Brian Strange analyses European portfolios

Focusing on currency overlay management and performance measurement issues in my recent consultant past, I completed a review of the value added by currency overlay managers. The complete study covered the results submitted by 14 currency overlay managers with a combined total of more than $40bn of currency risk under management1. The evidence indicated that currency overlay management enhanced returns and reduced risk.

However, the majority of accounts were managed for US dollar-based investors, most of which began before those based in other currencies. As currency overlay continues to grow in favour on the right hand side of the Atlantic, IPE wondered if the same conclusions might hold true for European investors. The answer could be found by focusing on the value added by currency overlay managers for accounts with European currency bases.

While these accounts produced a narrower data sample than the complete study, it does seem to be comprehensive and diverse across both manager styles and currency bases, although the average account duration is slightly shorter. However, during the period these accounts were managed, the dominant themes were dollar strength and yen weakness, with lots of volatility along the way. Given the heavy and comparable weightings of these two currencies in the MSCI ex-Europe index, one might expect the net currency result to be almost nil, and therefore, unbiased. Yet an adroit manager able to harness the volatility might do better.

The smaller sample covered:

p Six managers representing non-forecasting, technical and fundamental disciplines

p 23 overlay accounts

p BEF, CHF, DEM, GBP, HFL & PTA base currencies

p Average account life of 8.6 quarters comprising 183 account quarters (a quarter during which an ac-count was managed - thus, a manager with two accounts, the first run for five quarters, the other for 20 quarters would produce 25 account quarters; another manager with a single account run for 25 quarters would also represent 25 account quarters - equal experience and equal weighting in aggregations)

p Over $4.5bn of currency risk under management.

Comparing the performance of one currency manager with that of another is devilishly difficult. Each manager has a differing set of currency exposures, constraints, base currencies and benchmarks with which to contend. It is rare for two accounts to have the exact same characteristics and, therefore, it is impossible to establish one common performance measure for all accounts which would fairly rank managers by performance.

However, as all managers are given benchmarks reflecting these varying client defined mandates, it is possible to determine whether managers in the aggregate are producing value for their clients, by comparing each manager's performance relative to the assigned benchmarks for each account. In other words, while it is difficult to compare one manager's value-added with all others, and to contrast the magnitudes of their value-added for different mandates, it is certainly possible to see whether value has been created for any single account and for a broad survey of accounts.

Managers added value: the average currency return of the managed accounts was about 1.7 % per annum, versus the average near zero currency return of the benchmarks.

Managers reduced risk: the total currency return of the actively managed accounts studied had lower standard deviations on average than the performance benchmarks which the currency overlay managers were given. Annualised standard deviation of the quarterly currency returns was about 4.1% versus 4.9% for the benchmarks.

Performance was fairly consistent through time and across managers: Annualised average account value added per annum ranged from 1.6% to 1.9%, from complete through shorter holding periods.

16 of 23 accounts outperformed their benchmarks on a cumulative basis, producing a success ratio (we Yanks liken it to a baseball player's batting average) of 70%. Managers produced positive results in 103 of 183 account quarters.

Symmetrical mandates, encouraging managers to both increase and reduce their hedge ratios relative to the benchmark, had more consistent value-added than asymmetrical mandates: The more skewed the benchmarks were, the less consistent the value-added was. For example, when accounts managed against polar benchmarks (0% or 100% hedged) are compared with those with a benchmark hedging ratio somewhere in between (50% hedged being the most frequently occurring), the polar group shows a 1.8% higher standard deviation of excess return.

Each firm disclosed for each quarter for each of its accounts the:

p Total return of the managed ac-count: - this included the returns from translating the underlying investments at changing currency rates, plus the manager's returns from hedging activities.

p The benchmark return - this included the returns from translating the underlying investments at changing currency rates, plus the returns from hedging activities produced by following the benchmark rule.

p The value-added by the manager versus the benchmark for each quarter during which they managed the account.

Table 1 refers to results calculated from the data submitted by managers for all of their accounts. The information displayed includes:

p The average quarterly return and standard deviation for the entire time period of the included accounts, the number of accounts which, on a cumulative basis, showed positive value added, which is then used to define a success ratio - percentage of outperforming accounts for each time period. The average outperformance (win) and underperformance (loss) is computed, also producing a ratio of the average win to the average loss.

p The number of account quarters (a quarter during which an account was managed) for the category and the number of account quarters in which the results were positive, again being used to determine a success ratio - the percentage of account quarters with positive value added relative to the total account quarters for the respective period.

p The total currency return and the volatility of both the managed account and the benchmark to help determine if managers contributed to currency risk reduction of the account.

