Lose your constraints
A couple of years ago, currency overlay mandates were fairly few and far between. Most pension funds left overseas currency exposures unhedged and those that did seek to manage them sought, in the main, to expunge the risk and accept the resulting profit or loss as simply part of the hedging cost. Opinion was undoubtedly swayed by reports from Mercer, Watson Wyatt and Frank Russell in the late 1990s and 2000 that evidenced excess returns on average from currency management, something that the universe of equity managers has always failed to achieve. Those trailblazing pension funds, now with four or five years of currency management experience, are now giving money to currency overlay managers, not to hedge specific exposures already within the fund, but as completely separate absolute return focused mandates, aimed at generating additional performance.
The rationale for hedging currency exposures is that it is an unrewarded risk. Currency has been found, in research by Pareto Partners, to contribute 25-30% of the volatility of returns, if unhedged, and 40-50% of the gain or loss on international equity investing. Research by Record Treasury Management suggests that hedging reduces the volatility of returns from non-UK equity exposures by 2 percentage points. By not hedging currency, investors may be getting a false impression of the risk of investing overseas, and unnecessarily restricting their allocations.
The 2000 Russell paper found across 18 managers, an average excess return of 1.48%, and an information ratio of 0.63. A market that permits the aggregate of managers to produce excess returns must surely be extremely inefficient, according to finance theory. But this assumes that all participants are active in the market to generate returns, which is not the case in foreign exchange. The vast majority of the many trillions of dollars of flows are for the purposes of trade, travel, or skewing monetary policy, and are time and price-insensitive. This creates both short and long term price/value anomalies that can be exploited by currency managers.
Another feature of currency markets, which gives rise to the possibility of meaningful currency returns, is the tendency of the market to trend. The euro, since its introduction in 1999, has experienced two major trends, initially prolonged weakness against the dollar, and more recently a strong recovery. A passive strategy of hedging all non-euro exposures would have lost money in the downtrend and made it back in the reversal. Ammunition to those critics of currency management who suggest that, if one can accept the additional volatility, currency exposure ultimately “washes out”. But an active currency manager could have generated significant additional return, by correctly identifying and exploiting these moves.
A fully hedged currency benchmark anticipates the manager hedging 100% of all non-domestic exposures, effectively removing both the risk and the return of holding overseas currencies. The manager operating under a 100% benchmark can only add value by underhedging (and increasing risk), when the overseas currency is expected to strengthen. A 0% benchmark means that the manager should only hedge when his analysis suggests that the overseas currency will weaken versus the currency of the fund’s liabilities. However, each of these “polar” mandates build in a bias to the manager’s returns, by allowing him only to take one-way bets.
For this reason a 50% benchmark is popular, particularly with US funds, because it is deemed to afford managers greater potential to add value. It can also minimise “regret risk”, as it is the benchmark that gives fund trustee’s least cause for regret. Currency overlay management is often shunned because trustees do not want to miss out on foreign currency gains. Equally the fund may wish it had been fully hedged when the foreign currency weakens. By employing a benchmark of 50%, the fund is always half wrong and half right. Greater potential to add value is afforded by setting a 0% benchmark and allowing managers to trade boundaries 100% either side (from fully hedged through to effectively duplicating the fund’s existing currency exposures). But any mandate which links the size of the currency positions that can be taken by the manager to the existing currency exposures of the fund will likely result in a sub-optimal currency portfolio, relative to one whose objective is purely return generating.
Absolute return currency mandates break the link between the fund’s exposures and the positions taken by the manager, and are structured solely to achieve a certain level of return for a given risk, measured as the standard deviation of returns. Paul Duncombe, head of currency management at State Street Global Advisors (SSGA), comments: “The step required to decouple the currency mandate from the underlying portfolio and focus solely on return is not so great. After all, even mandates whose objective is just to control downside risk must generate returns to offset portfolio currency losses.” The trend to treat currency as an asset class, and allocate a risk budget to an unconstrained currency programme has accelerated over the last 18 months, according to Duncombe, who reports that SSGA is seeing more demand for this business line than for traditional currency overlay mandates. Duncombe avers that removing the link also leads to a more balanced portfolio of currency positions, saying, “The returns on a traditional mandate will be driven largely by the manager’s view on one or two major currencies, such as the euro and the yen, for a US based fund. Within an unconstrained mandate, all currencies are potentially sources of return.”
In these independent mandates, the manager will decide what maximum and minimum position sizes it should take in each currency so as to remain within the risk budget. Since none of the guidelines make reference to the underlying portfolio, a manager could end up hedging more currency exposure than is being taken by the fund, or creating currency exposure previously not present. Whereas in the past, this wanton deviation from the benchmark might have been a cause for concern, such is the disenchantment among trustees with slavish adherence to benchmarks that have not delivered the required return that an absolute-return emphasis in currency pitches is finding favour.
However, Adrian Lee, founder and president of Lee Overlay Partners, warns that typical total return managers may need to get up to speed on a range of investment management issues to run an active mandate on the full currency exposures of the fund, because they lack performance measurement and operational infrastructure. A manager that cannot properly attribute the returns from hedging versus the returns from taking an active bet will not be able to provide accurate reporting to the client on the success of the strategy. By combining total return with the strategic hedge, clients may well end up paying double the level of transaction costs, if one manager is taking care of risk control by fully hedging and the other operating a separate alpha generating capability, especially if the latter is taking opposing positions to the former. Lee therefore feels that the totally unconstrained currency mandate is best used as a satellite to a core overlay mandate, if risk reduction is also part of the client’s objective.
Lee comments that the information ratio of 1 that is typically targeted by currency managers provides an extremely good risk/reward trade-off compared to the 0.5 typically quoted by equity managers. Also he suggests that the return distribution of currency portfolios is narrow as the “fat tails” demonstrated in the short term returns of individual currency pairs tend to even out in a currency basket over the longer term. “It would be unusual for an investor to suffer unduly from an extreme return from the movement of one currency pair, since most investors have a variety of currency exposures.”