Europe following US example
There has been huge growth in the demand for currency management over the last two years, managers report. Institutional investors are seeking both to reduce the risk of foreign exchange fluctuations while at the same time making the most of the opportunities for profit.
Currency can be managed through a currency overlay. This is where currency is managed in an investment portfolio separately from the management of other investments. It is ‘overlaid’ on top of other assets, which means it can take place on a large portfolio but without reallocating more than a fraction of that portfolio.
Currency management can take other forms also. It can be performed without reference to another portfolio, with currency managers actively taking positions in the foreign exchange markets with the aim of making profits from these. There are many different approaches managers can take.
Though still more widely used by institutions in the US than on this side of the Atlantic, currency management is gradually catching on in Europe, says Kevin Bailey, managing director of BNY Overlay Associates, a subsidiary of Bank of New York (BNY). BNY Overlay Associates is one of the biggest currency managers with around $8bn (e6.2bn) under management.
The number of currency managers operating in the market worldwide is very limited compared, for example, to equities managers. Besides BNY, major players include AG Bisset & Co and Bridgewater Associates, both Connecticut-based, Barclays Global Investors, Pareto Partners, Record Currency Management and State Street Global Advisors.
The oldest users of currency overlay tend to be in the US, though many of the major currency managers have operations based in London. This is because of the importance of the London foreign exchange market, the largest and most liquid in the world.
Often, currency management is not really to do with hedging, says Bailey. BNY, for example, offers its currency alpha programme, which is typically overlaid on an international equity portfolio in order to add alpha. BNY’s approach is totally systematic and model-based.
“From a hedging point of view, pension funds have to decide if they’re looking to hedge (their currency exposure), leave it unhedged, or do something in between,” says Bailey.
“It’s a question of how much risk you’re willing to take,” he says. In general, people are looking for alpha programmes.
There have been big changes over the last few years in the way pension funds allocate assets, with an emphasis on diversification including widening the geographical spread within the portfolio. For many funds, this has meant an increase in exposure to foreign currencies. There are arguments for and against hedging this exposure back to their home currency unit.
“Now they are left with this exposure,” says Bailey. “Some pension funds decide they are happy with that, and some decide to put a 50% hedge in place.
“After that decision, they’ll typically go one step further,” using currency management as a way of adding value to the portfolio.
And there is evidence to show that overall, currency management can produce extra returns. A survey by Russell/Mellon reveals that 87% of fund managers who have sought to add value through currency overlay management have succeeded.
It all depends how much risk the investor is prepared to allow. Bailey says that for 300 basis points of tracking error BNY’s objective is to achieve 300 basis points of return.
“Which is quite attractive, given that traditional asset classes are unlikely to produce the stellar return of previous years,” he says.
Apart from the absolute level of targeted returns, a key attraction of currency alpha is that these returns are typically not correlated to other returns in the portfolio at all.
There are many different ways that currency managers attempt to achieve alpha through clever currency trading. Some managers trade in the currencies of developed countries, which are the most liquid, while others get involved with the currencies of emerging market countries.
Styles vary as well. Pension funds would typically put together a diversified portfolio of currency managers, says Bailey.
Historically, the dominant strategy used by currency managers was that of pure trend-following, says Emmanuel Acar, head of London Risk Management Advisory at Bank of America, although now a wider range of strategies are being considered.
“In my view managers at the independent boutiques running currency programmes are still mostly trend followers, but now we have new players launching currency hedge funds, namely real money and overlay managers, and they approach the market differently,” says Acar. The overlay managers tend to use more carry trades and fundamental strategies, which can both be used as systematic strategies.
Currency managers have been categorised as those that are systematic, model-driven following signals generated by trading algorithms and those that are discretionary.
Alongside the model-driven programmes, there are also the pure discretionary managers, he says; the discretionary managers do not follow models, but may use them (if at all) for guidance only.
“The problem is that the distinction is not clear cut in all cases, because you find managers using models, but overriding them, or using their discretion in deciding when or when not to follow them.”
Bailey says currency hedge funds are also used. “Because currency management is typically done by large pension funds, they might also use currency hedge funds,” he says. This would involve investing in a fund with leverage.
“Many pension funds feel an overlay on the international equities portfolio is where a currency programme comfortably fits,” he says.
Russell/Mellon’s experience also shows that pension funds are now becoming more interested in currency management.
“The number of accounts in our universe is continually growing indicating that pension funds are increasingly requiring external currency management,” says Louise Harris, client relationship manager at Russell/Mellon.
“Speaking to many of the currency managers there is a trend towards alpha generating accounts,” she says. “Many funds begin with traditional hedging strategies and move to alpha strategies later on.”
David Buckle, senior currency fund manager at Merrill Lynch Investment Managers says one of the
reasons why pension funds have turned more attention towards currency overlays is the steep decline of the US dollar. For a European pension fund, having a globally diversified portfolio means having high allocations to US assets, he points out. “But the speed and magnitude of the dollar’s depreciation over the last two years has led to concern,”
But while this put a focus on the need for currency risk reduction, pension funds mainly use currency overlays for adding value to their overall portfolio rather than purely to rein in the risk of foreign exchange fluctuations.
“The normal way currency managers look at this is to split it into two pieces,” he says. For example, a fund which has 40% of its assets in overseas securities may decide to hedge half of that back to its domestic currency unit. This is the risk reduction part. The second part is adjusting that hedge according to the view the manager takes on the currency markets.
When a pension fund insists on hedging its currency exposure to a high level, this is restrictive for the currency manager in terms of their ability to add value on top of this. But pension funds’ attitudes towards this are relaxing.
“One of the advances we’ve seen (in currency management) is the freeing up of the positions to make the job easier…the freeing up of the restrictions has been of advantage to both pension funds and currency managers,” says Bailey. Having witnessed the ability of currency managers to add value, pension funds have become confident enough to loosen their strict currency hedging restrictions.