Table 1 shows the data on the broadest basis possible - for all accounts that were submitted and were managed for a European base currency. The most encompassing definition of whether currency managers are doing their job is given by the overall quarterly average of the value added. It is positive and annualises to about 1.7% per year, and stays fairly consistent in all time periods. However, the volatility of the value added lessens slightly in nearer time periods; that is, recently, managers are more consistently beating the benchmark. Two factors might explain this.

While the dollar has been strong, making it tough to beat a 0% hedged benchmark, Yen weakness against European currencies has offset it, particularly against sterling. Depreciating currencies offer better opportunities to add value against a 0% hedged benchmark, and the forward market premium income from selling those currencies provides an extra kick.

The more recent popularity of 50% hedged benchmarks, which are easier to beat in both up and down currency cycles. Managers usually exhibit a greater range of hedging ratios when faced with a midpoint benchmark.

Additionally, managers' skill levels may be improving with more experience and the greater number of accounts in existence in recent years would weight their performance more. Currency overlay has been a rapidly expanding activity as reflected in the total account data. Only four of the total of 23 accounts have existed for more than three years and more than half are less than two years old.

A frequent focus of investors when establishing currency overlay management programmes is the desire to reduce the risk that currencies present to their international portfolios. Thus, a measure of performance ought to be whether or not the programme provided excess return at concomitantly higher risk, possibly producing an equivalent risk adjusted return. This can be assessed by comparing the total currency returns of the managed overlay accounts with the benchmark currency returns, rather than focusing simply on the value-added.

Table 1, also shows that in all time periods, the higher returns of managed accounts were produced at lower or equal risk levels than those yielded by the benchmark strategy. The standard deviation of those accounts was consistently lower than the same measure for the currency benchmarks given to the managers by their clients. The managed accounts produce a growing return/risk ratio ranging from .22 to .33. Active currency overlay management for European investors appears to have produced not only higher returns, but less risk, and thus a significantly higher risk adjusted currency return.

Results by managers: The analysis done thus far was based on the performance of the 23 individual mandates. To the extent that some managers have more accounts than others, the prior analysis does not show how the managers did on average for their clients. Let's look at the average performance of managers across all ofthe firm's accounts. As mentioned from the outset, it is misleading to compare one manager against another due to differences in their mandates.

This alternative approach analyses the effectiveness of currency overlay programmes averages the excess return of all accounts a manager has. This very simply states whether on an equal weighted average basis a manager has outperformed, or not, for all accounts. These manager averages could be further averaged, giving each manager an equal weight in determining whether managers, as a whole, are adding value. This approach contrasts with the earlier all account" approach, which is weighted to the performance of managers with greater numbers of account quarters.

Table 2 affords a look at these average results. The manager value added av-erage per quarter is positive, about 2.3% per annum, and not greatly different from the earlier, 'all account' calculations. The percentage of successful accounts on a cumulative and quarterly basis is 80% and 62%, respectively, and once again similar to values derived on an all account basis. Likewise, the consistency of adding value increases in nearer years, witnessed by the drop in standard deviations, and slightly rising success ratios. A look at overall performance using this approach corroborates earlier conclusions.

While the results are presumed to be reliable, they were not audited, so it is possible that managers put only their best foot forward. In the broader study, a concurrent attempt to broadly verify results was made by surveying 47 pension plans with currency overlay programmes. Because not all replied, we could not obtain a total verification. However, 22 of the 25 mandates which were covered in their replies showed positive added value and 100% of the investors surveyed were satisfied with the results. There is no reason to believe that those who replied to the survey were any more satisfied than those who did not reply; in fact, given the propensity of people to complain, one might be inclined to think that those who were most dissatisfied would have been most inclined to reply.

The findings in this smaller sample seem to mimic those from the complete study, though the analysis contrasting the performance of managers with restrictive mandates with those operating under more permissive guidelines, could not be undertaken because of the much smaller number of accounts. However, I submit that the conclusions drawn from the main study are fairly universal, and feel that this more focused review buttresses that.

Brian Strange is director, client services at Key Asset Management in Ohio. Key advises on US equity and fixed income and has a sub advisory agreement with Indocam Asset Management in Paris

1. The reader is referred to in the June 15 edition of the US publication Pensions & Investments for the study and more complete details on methodology and varied analysis than permitted by the space allowed here.

AG Bisset & Co did not provide data for the earlier study, but did so for this European study."