PRODUCT FOCUS: ACTIVE CURRENCY MANAGEMENT
Strathclyde and Lothian pension funds are just some of the investors that are allocating money to active currency products. But managers still have much to prove before they can reduce investors scepticism
SPECIALIST currency managers have been knocking at the door of the investment management mainstream for so long that their knuckles are getting raw.
They seemed to be making some real headway in 2006-07, when investment consultants including Hymans Robertson and Mercer persuaded several of the UK’s largest local authority pension schemes to make chunky commitments to active currency mandates.
The £8.9 billion Strathclyde pension fund put £450m (5.3% of its portfolio) into active currency mandates with Mellon Capital Management, Millennium Asset Management and Record Currency Management. The scheme has since added a further £550 million, meaning 10% of its portfolio is now in active currency management.
Not to be outdone, the £2.4 billion Lothian Pension Fund allocated £400 million to an active currency strategy with JP Morgan, Record and AG Bisset and a steady stream of other pension funds made similar moves. Clients like these can expect to pay their currency managers annual management fees of 1%-1.5% and performance fees of 15-20% on any gains above Libor.
Until quite recently, currency management was mainly a passive game – for example, it was used to hedge the currency risk in an international portfolio of equities and bonds, a methodology sometimes referred as ‘passive currency overlay’. So the recent local authority wins were considered to be breakthroughs for the asset class, and a consensus is emerging that large pension schemes should have between 2% and 5% of their portfolios in active currency management.
However, these positive trends have to an extent been undermined by investor scepticism that has been fuelled by the poor performance of many active currency mandates over the past three years. Active currency management has been marketed as producing returns that are uncorrelated to those from traditional asset classes – however this has not always been the case.
According to figures from BNY Mellon, the median return for active currency managers in the fourth quarter of 2007 was minus 0.32%, up from minus 0.42% the previous quarter. Taking stronger performance in the first half of last year into account, the overall return for 2007 was +0.26%. Partly due to a widespread bad call on the dollar in 2005, active managers have turned in a median annual returns of -0.23% over three years and -0.03 over five years.
One argument in favour of active currency management is that, since 95% of the $3,200bn of currency trades made daily are carried out for so-called ‘non-profit seekers’, there is plenty of scope for specialist managers to exploit anomalies in the market. Non-profit seekers, including corporates, tourists and governments, are usually trading for operational or political reasons.
Certain popular currency management strategies, such as the ‘systematic’ and ‘carry trade’ methodologies, worked extremely well during the five-year period of calm foreign exchange markets that ended with the onset of the credit crisis last summer. However, many based their approach on the assumption that those sideways, low-volatility markets and predictable interest-rate movements would continue.
They didn’t. The credit crunch intervened, triggering some unexpected and dramatic changes in global capital flows, revised expectations for economic growth and revised forecasts for current account deficits/surpluses.
This caught many quant managers off-guard. The New Zealand dollar – a favoured currency with “carry-traders” (currency managers who borrow billions in currencies with low interest rates to invest in currencies with high interest rates) – slumped 20% between mid-July and mid-August for example, and many emerging market currencies became detached from their former anchor, the US dollar.
The Goldman Sachs Global Alpha fund, a $10bn currency hedge fund, reportedly lost 39% of it value in 2007 after making a string of bad bets, including that the Japanese yen would continue to fall and the Australian dollar would continue to rise. But it has since revised its approach.
“Carry managers have experienced severe underperformance in the past nine months,” says Alan Eisner, head of currency management at Millennium Global. “As a general rule quantitative managers are able to do better in periods of low volatility but they struggle in volatile, fast-changing markets. Discretionary managers are able to be much more nimble at such times.”
Whereas discretionary fundamental players such as Millennium make their gains by determining the economic fair values for currencies over the long term, by going long on undervalued ones and short on overvalued ones in so-called ‘currency pairs’, systematic managers follow a broader spectrum of currencies over shorter time horizons from which they seek to make masses of incremental, smaller gains.
Whereas the decision-making on quant strategies is often computerized and based on past currency and past macroeconomic movements, more ‘grey cells’ are used in the fundamental/discretionary approach. Arguably this approach will come back into its own now we have re-entered a period of greater volatility in global currency markets – an era which some believe will persist for a while.
Mark Farrington, head of currency management at Desmoines, Iowa-headquartered Principal Global Investors believes it is too early to conduct a post mortem on which managers and styles were discredited by the credit crunch. But he adds: “I do forecast that the next phase will be reduction in use of simple, naïve trading models that are dependent on low volatility for their results.”
“In the past three to five years there has been an over-allocation to the systematic style,” adds Farrington. “There is now a need to reallocate back to discretionary managers.” He said Principal, a discretionary manager, is expecting significant inflows later this year.
The conventional wisdom is that medium-to-large pension funds should have three to five currency managers on their roster, says Farrington. This enables them to pursue a “blended” approach to currency management, in which different management techniques are played off against each other to enhance returns.
However Eisner concedes that some clients may be dissuaded from pursuing active currency management because bringing another active manager into their stables can be a hassle. “These are usually bespoke mandates, so there is a lot of documentation that involves a lot of work that can be very time-consuming and therefore it’s sometimes easier to avoid altogether,” says Eisner.
Joanna Sharples, investment consultant at Aon Consulting, believes one way around this, which is particularly suitable for small and medium-sized pension schemes, is the use of pooled diversified funds, a 21st century version of the balanced fund, many of which now include an active currency component. He said: “The currency management in such funds could be carried out by Fortis, Lee Overlay, Goldman Sachs, Mellon, BGI or Record.”
Yet there is already some evidence to suggest that the uncertainty in global currency markets since the start of the financial crisis last Summer may be limiting investors’ appetite for the asset class.
According to figures from Mercer investment consulting, manager searches have slowed considerably. Mercer performed just 14 active currency searches in 2007, two fewer than in 2006. By total value of searches there was significant slide between 2006 (when Mercer carried out searches worth $7.6bn) and last year ($1.8bn). The value of Mercer’s currency searches for UK clients has slumped from £9.4bn (26% of the total) in 2004 to £179m last year (0.6% of total).
Aon’s Sharples does not believe the trend towards greater use of active management has stopped in its tracks. She disputes the notion that quant investing is discredited by last summer’s troubles. “Not all quant managers suffered to the same extent; some did well”. However, she does stress that the extraordinary events of last August and November have reinforced the need for managers to have strong risk controls in place.
Karen Shackleton, senior adviser at investment advisers AllenbridgeEPIC, warns trustees who are considering a currency manager to tread warily and keep their eyes open. “There’s a widespread misunderstanding among trustees about what some currency models are doing. A lot are very highly leveraged, for example.”
This article was published in the September 2008 issue of The Fund Business