Market volatility and central bankers racing each other to zero have beaten up the carry trade. Does this make the case for a diversified exposure to currency absolute return strategies? Martin Steward reports

The active currency managers on Deutsche Bank’s FX Select platform have seen assets under management almost treble to over $3bn (€2.2bn)in the past year - and more than half of those flows have come from pension funds. Investors clearly believe that currencies represent one of the more robust alpha sources in tough, volatile market environments.

That’s a common-sense view. Because they are priced against one another it is impossible for all of them to go down in value at once (we might say that certain stocks or bonds ‘outperform’ others in a down market, but it is certainly possible for all stocks to lose value against cash). And despite being the world’s most liquid market, the overwhelming dominance of non-profit seeking participants - from central banks, corporates and bond fund managers to jet-setting tourists -maintains a decent level of inefficiency. Absolute return would appear to be the natural state of things in this asset class, and that makes for good non-correlation with traditional assets which, if anything, improves in choppier conditions.  

“In the currency world, volatility doesn’t necessarily translate into disorderly markets,” says Deutsche’s head of currency solutions for pension funds and insurers, Torquil Wheatley. “That sets it apart from the equity and fixed income worlds to some extent.”
You would never guess by looking at recent activity among pension funds. A rash of currency alpha mandates awarded over the past five years or so are being terminated.

“A few managers have been having problems because they were solely reliant on the carry trade for their returns,” says Wheatley. “There were consultants out there who said: ‘The only way to make money from FX is through the carry trade’. That was clearly proved the wrong strategy.”

Hymans Robertson was one of the consultancy firms influential in the success of currency alpha, particularly among UK local authority pension funds. Partner John Hastings says that carry was not the only style approved by consultants, and that it was made clear to investors that they would be taking on a significant carry bias with the managers they chose.

  “It was easy for investors to become seduced by carry when it was working,” he says. “The problem with carry is that it is intuitively plausible, and the reversal was quick and extreme.”

One of the main beneficiaries of the allocation was Record Currency Management. Chairman and CEO Neil Record says the firm saw 100% compound asset growth since it became “flavour of the month” in 2004. Some of that unravelled during 2008 - the local authority pension funds of Cambridge, Newham and Somerset and corporate pension funds including Silentnight’s and Avecia’s are just the more recent examples of investors that have terminated mandates.

“I can’t deny that our absolute return products have been correlated with risk premiums over the last 18 months,” Record concedes, “and it is accurate to describe our product as led by the carry trade.”

The carry trade, in its most ‘naïve’ formulation, involves selling low-yielding currencies to buy high-yielding currencies. In general, countries with higher levels of inflation tend to have higher interest rates than those with lower inflation, and that relationship holds pretty steady. But when things get stressed risk often flees towards the low-rate currencies, like JPY, CHF and SGD, that carry-traders are shorting. And as most of the world’s central banks have raced each other to zero the rate differentials that provide carry traders with their opportunities have fizzled away.

“The last 18 months has seen six years of returns from naïve carry wiped out,” notes Bob Arends, head of an ex-Fortis team that recently took its (diversified) currency alpha strategy to Henderson Global Investors.

Last year was particularly gruesome thanks to colossal positions built up by investment banks since the turn of the century. Record - whose approach to the carry trade is far from naïve, as we will discuss below - describes banks holding carry as a quasi-credit asset on their balance sheets, which perhaps suggests why behaviour in FX markets became peculiarly ‘investment-related’ rather than ‘currency-related’ at certain points last year - with hair-raising JPY volatility being ‘Exhibit A’.

“We’ve not been materially long the carry trade for the last 18 months,” he says. “But the banking sector has, and the fallout from their forced unwinding has been profound. I used to be able to say that the one thing you can rely on is that you won’t be correlated with equities, particularly in times of equity stress. All the things that had happened in currency markets over the previous 20 years - including 1987, 1997, 2000-2001 - had been domestic or international currency-related, but not investment-related.

Even in ‘normal’ times the carry trade is short-volatility and leptokurtic with significant left-tail risk: it can tick away nicely for long periods, but its history is littered with negative three or four-sigma events.

“It’s that tail-risk of carry that we focus on a lot,” says Bill Maldonado, head of alternative investments with Halbis, part of HSBC Global Asset Management, whose integrated model trading team has recently launched its diversified currency alpha strategy as a Luxembourg UCITS III fund.

