Putting currency in the blend
We believe a sound investment approach for enhanced cash and short duration portfolios is through diversifying portfolios across global fixed income and currency asset classes.
We view cash management in terms of actively managing along a risk spectrum, defined by the duration of the portfolio and the allocation to various strategies. The total return of an enhanced cash or short duration portfolio will be a function of the risk combination of an extended duration and the degree of active risks employed from other strategies.
Extending the benchmark duration, over and above pure cash, would be expected to enhance returns, as the portfolio is able to take advantage of the term and risk premium typically available in the market place. This extension will increase the underlying risk on the portfolio but investors have historically been over compensated for taking such risk. For example the risk adjusted return on a one to three year portfolio has consistently outperformed cash.
Employing a well-diversified active management strategy over and above the benchmark can further enhance returns. This active approach should ideally combine sources of excess return, which have a low correlation to ensure the benefits of diversification are realised. We have found that combining macro risk (market direction, yield curve changes and relative value county trades) with credit risk and active currency management have produced an outcome, which has consistently outperformed cash by a significant margin. The active risk must be equally well managed and our proprietary risk management software has enabled to customise portfolios to meet client specific risk parameters or tolerances.
For macro risk we combine a range of Fundamental, quantitative and technical factors to determine the direction of rates as well as relative value across different markets. Consideration is given to expected growth and inflation rates, momentum and valuation variables, taking into account what is already priced into forward markets.
For credit risk we employ rigorous research to select high quality issuers and diversify exposure among different sectors and individual issuers from around the world.
The table below sets out the risk and return characteristics of three ‘typical’ short duration products:
Currency is a very attractive third investment opportunity that often lies dormant in many portfolios. Portfolio return expectations can be augmented significantly by activating currency management for little or no disruption to the existing portfolio construction.
Currency has been traditionally viewed as an unavoidable consideration when seeking to identify attractive overseas money market, bond or equity investment opportunities. It is simply a means of exchange with no interest earned, coupon paid or dividend due. Currency itself has generally been viewed as a market risk that is typically either borne (in the case of equity investing) or passively hedged (in the case of bonds). This traditional view, however, is undergoing a transformation with currency coming of age and rapidly being recognised as an asset class in its own right.
There are many reasons to explain this development. Institutional investors are increasingly demanding of all their assets and are increasingly obliged to seek more creative ways to boost performance. Poor equity returns of the past and more recent concerns of a cyclical turn in interest rates are causing asset managers and plan sponsors to look to alternative investment opportunities to boost portfolio returns. Lastly, the currency markets demonstrate persistent inefficiencies that skilled managers are able to exploit.
Currency markets are not subjected to the same profit maximising motivations that tend to discipline the more traditional money market, bond and equity markets. As alluded to above, the fact that currency is traditionally seen as simply the means of exchange, and not an investment in its own right, helps fuel volatility and market inefficiency. This is due in part to the absence of any recognised measure of currency value, equivalent to a P/E for equities or a yield for bonds. Furthermore there are many other currency market participant who are, likewise, not motivated to maximise their currency investment decision but distracted by other considerations. The more commonly cited are the funding of trade flows by major multi-national organisations and market intervention by national central banks.
But meanwhile the scope for active currency management to contribute to portfolio returns is very significant. Given currency market volatility and liquidity, the return targets of currency products can vary enormously from a conservative 0.3% per annum, say, through to in excess of 20%.
Currency is especially attractive for two further reasons, namely the returns generated are typically very lowly correlated with traditional asset market and the capital commitment to the asset class can be likewise very low. Currency management, like other alternative investments, is based upon the skill of the manager to anticipate currency market behaviour. The drivers of currency market behaviour are numerous and include capital flows, political risk, monetary policy expectations as well as the global economic outlook. This variety of influence, combined with manager, skill results in the returns generated bearing little to no resemblance to traditional equity or bond markets. The low correlation of returns contributes to the diversification of portfolio risk as a whole.
There are number of different manager styles applied to currency management from purely quantitative, purely judgmental through to a hybrid of the two. There is no one management style that tends to dominate while a number of managers employ the hybrid of blending both quantitative techniques along with judgmental analysis in seeking to uncover attractive investment opportunity. We employssuch a blend of active management styles with rigorous quantitative models, based upon sound economic reason, employed along side qualitative judgement built around in-depth analysis and experience. This combination is considered more robust that any of the two component parts with certain market behaviour more reliably determined using a formulaic approach while other currency market opportunities demand manager interpretation and judgement. Built upon these skills, we believe that currency management is most successful by employing a broad array of different currencies where each is equally important in the management process and where both positive and negative views can be expressed.
Whether you choose to employ traditional enhanced cash strategies, active currency management or a combination thereof will very much depend on the nature of the plans for which you are responsible. However, one question you should be asking is: “How can my cash work harder for me?”
Ian Lindsay is executive director, head of product management for global fixed income and currency at Goldman Sachs Asset Management in London