In a volatile environment, systematic quantitative styles of currency management struggle to find their footing. Fundamentals-based strategies provide the best alpha-generation and preservation opportunities, argues Mark Farrington

For many years, currency management's primary role was as a principal preservation tool, protecting international equity and fixed income portfolios from degradation generated by adverse movements in foreign currencies. However, growing allocations to foreign asset classes over the past decade have led to a resurgence of interest in currency's alpha preservation capabilities, and in recent years it has reached some prominence as an asset class in its own right.

Highly liquid, transparent, and with little correlation to other markets, currency presents pension schemes with two major opportunities: the generation of alpha from an alternative asset, and the preservation of principal generated by the traditional portions of the portfolio.

The potential to generate absolute returns uncorrelated with other asset classes has in part led to heightened interest. This view has strengthened during 2008 as the equity, fixed income and property markets became increasingly correlated whilst generating negative returns.

The liquidity of currency markets has also provided good opportunities for active managers, particularly as the opportunity set has not diminished as a result of recent market turmoil.

Recent shifts
Unlike equity and fixed income markets, currency is a relative asset class offering opportunities in both rising and falling market environments. As an example, some currencies, such as the US dollar (USD) and Japanese yen (JPY), have performed particularly well of late. Currency markets have also seen some significant shifts during 2008, the main two being the increase in volatility and the reversal of the six-year-long structural downtrend in the USD.

The rise in volatility has been driven by a combination of policy uncertainty, misvaluation across multiple asset classes (in combination with some economic imbalances) and, increasingly, the volatility of the macroeconomic environment. This rise in currency market volatility has also led to a reconsideration of exposures to emerging market currencies with the depth of both the currencies and the underlying asset markets revealed to be less than previously assumed.

While the high levels of market volatility (see figure 1) can be attributed, in part, to the repatriation of flows from emerging markets, there are specific structural changes that have led to the bottoming and reversal of the USD in 2008 (see figure 2). These include a partial reversal of the over-allocation made by US investors to overseas markets, a widely acknowledged undervaluation of the USD against a range of currencies, as well as a fundamental reconsideration of the carry trade, which was principally funded in USD and JPY.

Whereas the USD has benefited from the financial crisis and global economic downturn, the euro has declined sharply since mid-2008, a trend that is likely to continue based on a number of factors, including:
• The global repatriation of international assets favouring those countries, such as the US, that have exported the most capital over the past eight years;
• High financial market volatility placing a premium on liquidity, which directly benefits the USD given the superior liquidity offered by US asset markets;
• The global deleveraging process and drastic reduction in US consumer spending that will likely accelerate the already improving US trade balance;
• Central bank reserve managers over-allocating to the euro during the USD downtrend;
• US economic policy makers being the most proactive and flexible, and therefore, the US economy being more likely to recover first; and
• Europe having a multitude of economic problems.



    A new era of volatility
The past year has been a challenging time for institutional investors generally, not only in fixed income and equity markets, but also in the systematic carry trade for currency investments. As we enter a new volatility regime, a key difficulty facing pension funds will be predicting changes in the level of volatility.

Popular methods of volatility estimation used within systematic investment styles use historical returns, option implied volatilities or any other price indicator that can then be extrapolated into the future. However, recent events have powerfully demonstrated the inadequacy of these models. The rise in volatility seen recently calls for a more fundamental approach that differs from these traditional styles. This approach suggests that investment processes that rely on such methods of volatility estimation need to be reconsidered.

Rather than forecasting financial market volatility itself, new measures or indicators are needed to establish various fundamental-based preconditions for a rise in financial market volatility. Our own indicator, the Base Volatility index, which focuses on the preconditions for a rise in financial market volatility, was signalling a less favourable volatility environment as early as the start of 2007. And research indicates that periods of higher volatility, such as the one witnessed since August 2007, do not occur in short bursts but generally last over many years. This should lead to a reorientation away from investment management styles heavily reliant on backward-looking systematic, carry-related inputs and towards management styles that are inherently more forward-looking.

The return of volatility to the currency market after a sustained period of abnormally depressed volatility has surprised many market participants; it has also undermined many trading styles established during the low-volatility phase. A forward-looking style is more suited to the type of market conditions we are currently experiencing, where historical financial market volatility becomes an ever decreasing predictor of future realised volatility and market timing becomes an ever-increasing component of successful currency management.

Perspectives in currency investing
In response to the increase in demand from pension schemes, the universe of currency managers has expanded, along with a growing distinction between the investment approaches adopted.

Being a largely inefficient market, the more widely known investment currency styles consisted of purely systematic trading strategies that exploited either the trending nature of currencies or the carry trade - which has historically worked remarkably well, to the extent that numerous newly created structured FX instruments are now based solely on carry strategies.

Carry trade and pure quantitative managers have been hit very hard recently, as the carry trade has unwound and as volatility has increased dramatically, as shown in figure 3. In addition, various systematic styles, such as short volatility and some long-term, trend-following models, have done poorly because they have a degree of correlation with risk assets.

Styles that are forward looking and have the ability to adapt dynamically to the changing environment, such as fundamental discretionary, have continued to do well, their inherent flexibility allowing some managers implementing these kind of styles to benefit from the new regime they find themselves operating in. The fundamental-discretionary style has continued to prosper, the combination of fundamental analysis with discretionary management and execution making the style highly adaptive, with the ability to utilise multiple trading strategies.

The primary difference between fundamental styles is whether the investment process is valuation-based or capital flow-based. Valuation-based managers tend to be more quantitative in their analysis and focus a lot of research time on fundamental inputs to valuation models. Capital flow-focused fundamental styles place a greater emphasis on the balance of payments trends and global cross-border capital flows which influence currency behaviour. Either approach can be analysed through a systematic/quant framework or a discretionary one. However, a discretionary style is unique in that buy and sell decisions are made by a fund manager, as opposed to a trading rule, and therefore are likely to be flexible and forward-looking enough to take advantage of the changing market environment.

Looking ahead
The growth in currency management over this past decade has been largely a function of the general growth of the asset management industry. Currency overlay strategies, for example, are always a function of the size of portfolio allocations to international markets and the proportion of the portfolio that is hedged; in the past five years we have seen the largest allocation to international markets in history.

This trend has now reversed and international portfolios have shrunk, primarily as valuations have fallen in line with most equity and fixed income markets. This, when combined with the return to more volatile markets, should lead pension funds to employ active currency management to a greater degree, primarily due to the uncorrelated nature of the return stream.

Currency markets have proved that, regardless of the global economic climate, they remain highly liquid relative to other asset classes and responsive to changes in underlying fundamentals. The right managers, utilising a flexible approach and, most likely, focused on the analysis of fundamental drivers, will be able to continue to generate alpha in the forthcoming years and so add considerable value to a portfolios. Furthermore, the continued inclination to allocate a high proportion of a portfolio's assets to overseas markets during a high volatility regime means that currency risk management will become increasingly popular.