Trading carry across a basket of G10 currencies, Halbis adds correlations to the usual matrix of interest-rate differentials and spot-price volatility in its portfolio optimisation. In theory, this increases the chances of picking carry-trade pairs that will withstand disruption from flights to safety. These “risk-neutral” carry trades might be a little less punchy, but they are much more stable.

 “For example, a currency pair like EUR/CHF has a fairly boring interest rate differential of 2%,” explains Halbis’s Soren Beck Petersen. “But when you look at how the euro and Swiss franc tend to move together you find that when the euro depreciates against the dollar, the Swiss franc pretty much does the same thing, so holding that pair offers some protection when we see market shocks.”
Arends makes a similar point when describing the Henderson fund’s “risk-adjusted” carry.

“If you look at the interest-rate differentials of USD/JPY and EUR/GBP, for example, they could both be equally interesting from a carry or yield-differential perspective, but not from a currency-dynamic perspective, because the currency pairs are completely different,” he observes. “A risk-adjusted approach compares different currency pairs on the same basis.”

At Henderson, each potential pair is subjected to several risk filters, from daily forward information on yield curves and implied risk from multiple third-party sources, through proprietary filters to limit country and correlation risks to monitoring on pairs at portfolio level once positions are in place. One of the results in the recent anti-carry regime has been a shortening of holding periods - trades that are facilitated by daily rebalancing of the model that can take advantage of short bursts of carry opportunity without getting caught by the quick reversals.

“We are closer to beta in an up market and closer to alpha in a down market,” he says. “The last 18 months have been interesting in showing that you can apply skill to provide performance when it really matters, in an environment that is bad for carry.”

Record Currency Management’s approach to managing the downside risk of carry involves optionality. Essentially, Record constructs a portfolio of 50-100 positions using forwards to synthesise call options on high-yielding currencies and put options on low-yielders. This means that, while it does not have to have exposure in risk-averse markets - the strategy is clocking-in at about -5% annualised at the moment, whereas without that optionality would be down about 24% - it effectively bleeds theta in the meantime.

“Our product, in effect, has spent the last 18 months paying out option premiums,” Record explains. “Usually we’d exercise about 60% of our options and in fact we’ve exercised less than 10%. But there has been a massive relative gain - by far the largest I’ve seen - in having optionality.”

The other way in which Record differs from the Henderson, Halbis and many other strategies is that it is not really diversified - its process harvests some momentum, but essentially it either gets a carry-trade payoff or pays an option premium. This is not about to change - Record simply believes that carry is the only robust source of return for the long-term, systematic, “process-led” manager.

“We’ve all learned lessons, but the one lesson that I’m not learning is that the carry trade is dead,” says Record. “I’ve seen every possible alleged inefficiency land on my desk, and most of them end up in the bin. There are very few inefficiencies which one can exploit consistently over a long period of time.”

The idea of carry as the beta of the currency markets is embraced by Record more easily than some of its peers, to the extent that it will soon be joining some of the other currency index product providers (which often exploit some form of naïve carry) to offer low-cost ‘pure beta’.

“We think that our future lies in two areas,” says Record. “One is to continue to be a currency hedger, and alongside that to offer a series of products ranging from very smart enhanced carry, similar to our existing products, at one end, all the way to pure beta in liquid currencies and highly scaleable at the other. On a 10-year horizon I’d expect us to have a lot more assets, possibly a high proportion in index trackers, off which we will leverage relationships to offer hedging, smart carry and momentum.”  

Most people question why one would reject potential style diversification, and according to Wheatley, only about 10% of the 60-plus managers on Deutsche’s FX Select platform generate the majority of their alpha from carry. Parker King, head of currency at Putnam Investments, agrees that carry has a great long-term information ratio (its own model clocks in at about 0.87), but also points out that while carry has delivered an IR of -0.78 over the past year, momentum has given investors an IR of 0.80. Furthermore, momentum’s long-term IR is a respectable 0.66, he says. A portfolio-flows strategy has a long-term IR of 0.41.

