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IPE special report May 2018

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Maha Khan Phillips assesses the various routes that pension funds can choose to access currency alpha

For some years now, pension funds have been managing their currency exposure. Traditionally their approach has been to adopt a passive hedging strategy, with the emphasis on risk, rather than on return. However, pension funds are now looking at currency as a provider of alpha, both as a standalone asset class, and as part of a global tactical asset allocation (GTAA) strategy.

According to Mercer's 2008 asset allocation survey, pension funds have identified both currency and GTAA as areas where they intend to increase their investment exposure.

In the UK, 3.9% of funds use active currency, and 5.7% use GTAA. In continental Europe, 2.3% of funds use active currency and 3.4% use GTAA, according to the survey. Mercer expects these figures to rise. "Many managers would have a set allocation to something like US equities, but wouldn't think about the way the markets move relative to each other. GTAA adds value by taking advantage of that," says Diane Miller, a member of Mercer's manager research team.

Still, there are some concerns about the ability of currency to provide long term returns. Performance of both GTAA and currency hedge funds has been mixed. "In terms of the information ratio, last year's median manager was just about zero. Some managers did well, and some managers did badly," Miller explains. 

Currency opens up

Part of the increased attraction to currency has come because of better technology, explains Alastair Constance, founder of Mercury FX, the independent broker dealer. "There's been an explosion of FX e-trading. There are now handfuls of online screens one can trade through, and banks have now got into shape and are providing much better platforms," he explains. As a result, currency has become more accessible. "In the past, FX wasn't considered an asset class. Now, financial directors, individuals, corporates, and funds are all starting to realise the advantages of trading currency," he says.

There was a time when only sophisticated investors developed alpha approaches to the asset class, explains Arun Muralidhar, chairman of Mcube Investment Technologies. "In the old days, it was the ‘sophisticated clients' who were comfortable with alpha-focused currency mandates. Today, these mandates are the norm so ‘sophistication' is not really an issue," he says. Muralidhar believes that pension funds have looked at allocating between 10-20% of their fund to some of these strategies. "A lot of funds are going up to 30% and 40%. It's not that high if you think about it from the point of view of contribution to total fund risk or even the exposure they may have to international assets," he argues.

And managers are vying for their business. Quant managers in particular, have built trend-following models that have proved very popular. Aspect Capital, the systematic hedge fund manager, is a momentum driven house that looks to profit from persistent effects in the marketplace. Aspect uses currency in its tactical asset allocation product, and its diversified fund. Currency is also used as a standalone asset class, although like many managers, Aspect calls its strategy an alpha programme, rather than a hedge fund. Consultants argue that the difference is often negligible, as both mandates give the manager the discretion to tailor the portfolio to a target risk, and use the same techniques and models.

Ted Frith, senior European sales executive at Aspect, believes investors are more comfortable with letting managers run with their mandates. "Back in the early 1990s, when currency overlay became fashionable, a lot of people, particularly in the US and Australia, hired currency managers to manage risk in equity portfolios. There was a view that you could go out and hire a currency overlay manager and in that mandate you could put a lot of constraints on the managers. Now the view seems to be that if you think these people are adding value, then why constrain them? If you hire a currency manager and tie one hand behind his back, its not as effective as letting him loose on an unconstrained currency alpha programme," he explains.

Frith also believes that investors, disappointed with the results of their currency overlay approaches, are looking for other solutions. "Currency overlay has been a bit disappointing in some ways. People are always on the look out for things that adjust risk versus the rate of return. I think in the next two to three years there will be a strong move towards alpha mandates." 

Risk management

Risk management relative to returns will be the key issue in the future, Frith believes. As a result, managers need to have a diversified portfolio, with a large, rather than a small number of currencies in the portfolios, he says.

Jon Stein, a managing director at Chicago-based Parker Global Strategies, the fund of hedge funds and index provider, argues that investors are better off adopting a multi-manager approach to currency. "We believe that to be really on top of the foreign exchange market you need to have a multi-manager approach. FX doesn't have to be expensive. You can partially fund your mandate. The FX world is so much more flexible than the hedge fund world. It's much easier for an institutional investor to have a multi-manager solution," he explains.

Stein says he is a big fan of FX as a standalone asset class in 2008. "FX has been very difficult to trade and make money in over the last four years, if you don't know what you're doing. But many of the underlying conditions have changed, including the fact that many central banks
are not micro managing their exchange rates anymore. A lot of constraints are coming off, such as emerging countries pegging themselves to a major currency like the dollar." 

Manager performance

Still, some managers will be able to provide alpha, and some won't. "Most hedge funds that have a carry bias have ended up being very badly hurt since last summer," explains Virginia Parker, founder of Parker Global.

Using a carry strategy, managers sell currency with relatively low interest rates and use the funds to purchase currencies with higher yielding interest rates, capturing the difference between the rates. Carry performs well in stable markets, but does badly when volatility comes into play.

"When you have a reliance on carry, there will be periods where you think it works and periods where it struggles. You see similar situations with other strategies, but what is more unusual is to have carry perform well for such a long period of time that people may have thought this could never reverse," explains John Collins, senior investment consultant at Watson Wyatt.

