Currency strategies evolving amid ongoing search for alpha

Global currency managers are venturing far beyond the carry trade to diversify their sources of returns from the foreign exchange market, in yet another sign that the asset class is entering the next phase of evolution following the credit crunch.

“Alpha has become more sophisticated,” said Neil Record, founder and chairman of Record Currency Management Ltd., Windsor, England. “The future of currency strategies depends on the ability to understand why, as a group, we have performed so poorly (during the credit crisis), and to strip out the various effects so that investors are clearer about their investments.

“Currency strategies are becoming more like equities,” Mr. Record said, referring to the development of a currency “beta” benchmark. If the allocation is active, then investors should expect a return on top of outperforming that benchmark, he added.

As beta and alpha are being separated in currency strategies, active management is being scrutinized more closely than ever, sources said.

Managers are taking the cue by diversifying currency returns away from the carry trade, which was the basis for many active currency strategies before the financial crisis of 2008-2009. Carry trading itself has been changing in the past couple of years to include more volatility filters within many systematic models. Dynamic hedging, which involves varying exposures to certain currencies within a portfolio to better control risk or add returns, is also gaining ground.

In addition, institutional investors are focusing more closely on how currency can be used within broader strategies such as emerging markets debt, global fixed income and tactical asset allocation.

“A key lesson (from the credit crunch) is that it is quite important for active currency managers to have, at their disposal, a diverse portfolio of active strategies,” said Monica Fan, London-based senior currency product engineer at State Street Global Advisors.

Until the financial crisis of 2008-2009, investors generally saw currency exposure as “a necessary evil rather than an opportunity,” said Sean Shepley, head of fixed-income markets research at Credit Suisse Group, based in London.

“What's different now is that the perception of the relative market liquidity has changed markedly (since the financial crisis). ... The ability for (the FX) market to stay open even at extreme dislocations elsewhere is worth a lot and has led many investors to reassess how FX can be used to hedge valuation and liquidity risk elsewhere in their portfolios.”

The global foreign exchange market is among the most liquid, with about a $4 trillion average daily turnover in 2010, a 20% increase from 2007, according to a triennial report published earlier this month by the Bank for International Settlements, Basel, Switzerland.

“If you're looking to profit from the big macroeconomic moves, currency is a very good way to play that theme,” said David Curtis, executive director and head of U.K. institutional business at Goldman Sachs Asset Management in London. GSAM declined to provide currency assets under management, citing company policy.

“It's the largest, the biggest and the cheapest market to trade in,” Mr. Curtis added.

Institutional investors are beginning to issue RFPs in the active currency management again following “a quiet period” in 2009, said Neil Smith, senior investment consultant in the global investment practice at Hewitt Associates LLC based in London. At Hewitt, searches for active currency managers tripled globally so far this year compared to 2009, according to Mr. Smith. He declined to name the clients.

“The case for active currency is still relevant,” Mr. Smith said. “We haven't changed our advice (to clients). However, the products, compared to two or three years ago, are different in that they're more diversified.”

However, skepticism remains among some consultants and institutional investors about the merits of active currency strategies.

Matthew Roberts, investment consultant at Towers Watson & Co. in London, said a number of currency hedge fund strategies, particularly those dominated by carry trading in the pre-crisis environment, dipped dramatically alongside other growth assets during the height of the credit crunch in 2008 and early 2009.

The carry trade, which is also known as the forward rate bias, generally had positive returns between about 2002 through 2007. However, performance fell sharply in 2008, delivering a -17.1% return measured against the London Interbank Offered Rate in dollar terms, according to data provided by Credit Suisse based on Credit Suisse FX Metrics indexes. Carry trades have since recovered, but results are still mixed, with a 1.7% year-to-date return over LIBOR as of Sept. 15.

“A number (of managers) were using quantitative factors that were difficult to differentiate and easy to replicate,” Mr. Roberts said. “Although many have since changed their models, the danger is that these developments, too, are similar across different managers. For example, a lot of managers are adding risk aversion indicators to help predict when the carry trade isn't going to work. If everyone is doing this, then the question becomes how effective are those types of new signals?”

Managers including SSgA, Record and GSAM have responded by pushing to further diversify across active currency investment styles. The strategies vary, but might include one or more of momentum, growth, value, terms of trade and emerging markets in addition to carry trading, according to consultants and managers.

RCM, long considered a “purist” in carry trading, will introduce an emerging markets currency strategy within the next year, said Mr. Record, whose firm manages $29.5 billion in currency assets.

“If you invest in emerging markets equities, about half of the overall return from equities has been made and will be made by holding the (underlying) currencies,” Mr. Record said. “So if you don't want to hold equity risks, emerging markets currencies can be a very efficient, low-cost and transparent way of benefiting” from the emerging markets growth potential.

At ING Investment Management, a new active currency strategy launched in August combines alpha extracted from three different sources. About a third of the return is gained from carry trading with a risk indicator overlay to control volatility; a third is from a top-down theme-driven approach; and the remainder comes from a bottom-up fundamental strategy focusing on emerging market currencies.

“If you look at various strategies within (active) currency — for example trend or value — and combine that with carry trading, the returns are relatively uncorrelated compared to other asset classes,” said Jaco Rouw, senior investment manager in global FX at ING IM based in The Hague, Netherlands. The firm has €15 billion ($19.6 billion) in currency assets under management.

Dynamic hedging has become more popular following events in 2008, when some domestic currency depreciated at the same time that global equity portfolios were falling, exacerbating the impact of negative returns, consultants said. By allowing managers to take active bets on which currencies should be hedged and which shouldn't, investors theoretically can reduce the overall investment risk profile.

“Historically, currency is an inevitable byproduct of investing overseas,” said Ms. Fan of SSgA, which manages $83 billion in currency assets under management globally.

“Now what (investors are) seeing is that in addition to reducing volatility, they can actually look to add alpha from more proactive management. This has been one of the biggest trends.”