CURRENCY MANAGEMENT: Money madness

Demand for currency alpha is red hot.

As late as 2000, executives at major pension funds considered foreign exchange exposures as nothing more than an unrewarded risk to be managed, typically through a passive currency hedging program.

Fast-forward to 2006, when active currency tied with hedge funds as the second most popular alternative investment among 574 European pension funds with assets totaling e364 billion ($478 billion), according to a survey conducted by Mercer Investment Consulting, New York.

“This is not a gradual process. This is a major move away from the defensive hedging,” said James Binny, director of FX analytics and risk advisory at ABN AMRO Holding NV, London. “There is still a role for that type of management, but the greatest demand in recent years has been in the alpha-seeking mandates.”

European pension funds also have increased exposure to currency alpha through global tactical asset allocation strategies, said Diane Miller, London-based manager researcher specializing in currency and GTAA at Mercer. Currency alpha as a proportion of the overall excess return of a GTAA portfolio can range from 20% to 50%.

No hard numbers exist for total assets in active currency management. But data from the Parker FX index showed they had $26 billion under management as of Dec. 31, up from about $16 billion a year earlier. The Parker FX index is run by Parker Global Strategies LLC, Stamford, Conn., and currently tracks 65 currency managers.

Plus, well-known money managers previously absent from the active currency market — including Pacific Investment Management Co. LLC, Newport Beach, Calif. — are getting into the business.

“For the most part, we’ve been doing a lot of this anyway,” said Scott Mather, managing director and PIMCO’s head of European portfolio management based in London. “We’ve been seeing a lot of demand from some of our bigger clients and so we started to think about a strategy that separates out active currency.

“In terms of asset allocation, this is the cutting edge of demand.” Mr. Mather said PIMCO will begin offering currency management in the second quarter.

Market inefficiencies

Unlike defensive hedging of foreign exchange exposures linked to an underlying pool of assets, active currency management is not necessarily constrained to existing assets and seeks to add alpha through market inefficiencies. Although interest has been global, U.K. pension funds are at the forefront of the push into currency as an alternative source of alpha, investment consultants and managers say.

The reasons: U.K. pension funds have been forced to find better ways of controlling volatility by diversifying risks, largely as a result of mark-to-market accounting; plus, international equities and foreign exchange exposure swelled as U.K. pension funds diversified away from domestic stocks.

“The U.K. has been on fire,” said Robert Stewart, vice president and head of currency management at JPMorgan Asset Management, London, which managed $87.2 billion in notional active and passive currency assets as of Dec. 31, an increase of 31% from the previous year.

Of 17 searches for active currency-only managers in which Mercer assisted last year, the U.K. accounted for 11, said Mercer’s Ms. Miller. In 2005, 10 of 13 active currency searches originated in the U.K.

The £2 billion ($3.9 billion) Leicestershire County (England) Council Pension Fund has two £340 million active currency portfolios managed by Millennium Global Investments Ltd., London, and Mellon Capital Management Corp., San Francisco.

Millennium, Mellon and Record Currency Management Ltd., Windsor, England, manage a £150 million active currency portfolio each for the £8.9 billion Strathclyde Pension Fund, Glasgow, Scotland. The £2.4 billion Lothian Pension Fund, Edinburgh, has $800 million in an active currency strategy managed by JPMorgan, Record and A.G. Bisset & Co., Rowayton, Conn. A spokeswoman for Lothian wouldn’t say how much each manager runs.

Mr. Stewart and others say interest in active currency has spread to larger institutional investors in the Netherlands, Scandinavia, Germany, Australia and Asia. Some of the largest North American pension funds also are pursing active currency management, but often wrapping it into a global tactical asset allocation strategy, rather than a stand-alone one, said Brian Zeiler, investment consultant at San Francisco-based Callan Associates Inc. who specializes in global manager research.

Traditional currency management originated in the United States, although historically, the average U.S. pension fund had less than 20% of its portfolio exposed to foreign exchange vs. more than 30% for U.K. funds.

“Over the long term as international — and, therefore, currency exposure — goes up, I think it will be more common for (U.S.) investors to come around to the thinking that this is not only a risk to be managed, but also a source of alpha to reap,” Mr. Zeiler said. “But I don’t think we’re there yet.”

Still, some big U.S. pension funds are taking the plunge. The $158 billion California State Teachers’ Retirement System, Sacramento, plans to name its first external managers to run active currency-only mandates later this year, said Michelle Cunningham, director of fixed income. The externally managed portion would comprise about 20% of the fund’s $33 billion foreign currency exposure.

“We looked at all areas for opportunities in alpha, and there are opportunities to make money in the currency area,” Ms. Cunningham said. “Having seen that, we decided to design a program to take advantage of those opportunities.”

