Watershed for FX managers: Diversify or die

The five-year drought for currency investing claimed a major victim in October after FX Concepts lost nearly all of its assets under management over the past six years.

But FX Concepts isn't alone. The length of the challenging environment is putting pressure on all currency managers, pushing them to diversify their businesses by adding strategies within the asset class and expanding beyond it.

Since the financial crisis of 2008, currency managers have struggled in an environment in which multiple countries' central banks have dampened currency volatility through a variety of tools, such as quantitative easing.

The Parker Global Currency Managers index returned -0.29% in September, with a year-to-date return of -4.65% as of Sept. 30. The index had an annualized three-year return of -3.66% through September, and an annualized five-year return of -1.98%

The difficult environment came to a head for FX Concepts LLC on Oct. 9, when the New York-based firm announced it would close its investment management business over the next few weeks. The firm will continue to operate its newsletter and FX overlay advisory business.

“The market has been moving toward vanilla-type instruments,” said John Taylor, founder and CEO of FX Concepts. “We, as a shop with a long record, had gotten away from vanilla. This year one of our products was up in the middle double digits, an overlay product, but it depended on options and that's a very rational and sensible vehicle, with our track record. On the other hand, that kind of product is too esoteric for most of the clientele, (and it) never was more than 5(%) or 6% of our total” assets under management.

Mr. Taylor said much of the firm's difficulty was finding institutional investors that would understand and embrace the more complicated vehicles the firm was introducing to counteract the underperformance of its larger strategies.

The firm's assets under management dropped to $661 million as of Sept. 26 from a peak of $13.5 billion as of Sept. 30, 2007.

“I think there was a tremendous boon in complicated currency management from 2008 and we were very successful in that period and bad times have made people like us look at different ways (of)managing currency,” said Mr. Taylor, “and then finding those fancy ways very difficult to sell.”

Mr. Taylor said there are four or five large searches by pension funds out there for simple currency overlay strategies.

“The fact is I believe we will appear elsewhere as an emerging somebody,” said Mr. Taylor. “The overlay business, you can't manage that when you're closing down so we have to find a partner. I would expect — knock on wood — that we will.”

Currency managers need to adapt to survive, consultants say.

Today's environment “requires a very different skill set. What's interesting to see if you go back five or even 10 years, currency players (had) the advantage of being able to use high-volume, real-time trading information and draw conclusions from that,” said Yariv Itah, partner at money manager consulting firm Casey, Quirk & Associates LLC, Darien, Conn.

However, since the financial crisis currency managers have had to cope with a new environment, one in which politics has played a large role through governments' willingness to take actions that affect currency volatility, according to Mr. Itah. ”Currency traders who developed the skill, for example, to develop cutting-edge political analysis would have an advantage over those who believe the markets have behaved like they always have,” said Mr. Itah.

Through the difficult environment, some managers' approaches had an edge. Discretionary managers have performed a little better than others this year, said Parker Philp, assistant vice president and director of research at Parker Global Strategies LLC, Stamford, Conn.

“Discretionary managers have models (and) they have different programs they use, but they are not totally model-driven,” said Mr. Philp. “They have an investment idea.”

Still, many managers are “recalibrating their models,” said Zainul Ali, Toronto-based director and head of manager research, Americas, at Towers Watson & Co. “Some of the strategies that led to the success of currency managers 10 years ago, those strategies seem to be deteriorating right now and managers are just looking for new ways to recalibrate their models.”

Managers that have previously depended solely on carry trade, the momentum trade or value trade find the environment even more challenging.

“It worked well for eight, nine, 10 years, (but) they haven't worked in the last three or four (and) now they're scrambling,” said Mr. Ali.

Because currency management has always had a niche position and few institutional investors invest specifically in currency, Mr. Itah said managers have been moving further into emerging markets where governments have been less apt to intervene in the financial markets, and also moving beyond currency into new asset classes using the tools they already have.

Among the traditional currency managers expanding their focus is Lee Overlay Partners Ltd., based in London and Dublin, which recently launched an emerging markets fixed-income strategy.

“We have a pretty good pedigree and our clients have good experience with emerging currencies,” said Adrian Lee, president and chief investment officer. “It's a logical extension of our skill set, by no means a capitulation from the currency space.”

Other managers have diversified within currency management.

Record Currency Management, London, introduced what it calls its Multi-Strategy Currency Portfolio, a smart beta mandate, in July 2012, said James Wood-Collins, chief investment officer.

The firm previously had offered four separate strategies: the forward-rate bias, also known as the carry trade; momentum, or trending; value; and emerging markets currencies.

“We typically see that those four strategies behave quite differently in different markets,” said Mr. Wood-Collins.

The forward-rate bias and emerging markets currencies often perform strongly in what Mr. Wood-Collins calls a “risk-on” market when the market is willing to reward risky strategies, while value and momentum are more risk-neutral.

Momentum can actually perform more strongly in a “risk-off” market, Mr. Wood-Collins added.

“Combining those four gives a smoother diversified return stream for clients,” said Mr. Wood-Collins.

Another firm, BNY Mellon's currency manager affiliate Pareto Investment Management, dropped its active currency offerings in January when it became a unit of the firm's liability-driven investing affiliate Insight Investment. At the time, the move was attributed to allowing Pareto's clients to tap into Insight's rates and liability management expertise and become more of a global rather than solely U.K.-based player.

“The divide is very clear (between) what Insight did before in currency alpha and what they continue to do and what Pareto did in hedging,” said Paul Lambert, a portfolio manager and head of currency with Insight, London.

Currency managers have said that while they've experienced significant difficulty because of the environment, there still are opportunities.

“I think our view going forward again, as we move further and further away from the financial crisis, (is) that the potential for more divergence in monetary policy will increase,” Mr. Lambert said.

What might help currency managers is institutional investors' flight from core fixed income, which has resulted in part from the knowledge that interest rates may very well rise as a result of the U.S.' inevitable move away from quantitative easing.

The end to quantitative easing would benefit currency managers by reintroducing currency volatility.

“We have definitely heard a significant rise (in interest) in products uncorrelated to stocks and bonds,” said Dori Levanoni, partner at quantitative money manager First Quadrant LP, Pasadena, Calif., which had $3.4 billion in active currency AUM as of Dec. 31, according to Pensions & Investments data. “The bond part is newer, sort of a tail-risk component in liquid alternatives.”

“We've begun to hear concern about ... "We want something as an alternative or a tail hedge to equity. Normally, we'd go to bonds, but we want something new, please,'” Mr. Levanoni said.

Unfortunately, for FX Concepts, those opportunities might have come too late.

“The closing of FX Concepts to us currency managers is like the death of a favorite rock star. It's kind of a sad day in the business,” said Mike DuCharme, head of currency strategies at Russell Investments, Seattle, which manages about $38 billion in passive currency hedging.