In contrast to many consultants, Watson Wyatt does not recommend currency as a standalone mandate. "We think there is limited breadth within the decision making of currency and believe there are strategies with better risk adjusted returns for clients in some other hedge fund strategies," he says. Additionally, Collins believes that the use of currency in GTAA is problematic. "The difficulty with mainstream GTAA offerings is that you still end up with most managers having a reliance on currency which might be 30-40% of the risk allocation."

George Dowd, director at Newedge Group, the global brokerage firm, believes that investors need to look at other currency approaches aside from carry. "My feeling is that people need to diversify away from carry. Investors tend to see carry as the only currency strategy, and that's certainly not the case. Within the industry it's viewed as one of the least innovative trading styles," he explains.

He also believes that better performance will attract investors. "Most institutional investors realise they are underweight currency exposure, but there hasn't been much performance in the last few years. What you will see in currencies is going to be similar to what you see in commodities - a period of outperformance when people shifting assets into the space moved in very quickly," he explains.

One area where outperformance is coming from is emerging markets. Thanos Papasavvas, head of currency management at Investec Asset Management, predicts that emerging markets, or non G10 currencies, are going to perform very strongly in the future. "A lot of these currencies have different opportunities, and a well diversified portfolio will generate strong returns."

Papasavvas points out that, over the last 11 years, a diverse local currency portfolio generated very good risk/return characteristics, despite the number of crises that occurred during the period.

For his part, Muralidhar says that managers with a G10 bias have already faced difficulties. "Managers who are constrained to working in the G10 currencies ended up struggling, while those working with emerging markets ended up doing extremely well," he says.

Volatility

Still, managers will have to think about how they position themselves in the future. "The reason quant currency managers have done badly is because volatility in the market has changed.

If volatility stops trending and comes around, then quant models tend to do quite badly. Over time, you would expect these corrections to take place and for volatility to come down. The difference is that we were used to volatility at exceptionally low levels," Papasavvas explains.

The reasons for such levels occurred at the beginning of the decade, he explains. "We had the stock market crash, the terrorist attacks, and the Iraq war. Central banks eased monetary policy and G7 finance ministers were trying to drive down volatility. Of course volatility will not remain high forever. It will go back down, but not as much as it was before. The false sense of security the market had in 2006 and early 2007 won't happen again," he says.

Papasavvas believes that quant managers will continue to have a difficult time in the future. "There are, however, managers who are combining quantitative with qualitative, and this is a very good environment for that," he says.

Collin Crownover, head of currency management at State Street Global Advisors, believes some investors may be put off by the volatility. "One of the big trends in the market place has been pretty high risk currency hedge funds, which would be targeting 20-30% annual returns, taking 20-30% risk.

"We think some people would have been scared out by the market volatility. Some clients realise it doesn't take a hugely bad outcome before you start to worry about losing your capital."

He believes that some managers will fall by the wayside as a result. "This market volatility is going to wash out a few participants. This is not just true for currency, but for a lot of different asset classes. This is probably healthy for the industry. Absolute return strategies had become a bit of a bubble. We are in a period of unwinding some of the global macro economic excesses of the last few years, and certain currencies are overvalued."

Dowd disagrees: "If managers were going to fall by the wayside, they would have done so already; 2003 until the end of last year was a fairly difficult period. When you look at currency as an asset class, you're going to have periods of outperformance and underperformance," he argues.

For investors, though, the ultimate decision will be based on risk adjusted performance. Muralidhar believes that investors must be aware of the bigger picture. Hedging mandates are on the decline as investors look at currency as a source of pure alpha. "Yet hedging currency risk is an important activity for pension plans, and the two are not mutually exclusive," he warns.

Pension fund case studies

APG

APG, the asset management and administration division of the Dutch €217bn ABP pension fund, has a strategic and tactical currency policy. Strategically, most of its dollar exposure is hedged, and sterling, Canadian dollar and Australian dollar exposures are fully hedged. Other currencies are left unhedged. All tactical currency positions are managed in the global tactical asset allocation fund in an absolute return context.

The fund does not have a currency overlay programme, and does not disclose the number of external managers that it has. "But we have both internal and external managers involved in active currency management. In-house we run a fundamental discretionary and a systematic portfolio. The latter exploits the forward rate bias in developed and emerging currencies," explains Gerlof de Vrij, head of global tactical asset allocation. In addition, the fund has a portfolio that positions for long-term mean reversion trends, which also takes on positions in currencies.

De Vrij says the fund has profited from the current economic climate, and that he sees many opportunities for the future. For risk management, APG uses a VaR approach to monitor long/short positions. "Our strategies are well diversified over currencies, styles, and horizons," he says.

San Bernardino County Employees' Retirement Association

Not much has changed in the $4bn-plus San Bernardino Country Employee's Retirement Association's currency approach over the last two years. The pension fund uses Mcube's AlphaEngine for currency management, and uses both curve and carry strategies.

The fund has an unhedged benchmark, because most of its currency exposure is in the dollar. However, that has brought its own difficulties. "It's been tough for the last 9-10 months when the dollar began its deep slide in the middle of 2007," explains investment officer Donald Pierce.

Over the last two years, San Bernardino's international assets have increased from about 30% to 35% (mix of developed market equity & debt, emerging market equity & debt, and private equity & private debt) of the total fund. The fund uses overlay strategies, and managers can go long or short the dollar.

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