“Our technical model has an IR of 0.82, which is almost as good as carry over 20 years,” he claims. “So the idea that carry is the only stable source of absolute return over the long term is not supported by the data.”
The kinds of shocks that are moving currency markets at the moment are very difficult for systematic programmes to pick up: the governor of the Swiss National Bank announcing that he is contemplating intervention, for example; or upside surprises in economic data jarring against USD or GBP shorts put on by trend-followers who have gone bearish in response to quantitative easing. Risk-aversion strategies (tilting towards USD, JPY or CHF), mean-reversion strategies betting against big misevaluations and, in general, a qualitative, judgemental approach to fundamentals, appear to be winning-out.

“However good your risk management and execution platform, it’s still extremely valuable to have a judgmental overlay on top,” says Halbis’s Maldonado. “For a lot of people that translates as ‘The model’s great, but in the end I can do what I want, choose to follow it or ignore it’. It does not mean that to us. If we think that a model is missing something that’s happening in markets - a macroeconomic or political event, a war, an earthquake - we are free to dial down risk. But we are never allowed to say, ‘Why has this wretched thing gone to sleep on us?’ and dial up risk. That’s worked very well for us, and we’ve made use of it quite a lot in the last couple of turbulent years.”

Interestingly, his colleague Petersen identifies one of the key discretionary decisions made by the Halbis fund’s traders as the one made in 2008 to move to a five-strategy diversified model: when the programme launched three years ago it was based on two distinct carry strategies. Now it includes three “lead/lag model” valuations-based strategies that use fundamental indicators and have more long-volatility profiles. The process allocates risk to each of these based on drawdown risk management, so that risk is dialed up to strategies exhibiting good recent performance, and down to those exhibiting bad recent performance.

“Could you find yourself concentrated all in one strategy?” muses Petersen. “In theory you could - and that’s exactly why we have five.”
This drawdown risk-management approach to a portfolio of strategies seems to be widely employed as a way to maintain ‘all-weather’, factor-risk diversification. At Investec Asset Management, head of currency management Thanos Papasavvas explains how its processes are broken-down into quantitative (various carry styles), qualitative (macro, momentum and contrarian, valuation, technicals, geopolitics and themes) and emerging-markets.

“We do believe carry adds value over time but we don’t think it should be the core part of our process,” he says. “We believe that all these drivers together will give us a better long-term information ratio. In a carry environment we won’t outperform a carry manager, and in a value environment we won’t outperform a value manager.”
Similarly, Pareto Partners splits its strategies into short-volatility (carry, mean-reversion, options-selling) and long-volatility (momentum, fundamentals trading, trend-following, long synthetic options), again with a drawdown risk-management approach to strategy weighting. “I’ve yet to see a reliable signal for when to switch out of carry and into another strategy,” says Constantine Ponticos.

The same philosophy drives things at Overlay Asset Management. “It’s pretty central to our policy to diversify the alpha levers in our strategy,” says currency strategist Elizabeth Para. Recently, she says that that has meant diversifying into more discretionary strategies to balance the firm’s core systematic strategies. “We think it makes sense for investors to diversify across different approaches, so we are doing it ourselves.”
But that throws up another question for allocators. If you buy the argument for the long-term benefits of style diversification, how can you be sure of getting it when so many managers appear to have reacted to recent circumstances not only by changing their processes, but by changing them to tilt more decisively towards discretionary styles? At least with systematic, beta-like strategies such as carry you know what you are likely to get from one regime to the next.

“Whilst we think that it is possible to make money from the currency markets in more ‘normal’ times, at present there are only two drivers of return - EUR and USD,” as one UK pension fund manager put it in IPE’s latest Off The Record survey. “In those circumstances quant managers cannot make money, and fundamental managers need to be on the right side of the trades in those two currencies, which is a macro economic bet and not a currency bet and therefore makes trying to make money from the currency markets a matter of luck. We terminated our mandate when it became clear what we needed was a lucky fundamental manager.”

This neatly sums up why pension funds adopted a ‘carry-only’ approach and shied away from the more qualitative, fundamentals-driven strategies in the past - the suspicion that they amount to little more than ‘punting’.

“Asset consultants are looking for managers with a systematic investment process, although that’s not necessarily a systematic investment style,” says Monica Fan, senior currency product engineer with State Street Global Advisors. “But it is difficult systematically to quantify the value-added from a discretionary strategy - they could have a strategy focused on carry today and growth tomorrow, depending on where they see market sentiment. There are definitely benefits to having a diversified portfolio of investment styles - but that depends on managers trading true-to-label.” 