Main advantages

The opportunities for alpha and diversification are the main advantages for investing in active currency, according to consultants, managers and pension fund executives.

Currency has low to zero correlation with other asset classes such as equities and bonds, consultants and managers said. ABN AMRO’s Mr. Binny, who researched the level of correlation of currency with equities, bonds, real estate and other asset classes in a paper published in 2005, said the correlation appears to “oscillate around zero” in simulations analyzing returns of various asset classes from 1978 to 2005.

“That correlation is considerably lower than that provided by a fund of hedge funds,” Mr. Binny said.

With active currency management, institutional investors expect anywhere from 50 basis points to 500 basis points. Strathclyde, for example, is seeking 100 to 150 basis points net of fees.

Officials at New York-based Goldman Sachs Asset Management say their global currency portfolio fund should produce an annualized excess return of 300 to 350 basis points with a tracking error of 400 basis points.

Currency also presents advantages in terms of capacity, liquidity and transparency. Its efficient use of leverage means assets can be stretched further. As such, it also has been dubbed by investment experts as one of the purest forms of alpha around.

“It has taken quite some years for institutional investors to be convinced, but they are being convinced in a big way,” said Ian Battye, director of currency implementation at Russell Investment Group, Tacoma, Wash.

Demand has been so strong that at least two top managers — Barclays Global Investors and Bridgewater Associates — have closed active currency-only strategies to new investors.

“As soon as they (money managers) get any capacity, it gets eaten up in a few hours,” said one consultant, who requested anonymity.

BGI officials declined to comment on capacity questions about its active currency strategies.

Raymond T. Dalio, Bridgewater’s founder, president and co-chief investment officer, said the firm hasn’t accepted new currency-only clients in at least a year. “Some currency markets are very liquid and others aren’t. If we were to grow, we would have to grow disproportionately in the liquid markets, which would reduce our diversification and hurt the risk-adjusted returns for our clients.”

Bridgewater, Westport, Conn., manages $70 billion in notional assets within active currency-only portfolios. Currency bets also feature prominently in the firm’s pure alpha and optimal beta strategies, which have $55 billion and $13 billion in notional assets respectively.

By closing the active currency-only strategies to new investors, firms are better able to ensure capacity exists for the underlying investments of their portable alpha products, said John Collins, investment consultant at Watson Wyatt Worldwide, Reigate, England.

“Five years ago, I would never have dreamed that there would be capacity problems in currency,” Mr. Collins said.

Overall, currency is considered one of the most liquid of all asset classes. Foreign exchange trading volumes averaged about $1.9 trillion a day, according to a triennial report compiled in 2004 by the Bank of International Settlements, Basel, Switzerland. The next report is due later this year and is expected to show that daily foreign exchange trading volumes have surged to about $3 trillion, investment experts estimated.

Embedded inefficiencies

Opportunities abound to garner returns from a host of inefficiencies embedded in the foreign exchange market.

“Unlike the stock exchange, the foreign exchange market was not created for people to make money out of it,” said Mr. Binny of ABN AMRO. “Take a car manufacturer. The reason it is selling dollars isn’t because the dollar is going down. The reason is that it has sold a lot of cars and needs to settle transactions.”

Tourists do not buy and sell currencies to make a profit, he added. Likewise central banks are motivated by their own agenda, such as stabilizing currency movements, rather than making money. This leaves asset managers plenty of opportunities to gain returns from market inefficiencies.

According to estimates by ABN AMRO, foreign exchange trading volumes among asset managers comprise less than 5% of the total worldwide.

There are generally four sources of inefficiencies that managers tend to exploit: value forecasting, which seeks to define a fair value of a currency using fundamental factors such as relative inflation rates; yield, where managers seek to buy high-interest rate currencies and sell low-interest rate ones; trend following, which favors price momentum over external, fundamental factors; and volatility capture, which tries to benefit from currency volatility, usually by trading in options.

During the 10 years ended Dec. 31, the carry trade has on average outperformed other styles, according to simulations conducted by ABN AMRO. As a result, some consultants fear too many managers are dependent on that approach for gaining excess returns.

In research released in February, State Street Global Markets LLC, Boston, estimated the correlation between foreign exchange flows and yields as a result of carry-trading was at 61%, the highest level since March 1999. State Street Global Markets, the investment research and trading arm of State Street Corp., tracks a basket of 19 developed and emerging market currencies.

“Right now, this whole planet is one giant carry-trader,” Mr. Zeiler said. “A lot of managers are shorting the yen and long everything else.”

