1. Do you think that most Institutional investors are fully aware of how influential currencies can be on portfolio performance?

Institutional investors will be only too aware of the potential impact from currency on portfolio performance. Take the return from equities over the three years to the end of August 2011. In local currency terms, the FTSE All-World Index has had its ups and downs but, overall, it’s barely marked time with a return of -1.4% p.a. over that period. If you were a UK-based investor in the same markets, you’d not be overjoyed but at least you’d have achieved a return of 4.1% p.a. But if you were investing from Australia, you might find it rather uncomfortable reporting the -6.8% p.a. return to your Investment Committee, especially if you could have avoided some of that loss by hedging the Australian dollar.

The 4% return for the UK-based investor would actually have all come from sterling depreciation, not from equity markets. While fortuitous in this instance, taking a punt on sterling might not have been what the investment strategy was designed to target. In this case, it would have paid off but it may not always. If you were a client of Mercer, we’d probably have advised you to hedge at least some of the currency exposure so as to reduce this source of unwanted volatility. Then you could have used a risk budgeting approach to reduce risk overall or allocate the risk to investments that offer a better expected rate of return than taking passive currency exposure. 

2. Most investors can see the benefit of a passive currency hedging policy to mitigate risk. As currencies become more widely accepted as an asset class is there likely to be significantly increased interest for active overlay strategies that can deliver modest returns and if so, do you see regional variations in demand for these?

We find it helps to think of currency exposure as two different types: the strategic currency impact, whether it should be hedged, and if so, how by much; and the active currency opportunity and how this could best be implemented. The first is all about reducing risk and the second is about using risk to add value, or alpha, from active currency management. By considering these two decisions separately, investors are likely to achieve a better result.

Of course, when it then comes to implementation, it might be more practical to combine them again, or maybe not. The hedging is usually implemented via an overlay but the alpha generation doesn’t have to be. There do seem to be some regional differences at this stage. Recently, we have seen increased interest in overlay mandates from North American investors and Australian investors who want to meet specific requirements; UK investors tend to prefer to invest in absolute return currency funds.

3. Generally speaking in your experience, are active overlay programs less contested by investment committees and boards than an unconstrained currency alpha mandate and if so, why is that?

The nature of the program should meet the client’s requirements. If that is the case, there should be less scope for argument about the way it is implemented. An overlay can also be managed on an unconstrained basis so the two are not mutually exclusive.

4. What steps can investment professionals take to help educate investors and Plan Sponsors about the relative merits of achieving absolute returns with currencies as part of an investment strategy and not just as a by-product of an active or passive de-risking program?

Investors should be helped to understand the nature of currency markets – the large volumes transacted; the good liquidity and low dealing costs that result; and the high proportion of activity accounted for by participants who are not trying to maximise profits. These combine to give active currency managers a particularly good start when generating alpha. Analysis of the Mercer Currency Manager Universe shows that the median manager has consistently been able to add value over rolling three year periods on a risk adjusted basis. This can’t be said of many other investment categories. 

Investors should also be introduced to the benefits that active currency management can provide in generating an additional source of returns that brings diversification at the same time.

5. Should investors be more concerned about the return attribution process to understand more clearly about how much of a currency return is alpha and how much is beta?

It is important to understand where the returns come from - if the manager is just producing returns from beta, then investors should not have to pay alpha-based fees.

When people talk about currency beta, they are usually referring to persistent sources of return that have become commoditised; effects like carry (exploiting interest rate differentials), trending and value. While all these can be shown to have worked well over the long term, they are prone to prolonged periods when they can be loss-making. A manager with skill should be able to harness these influences and others to generate more robust returns. If investors can understand how managers generate returns, they will know what to expect from different market conditions and be better able to assess which managers really do have skill.  

6. In what ways might the currency policy chosen by a particular investor impact on their choice of currency management practitioner?

It depends what you mean by currency policy. If this relates to how currency fits into the investor’s overall strategy and whether the currency manager is expected to implement a currency hedge as well, then clearly the manager chosen has to be able to meet these demands. If the currency manager doesn’t have to hedge the assets or is part of a multi-manager program, then the way is open to consider a wider range of managers, including small niche players.   

Investor preferences and the time they have available will also affect how much detail they want to get into. Some will want to know all about the different active currency management approaches and be directly involved in the selection of managers. They will want to consider how different styles will sit alongside their existing managers, and will have strong views on what styles they favour, systematic or judgemental, fundamental or technical, or a blend of different approaches. Others will be happy to delegate the decision to specialists. Most will find it useful to take expert advice, even if they retain the ultimate decision making power.

7. Passive overlay strategies are widely perceived as being fairly straightforward to implement. Is that true?

Passive strategies require efficient implementation at low cost and the ability to meet cash flow requirements. They should be relatively straightforward to implement provided that they are properly set up with the right attention to all details, such as how to meet cash flows even when market conditions are adverse. This will require having a process in place to deal with unexpected events.

8. What do you see as the key attributes of a good currency manager?

How much time do you have?

We try not to be too prescriptive as to what makes a good manager. Don’t forget the advantages of active investment in currency mean that even the average manager should be able to add value. So to be good, we need to be convinced that the manager is better than average. That means that we are looking for evidence that the individuals involved are talented and demonstrate original insights. If the manager is discretionary, it could be the quality of analysis or thinking outside the box that convinces us. If the process is quantitative, we need to know enough about it to be able to form a view. We also look at the checks and balances in the process - effective control of risk and dealing costs - and a supportive business structure that will foster and sustain any advantages.

9. How much emphasis do you think investors should place on the investment style of managers (i.e discretionary, systematic, active, passive, etc) and how important are the merits touted by investment specialists of exploiting more diversified strategies?

Investors have to understand the nature of the manager they are appointing. For starters, there’s a big difference between an active and a passive approach! 

If an investor is looking at active currency management, some styles will be better in certain conditions but all will only be as good as the quality of the people responsible. In theory, a more diversified strategy should do better than a less diversified approach, but only if all the components are equally good. So a narrower strategy implemented well might be better than a more diversified strategy that is only average.

The use of more than one manager will allow investors to obtain diversification benefits while retaining the use of specialists. Our analysis has shown that active currency managers tend to have very low correlation with each other which means that it can be effective to use a number of managers as part of a multi-manager portfolio. The best solution for each investor will depend on the resources they have available (internal or external) to manage this process.

10. