| The
currency cure
Three years
ago, UK pension fund trustees just weren't interested in currency
overlay. Today the subject is attracting unprecedented levels of
interest. Iain Morse finds out why
In the short-term,
currency movements can have a large and unpredictable effect on
investment returns. This is an urgent issue for UK pension schemes
which now invest between 30 and 40 per cent of their equity assets
abroad.
But while buying assets in another currency brings uncompensated
or un-rewarded currency risk, the use of currency overlay can offer
a means of reducing volatility as well as achieving a better match
between assets and liabilities.
Of course, consensus wisdom is that, in the long-run (i.e. 20 years
or more) currency risk “washes out” – as one currency
rises, another falls – making currency speculation a zero
sum game. The only problem with this argument is that pension scheme
liability streams must be met now and paid in pounds.
In the case of pension funds, treatment of sponsor liabilities under
Financial Reporting Standard 17 (FRS 17) in the UK and International
Accounting Standard 19 (IAS 19) across Europe hastens the matter.
Scheme funding will be visible on the balance sheets of all listed
companies; under-funding due to currency volatility will then be
a possibility.
The uncompensated risk implied by un-hedged currency exposure is
best seen as relative to these current and future liabilities. “Pension
funds and insurers can predict what liabilities they must meet,
but cannot predict short-term currency volatility,” observes
James Binny, head of currency overlay at Gartmore. “It’s
a risk they want to control as their exposure grows.”
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Declining equity values have thrown this into relief; under-funding
and capital shortage are already facts for pension funds and insurers.
Losses due to currency risk are being noticed for the first time.
Relative currency volatility is normally given in pairs as a percentage
range within which each is expected to move. The UK pound to the
US dollar, for instance, has current volatility of 7.17%, the euro
to the US dollar 10% , the euro to the pound 7.61% and the yen to
the pound a volatility of 12.94%.
So, an investor with 30% of assets in a currency which has a 10%
volatility relative to that of its liabilities could face a 3% added
cost in meeting these from across its asset pool. The early overlays
designed to eliminate currency risk did so by hedging these assets
back into the liability currency. This type of passive hedging ,
still widely used, eliminates currency risk but adds no alpha return.
By the late 1980s, overlay managers noticed that the world currency
markets were inefficient, despite being hugely liquid with a daily
trading value in excess of US$1.3 trillion. Active trading of forward
currency contracts could yield a profit
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Why are currency markets inefficient? The answer is glaringly simple
– most participants don’t buy currency, as such , but
use currency purchases to buy a vast range of goods and services.
As a result, they are not looking to squeeze alpha from currency
trading. “This creates a narrow but fairly constant space,
if you like, in which active overlay managers can trade currencies
for profit,” observes Ron Liesching, head of research at Pareto
Partners.
From the late 80s onwards, a number of overlay managers entered
the market using one or more of several styles to run mandates.
Forming a clear map of how these vary is not easy; these days, most
managers combine two or more, depending on where the currency trading
cycle sits at a given time.
Quantitative techniques of some description are used by every manager
but these tend to fail when markets re-align suddenly. Tactical
trading puts a strong emphasis on technical analysis following micro-trends
and short-term momentum, doing poorly when markets are very volatile.
Meanwhile, top-down fundamental analysis of macro economic data
leads to medium-term positions. “The time-scale and size of
bets are related," observes Michael Collins, head of currency
management at Deutsche Asset Management. “Quants put on lots
of small intraday bets with values in low basis points; technicals
ride momentum like surfers ride waves looking for one or two per
cent; and the fundamentalists look for big bets that might only
come right once every six months, but make them 20 per cent.”
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Whichever style they use, actively managed overlays offer the prospect
of alpha returns which have low correlation to other asset classes.
“The search for any source of alpha is on,” says James
Mitchell of Frank Russell Consulting. “Passive overlays can
reduce portfolio risk by eliminating currency risk, giving investors
more risk units to spend elsewhere. Active overlays also reduce
risk by offering little or no correlation to other assets for their
alpha return, so both fit neatly into a risk budget framework.”
Demand for active overlay has expanded rapidly over the last decade,
as has the number of companies providing this service on a stand-alone
basis. Several of these, such as Pareto Partners, Record Currency
Management (RCM) and FX Concepts, are currency specialists doing
little else.
Others, including State Street Global Advisers or JP Morgan, are
global multi-asset managers which see currency as an emerging asset
class. Start-ups and new entrants to the market include firms that
belong to either group.
New currency specialists include Lee Overlay Partners, Alder Capital
and Appleton Capital Management, but now traditional asset managers
like Credit Agricole, Gartmore Investment Management and Deutsche
Asset Management are also marketing their overlay services on a
stand-alone basis. Gartmore is typical of this group, managing overlays
with a current value of under US$600m, of which about half is for
existing equity and bond clients. “Like others, we have the
capacity to manage a far larger amount," notes Gartmore’s
Binny, “and hope to do so soon”.
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Currency
overlay: how does it work?
Active overlays use currency forward contracts conferring the right
to buy or sell at a price fixed now. Overlay managers act as agents
between investors and banks selling or buying the forward contracts.
Transaction costs in this market are low – two to three basis
points on value is a commonly quoted figure for passive overlays.
Active overlays cost more with charges ranging from five up to 25
or 30 basis points depending on currency and mandate size. Some
managers charge a flat basis point fee, others add incentives for
benchmark out-performance.
Comparisons are made difficult because all mandates are segregated,
vary in size and differ in benchmark. Mandates may allow managers
to vary their hedge ratio between 0 and 100%, regardless of performance
benchmark, which might be a hedged tradable index like the MSCI
World.
Polar or asymmetrical mandates may also be used; a 0% mandate implies
that the benchmark is 100% hedged back into base currency and the
manager can only hedge more than this amount rather than less. A
100% mandate implies the opposite. Many mandates are also 50% hedged,
allowing the manager to hedge over or under-weight relative to benchmark.
Again, depending on the investor’s attitude to risk, some
mandates may only allow the overlay manager to trade forward in
two currencies, while others will permit multi-currency trading.
A set of permitted currencies will always be stipulated when the
mandate terms are agreed.
There are obvious problems about measuring performance or even building
a universe of overlay providers. The Frank Russell Company is acknowledged
as having the best universe and largest data pool, although Mercer
Human Resource Consulting is soon to publish a new overlay universe.
The Frank Russell Company measures segregated funds run by 20 overlay
providers, breaking returns into three groups: All Currency 0% Hedge,
All Currency 50% Hedge and All Currency All Hedge. The first two
of these show annualised returns of 1.86% and 0.58% over periods
of seven and six years to the end of June 2002. All Currency All
Hedge, meanwhile, returned 1.61% over seven years to the end of
June 2002. Cumulative added value over the same period for each
group respectively is just over 12.50%, 3.50% and just above 11%.
Volatility of return can also be high.
These are hardly earth shattering amounts and sceptics could be
forgiven for wondering if active overlay is being oversold. However,
for hard-pressed investors, even these slim margins of alpha are
likely to be a temptation.
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- Pensions Age January 2004 -
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