Perhaps because different currency-management styles get rewarded so decisively in particular regimes, style drift does seem to be widespread. Nearly all the managers IPE spoke to could point to examples of peers who claimed not to be trend followers but whose returns fell off a cliff when the markets stopped trending; or long-vol strategists who abruptly piled 100% into carry in 2006; or who remark that the low correlation between managers at the moment indicates that the large proportion who swore by carry two years ago have abandoned it since.

Their own changes of process are, of course, ‘strategic evolutions’. That is perfectly reasonable in currency markets, and its acceptability to investors really revolves around effectiveness of communication, but reasonable or not, this may inform against trying to get style diversification through a portfolio of managers - unless you can find a group that is as ideologically wedded to one style as Record. “We do the things we do because we think it’s the best way,” says Andreas Neumann, head of Investment Advisory at Berenberg Bank, puts it. “Of course, others might have very different approaches to the same markets.” Berenberg has tailored an alpha strategy based on momentum-based technical models for the West Yorkshire Pension Fund, which put it in a portfolio of diversified alpha sources alongside Auriel, BNP Paribas, Credit Agricolé, Mesirow and Oppenheim. Berenberg’s is a 100% systematic style, but as more managers adopt potentially unpredictable discretionary straegies, the higher the correlation risk, the greater the number of managers required to ensure diversification, and the higher operational and transaction costs go.

“You can put together a diversified portfolio of single-strategy currency managers if you have the resources,” notes Maldonado. “But over the last couple of years it’s been too volatile and difficult to do that, and people have come to value managers that can actively allocate between strategies.”

After all, as Record says, carry is not dead - and at some point it is going to make a comeback. He draws parallels between today and 1979 when, after two years of dreadful returns from the carry-trade buying into sterling, it experienced its strongest ever rally as interest rates chased after a big bout of inflation.

“We assure clients that they will continue to hold smart-carry with us and that we will be very careful to pay option premiums as cheaply as we can given the high-volatility environment,” he says. “The opportunity from here could be immense. This period is the classic bottom of the cycle. The reason the pound is at the level it is has nothing to do with the market’s view of our economy - it’s the unwind of the carry trade. And now there’s nothing left to unwind. That doesn’t mean we’re going to see a big rise in the pound from today onwards, but we are sowing the seeds: if we have to start chasing inflation up - which I think we will - there is potential for very strong returns in carry.”

The foundations certainly look more solid now than they did in December, when currency markets were still suffering volatility aftershocks from the Lehman Brothers earthquake. Even before the recent risk-asset rallies, when markets were testing new lows in February, currencies continued their trajectory back to relative normality. JPY stood out again, as weak economic data triggered a reversal of last year’s unsustainable appreciation. This normalisation should make it easier for systematic strategists to rely on indicators of relative growth in industrial production, inflation and interest rates.

“The lower volatility we are seeing across the board - not only in currencies - is an improvement,” says Arends at Henderson. “We see global imbalances improving, rates cycles between central banks stabilising, and these are all good signs for carry in general.”

A foundation is all very well, but ultimately the carry-trade edifice needs sustainable interest-rate differentials - and the timing of a return to that environment is anyone’s guess, particularly now that quantitative and credit easing has thrown another spanner of unpredictability into the works. Economies that are not employing non-conventional policies tend to have higher interest rates than those that are, and this is arguably the basis of recent signs of the comeback of carry - and arguably an anomaly.

“I’d be careful,” says King and Putnam. “What are the other characteristics of the high-yielding currencies? They’re not aggressively expanding their balance sheets and they’re in better fiscal shape. Things have improved but volatility  is still extremely high, and I wouldn’t get excited and bet the farm on carry for the next 12 months. And if inflation and yields start to rise, particularly at the long end of the curve, that is not necessarily going to be positive for carry. The signal at the moment could turn out to be dead wrong.”

So there is a profound degree of contention out there, both tactical and strategic, and that has implications for the way in which institutions allocate to currency strategies. As Fan points out, non-systematic styles do not have to be implemented in a non-systematic way, and for institutional investors looking for some predictability and visibility in their multi-strategy allocations, that is the key. Whether it be drawdown risk-management or some other systematic approach to style allocation, this is the only way to guarantee that your manager does not become unacceptably concentrated in one style or take a ‘punt’ on what the next market regime will look like.