Most active currency managers use a largely quantitative approach and focus mostly on G10 currencies and maybe the Singapore dollar. Because there is such a limited number of ways of making money, there is a danger of style convergence, or an overconcentration of managers all doing the same thing to gain alpha, consultants said.

“Currency is an area where we get at least a good crisis every six, seven or eight years,” Mr. Zeiler said. “There is a danger that a lot of managers will get caught up in the same one. In 2005, they all bet on the weak dollar and the dollar rose.”

In 2005, Hurricane Katrina, Iraq and a burgeoning U.S. deficit, among other factors, led a slew of managers to go short on the dollar. But against predictions, the dollar rose 14% against the euro and 15% against the yen for the year.

Data from Pittsburgh-based Mellon Analytical Solutions, which tracks 19 currency managers with total notional assets of $103 billion, showed that managers failed to beat their benchmarks for five consecutive quarters starting from the third quarter of 2005 and only recovered in the last quarter of 2006 with a 0.38 median excess return.

Maarten Nederlof, a managing director at K2 Advisors LLC, Stamford, Conn., a hedge fund-of-funds manager, believes style convergence is at least partly to blame for the muted performance among active currency managers since 2005.

In an effort to counter this effect, K2 has introduced a multimanager currency strategy in a single fund. Mr. Nederlof explained that style convergence is partly due to the growth of multistrategy currency managers that are using similar approaches that highly correlate to one another.

“Smaller and more focused hedge funds are in a better position to run purer strategies that are less correlated with each other,” Mr. Nederlof said. “The main challenge is careful, deliberate allocation across focused managers. You have to be thoughtful in what strategies you want and at what time.”

Other managers are searching for ways to further diversify by introducing new currencies, different strategies, additional signal factors into the models, or some combination of all three. High-frequency trading, algorithmic trading and volatility trading are all being considered by various firms, said Yariv Itah, partner at Casey Quirk & Associates, a money manager consultant in Darien, Conn.

To succeed, managers must add value not only in terms of skill but also in terms of “packaging currency on top of broader mandates, such as GTAA,” Mr. Itah said.

Risk levels

“The other very important factor is the ability to customize risk levels successfully,” Mr. Itah said. “Most non-leveraged strategies target an alpha of 2% to 4%. Even if it’s alpha, it doesn’t pay the rent. It’s not enough to meet long-term investment needs. Now, if a manager can give me a juiced-up version closer to 8% to 9%, that’s what institutional investors want.”

Andrew Bound, managing director and head of currency management for Goldman Sachs Asset Management, London, said: “About 60% of the (new) mandates we’re getting are unconstrained, alpha-seeking strategies.”

“Only a few years ago, very few even had specific allocations to cash-based alpha and when they did, there were quite often a lot of restrictions on the types of bets within a portfolio,” Mr. Bound said. “Now there’s much more flexibility and indeed (it is) rare for people to put constraints on managers.”

At GSAM, quantitative and fundamental approaches are blended into one strategy to further diversify alpha sources and help smooth the return. GSAM also offers segregated accounts in each style, but it is the blended strategy that has helped to set the group apart from its competitors.

“Most of the market focuses on a quantitative or systematic approach,” Mr. Bound said. “We also believe in the importance of following our judgment, to be more flexible.”

The blended strategy has attracted $17.9 billion in scaled assets under management, or 26% of GSAM’s total currency assets under management as of Sept. 30.

Meanwhile, the largest pension funds are expanding their active currency programs, including the e209 Stichting Pensioenfonds ABP, Heerlen, Netherlands.

At ABP, where active currency strategies are managed both internally and externally as part of the pension fund’s GTAA portfolio, officials declined to specify how much of the portfolio is exposed to active currency or name the external managers. But they did say they are expanding and might consider hiring additional external managers.

Active currency, not correlated with the rest of ABP’s assets, “is also an efficient way of translating risk into returns,” said Gerlof de Vrij, head of global tactical asset allocation for ABP Investments, the asset management division of the fund.

In 2006, active currency realized a 0.7 information ratio, a measure of risk-adjusted return. The overall GTAA portfolio, including active currency, realized an information ratio of just more than 1.0.

One of ABP’s main approaches to active currency is diversity.

“What we try to do is to have a well-diversified portfolio,” Mr. de Vrij said. “If we add something new, it should be different from what we already have. If you have five different managers, and if they all only play the (U.S.) dollar/euro, then they can neutralize each other.”

Hermes Asset Management, which manages the £38 billion British Telecommunications Pension Scheme, London, and £31 billion in additional assets, is considering expanding into emerging market currencies. CIO Roger Gray declined to be specific about the active currency portion of the BT fund because it fluctuates over time. Another idea to add alpha is broadening the use of volatility-related instruments.