sensible when most of your exposure is to a currency that has a recent history of appreciating against your base currency - as is the case for UK investors with US dollar exposures. But end-investors are increasingly regarding any off-benchmark exposure from random currency appreciation as a problem, especially if it obscures the true risks that their asset managers are running.
In any case, there are plenty of academic studies that show that unmanaged currency risk has no inherent long-term value, so equity or bond managers who do not want to find themselves morphing into currency traders have a case for hedging out currency risk altogether. However, being near 100% hedged, by definition, eliminates the upside from FX moves, as well as the downside. No wonder we so often see the so-called ‘least regret' approach - setting the passive hedge at 50% and rationalising the residual risk as an additional source of portfolio diversification.
For Keith Guthrie, CIO of Cardano, this represents a lame approach that shows little or no understanding of the opportunities presented by FX or the macroeconomic sources of those opportunities. Guthrie argues that, even when managers go for an active alpha generation strategy, their thinking tends to start from the wrong place.
"The typical approach, even with an active alpha strategy, is to say ‘OK, here is an asset class, currency, and we'll allocate 10% to it because it is a nice diversifier in the portfolio'," he says. "The more appropriate starting point is an analysis at the macroeconomic level to try to understand what is happening across asset classes, including currency. If the macro level creates opportunities in currency then we look to exploit those - and right now there are massive mid and long-term opportunities being created in currency."
With advanced markets undergoing balance sheet deleveraging at the consumer, corporate and governmental levels while trying to avoid recession, the unavoidable policy option seems to be to ‘print money'. Many emerging markets are battling inflation with rising interest rates, even as they all want to weaken their currencies to keep their export engines competitive. These big macro trends are having a huge impact in currency markets.
"We have been seeing risk reversal with the US dollar, with fear driving investors into the dollar, but as soon as the fear wears off, the US dollar devalues again very sharply," says Guthrie. "At the same time, every country wants to weaken its currency to improve competitiveness, so you get a tremendous race to the bottom, the latest instances of which were the Swiss and Japanese central banks printing money."
Emerging economies clearly do not want to raise rates, but the fear of political instability through rising food commodity prices will eventually force them to allow their currencies to appreciate. This has massive implications both for hedging and for active FX alpha generation - and none of it is particularly straightforward. Central bank initiatives can play havoc with hedging and trading strategies.
Guthrie points out that despite strongly rising inflation, the central bank of Turkey cut interest rates again in August because it rated growth above concerns over inflation. Moves like that are hard for FX traders to foresee, while the move by the Swiss central bank was easy to see, but hard to judge in terms of precise timing.
"For alpha generation, you need to know which country is allowing its currency to appreciate and the million-dollar question in FX at the moment is deciding what rate the Chinese are going to tolerate," says Guthrie. "Right now it is appreciating by some 7% annually against the dollar and not much at all on a trade-weighted basis."
As Ugo Lancioni, lead portfolio manager for currency strategies at Neuberger Berman, puts it: "Political interference makes alpha extremely difficult."
Maria Heiden, a currency specialist with Berenberg Asset Management, a quant specialising in currency alpha and dynamic hedging, argues that perhaps the main reason why institutional fund managers have not gone more for currency alpha generation is that non-quant active FX managers have generally failed to deliver. "Their sales teams have taken the message of currency as a diversified alpha source to fund managers but the results have generally been disappointing because currency is very difficult for individual traders to trade successfully over the medium term," she says.
Heiden argues that quant models are simply much better than humans at exploiting both range trading and sudden break-outs.
The track record of quant FX funds is attracting both UK and US pension funds to pay more attention to quant-generated FX alpha, she says. "It is now common for a UK pension fund with euro[-denominated] stocks to hedge their euro exposure and then to add an FX alpha overlay with a fully diversified currency position, trading multiple currency pairs long and short," Heiden comments.
Berenberg uses a multi-model architecture with three basic strategies: a high frequency intra-day model and longer-term models that trade trends over months. Once the client investment manager has decided what and how much to hedge and whether to have an alpha overlay, the rest of the decision-making is left to the models. For Heiden, an active alpha overlay requires a time frame of at least 12 months to generate significant results.
Max Darnell, CIO at First Quadrant, which manages around $17bn for institutional clients and is generally regarded as a quant house, says that, in reality, it combines a value investor's view of how markets work with a systematised approach to trading. "Currency trading tends to split into technical and fundamental currency management styles, along with what you might call an asset management style that aims to simply capture market beta," he says.
For him, the two main sources of gain for currency traders, namely the carry trade (borrowing low interest rate currencies to invest in high interest rate currencies) and momentum are both sources of beta. "Both are cheap and easy to replicate and you know that everyone who is trading is going to be doing it, which makes it beta," he reasons. "You get what the market gives you."
The carry trade works well in a low-risk environment with lots of leverage. Trends work well when there are gradual and incremental changes in macro fundamentals. Both hit turbulence in an environment where central banks are trying to fight against (or indeed flow with) the two major influences in markets over the last few years - the flight to safety and fundamental mis-valuations in markets.
"Look at the Swiss franc," says Darnell. "It is clearly overvalued, but people continue to look at it as a safe haven. Now it is pegged to the euro but is arguably still overvalued. The Aussie and the Kiwi were meaningfully overvalued in 2008 and are overvalued today against a background of stalling economic growth."
These complexities turn the apparently simple decision between whether to go for a passive or active hedge into a very complex calculation.
"Australian and New Zealand fund managers had passive hedging policies in 2008 and they went through some very severe pain as the market fell," Darnell continues. "They had to deal with the value of their assets falling at the same time as their currencies were falling, which meant that their passive hedge required them to write some very large cheques to pay the P&L on their forward options or swaps. So a passive hedge might seem benign, but circumstances can make it anything but benign."
John Belgrove, a principal consultant with Hewitt Associates points out that FX specialists need to be aware of the huge complexities that scheme managers and scheme trustees are facing. "The best funds, those that have put time and resources into upskilling the trustee board, are clearly embracing a wider investment opportunity set," he says. "These are the funds that will be looking to add FX alpha, and they will be more nimble and looking to take decisions about investment strategies, including hedging and FX, that are more reflective of present market conditions. At that level, active currency management would fit, but it remains true that all schemes face currency risk, irrespective of whether they have the resources to properly delegate the management of that risk or not."
The currency markets resemble nothing less than a frantic bucking bronco at the moment. No one would blame you for not wanting to saddle up and take your chances. But that bronco will trample you under hoof whether you like it or not - while ‘passive' might be one answer, doing nothing emphatically is not.