Mushrooming demand

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Demand for currency management and overlay has ballooned in the last two years as investors embrace it as an alterative source of return. As currency managers tune their services to the needs of pension funds and other institutions, the future of the sector is beginning to take shape.
Currency overlay first emerged in the 1980s, says Ulf Lindahl, chief investment officer at AG Bisset in Connecticut. Now, there are around 25 investment management firms providing currency overlay, and more than $200bn (e158bn) of assets are involved worldwide.
Right now, Neil Record, chairman and chief executive of Record Currency Management (RCM) in Windsor, says the sector is in a period of exceedingly high demand. Since 2001, there has been good growth in currency overlay in continental Europe. The UK started on a real upwards curve between about 18 months and two years ago, he says.
The specialist currency management firm has had eight serious enquiries in one recent two week period alone. Says Record: “Four years ago, I would have been delighted with two a year.” It has been a depth change, he says. RCM’s experience is probably slightly more extreme than other managers, he says, because it is already a long-established specialist, now in its 23rd year.
While equity and bond markets have been delivering low levels of return, currency overlay managers have had good performance. “The reason we’ve had it is that there are very large non profit-orientated users (in the currency markets),” he says. “The arbitrage opportunities aren’t immediately squashed.”
This argument appeals to investment consultants in particular, and then the performance record speaks for itself.
Pension funds looking for currency management can either use overlays or turn to pooled funds. While each option has its pros and cons, managers see a trend towards pooled. Paul Duncombe, managing director of the UK office of State Street Global Advisors in London says: “I’d say at the moment, the more popular route is having an overlay manager, although I think the pooled route is gaining ground.”
When pension funds decide to add currency management to their overall investment strategy, they are probably looking for an uncorrelated asset class which has the potential to generate positive returns, says Scott Arnott, executive director, portfolio manager in Goldman Sachs Asset Management’s (GSAM) global fixed income and currency team.
This is the firm’s starting point; then comes the question of whether to implement the strategy using a separate account, or a pooled fund. Anecdotally, in GSAM’s experience, says Arnott, more European pension funds are going down the pooled fund route.
An overlay implemented using a separate account typically requires a pension fund to manage the cash flows. If the currency management is run on an unfunded basis, then the pension fund is potentially responsible for maintaining margin on forward positions. “That is a potential administrative headache for pension funds because they’re not necessarily set up to do that,” says Arnott.
Pooled vehicles can also have the benefit of limited liability for the pension fund. “The manager is trading in the name of the fund, not the client,” he says. And the pension fund, therefore, does not necessarily have to set up individual credit arrangements with counterparties.

With a straight overlay, effectively, the pension fund is asking the counterparty to extend credit to them, and therefore, each bank will want to establish the pension fund’s credentials. So with a pooled fund, the pension fund is one step removed from these administrative issues.
“When venturing into new territory, (investing in a pooled fund) gives further comfort that should anything go wrong, you’ve limited the downside to the amount you invested into the funds,” says Arnott.
In the field of funded currency overlays, increasingly providers are giving clients options which enable them to keep their asset allocation in line with strategic aims. “The replication of existing allocations is becoming more and more common,” he says.
“Managers are increasingly offering services to replicate the assets liquidated to fund a currency mandate using a pooled vehicle. This minimises the potential impact of adding a new strategy to the existing plan. In this way, implementation should not be a big deal.”
Sinead Colton, head of portfolio management at Lee Overlay Partners in Dublin, says her firm has also seen some increased demand for currency funds recently. “Funds permit investors with smaller amounts of capital to access currency management,” she says, pointing out that the typical minimum investment for many currency funds is $1m, whereas the minimum size of an overlay mandate is usually $100m.
The key change over the last few years in currency management is that investors have switched from simply using stand-alone overlay mandates as risk control towards using them to chase extra returns, says Michael Sager, currency portfolio manager at Putnam Investments.
“The idea used to be, not to get a big impact in terms of return, but more in terms of controlling risk,” he says. But over the years, institutional clients have been able to witness the returns generated through currency management. Information ratios are twice as large in the currency world as they are in many parts of the equities world, he says. “That is a pretty impressive statistic.”
The combination of low interest rates and equities returns has left investors searching for alternative sources of performance, and currency is now seen as an attractive option. Currency return mandates often target returns of between 400 and 1,500 basis points, says Sager.
Increasingly, there is an emphasis on consistency of returns as well as magnitude. Whereas a few years ago, it was acceptable to judge returns over three to five year periods, investors are now less willing to tolerate weakness at points within this time frame. “High returns, but consistent returns – that is the name of the game,” he says.
Putnam Investments is setting up a pooled fund at the end of the second quarter this year, he says. It is important, when targeting absolute returns in currency management to blend styles.
“If you focus on a particular style, your returns will be lumpy,” he says. Each style, whether it is purely qualitative or purely technical, works in a certain environment, but a combination is the best way to achieve consistent high returns whether the market is range-bound or trending.
To show how only a mix of styles really works, Sager gives the example of the dollar’s rise in the last few months. “The trade-weighted dollar index has appreciated 3.4% since the end of 2004,” he says. “This really has been an interest rate story… so traditional interest rate carry signals would have worked well as a result.
“But with longer-term US dollar fundamentals continuing to deteriorate, we are likely to see a resumption of the trend depreciation of the dollar on a one to two year horizon, implying that interest rate carry signals will work less well, and that other factors will be more relevant. Hence the need to develop a blended investment process that has broad capture in terms of the factors it exploits and the range of currencies included,” he says.
Lindahl notes that some pension funds have jumped the step of doing currency overlay first, going straight for absolute returns. But, he says, a currency alpha programme is not a substitute for a currency overlay programme designed to manage pre-existing currency exposures. “A pension fund with cross border investments needs to have both; a traditional overlay to manage the existing risk and then a currency alpha programme to boost overall returns.”
As an asset class, currency is still in its infancy, but growing very rapidly and faster then overlay did when it was born as a concept. “We believe the future will see a large percentage of institutional investors including currency in their portfolios,” says Lindahl.
“Currencies also have the added benefit of being very transparent, they do not need to be held for long periods to reap the return, as is the case with private equity, venture capital and many other alternative asset classes. A currency alpha programme can be established in a few hours and liquidated as quickly. And, with continuous pricing, there is never a mystery as to what the investments are worth.”

In the UK, there is an added benefit that comes with the hedging of foreign currency back into sterling. The interest rate differential means this passive hedging automatically provides a return of around two percentage points. But this is only a side effect of passive hedging which would be conducted primarily for risk-control reasons.
“That doesn’t have a major impact on people’s decision making,” says SSGA’s Duncombe. It is a nice secondary effect but not the prime motivator. The difference is worth about 2% at the moment, but if sterling were in a weakening phase, it could quite easily fall five or 10%, he says.
Colton says UK investors have an identical excess return profile as investors from other base currencies. “Currency is an equally attractive investment opportunity for all investors, due to the proven high track records of currency managers and the diversification benefits on a total portfolio basis due to the low correlation of currency with most asset classes.”
In terms of future trends, Colton says plan sponsors and investors are becoming more sophisticated in how they structure currency mandates. They are using tracking error targets and permitting symmetric index deviations, she says.
“In many cases we now see mandates that are simply notional amounts, rather than being necessarily related to the underlying assets as would have been more common five years ago.”
(Currency overlay providers table on page 64)

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