Currency - the performance conundrum
It is regularly stated that very few people can forecast currency movements, yet currency as an asset class is one that seems more capable than most of delivering reliable and attractive returns. Why this should be would seem a mystery until one is told by people like Neil Record, one of the most respected players in the currency market, that trades conducted by profit maximisers make up less than 5% of the total amount of foreign exchange business.
Apart from governments intervening to protect their currency and rarely being concerned about making a profit, the majority of currency trades depend upon ordinary people and ordinary businesses conducting ordinary transactions such as buying commodities or currency to go on holiday.
Indeed, even the majority of fund managers and custodians care little about whether they are getting the best currency deal, it is much more important to buy or sell that stock or bond. Those managers that really do care can pick up quite a few basis points as a result and we are now seeing a relatively large number of new mandates being awarded in currency management.
The size of the foreign exchange market is staggering. It is estimated to trade about $1.5trn a day. I have seen various statistics that seem rather unreliable but let us just say that it is many times the size of world stock market and futures markets combined.
In recent years the market has seen the Bank of Japan place orders for up to $10bn at a time in a matter of minutes just because it felt the US dollar was depreciating too fast against the yen and was starting to affect the competitiveness of Japanese exports to the US. In the long term they have not halted the trend but they have sometimes had a short- term effect.
Although the most common use of specialist currency management is still to provide a straightforward currency hedge – essentially removing unwanted risk exposure – we now have hedge funds providing absolute return strategies based upon the provision of investment returns from management of positions in the currency markets. Both traditional and specialist managers such as Pareto Partners or Record Currency Management also offer currency overlay strategies based upon the management of currency positions inherent in a portfolio of international assets, with the aim of generating additional return and reducing the contribution to portfolio risk made by currency movements.
Most pension funds still do nothing at all with their currency exposure but 2003 has demonstrated that doing nothing can often hurt. Indeed, one major Dutch pension fund that returned 13% in 2003 claims that nearly half of the return (6%) came from hedging currency. Hedging is one of those few activities in the investment world that can be relatively easily categorised. Funds either do it 100% or don’t do it at all.
Occasionally, we see funds that cannot make up their minds and hedge 50% of their exposure but it seems very few other percentages are ever seen unless a fund employs a very specialist active currency hedge manager.
A few pension funds realising how little traditional investment managers worry about such things have started to employ the specialist managers and consultants that offer a currency audit. This is perhaps more accurately described as a currency transaction cost analysis. This service examines the quality of foreign exchange execution traded on funds’ behalf by either custodians or investment managers. Indeed, the London Regional Transport Pension Fund, one of the UK’s largest schemes, went on record last year by announcing that it had achieved a 50% reduction in its foreign exchange transaction costs by applying a currency audit.
With the dollar exchange rates at record levels around the world, I guess it is little surprise just how much interest currency management has generated over the past 12 months. It seems to be one of those happy coincidences that come along every now and again. After currency managers such as Neil Record have invested a lot of time and effort in educating the market place, we have seen huge currency movements and at the same time stock markets fail investors. Suddenly every opportunity for alpha generation, every opportunity to cut costs is rather more eagerly seized upon than before. A few years ago a few hundred thousand pounds or euros might have been considered only small change, but not now.
Whether, currency hedging continues to be of benefit to pension funds in the future I cannot forecast but I do feel confident in forecasting that pension funds will continue to need strategic and tactical advice on how to create and implement risk management solutions for currency exposures just as much as their other exposures.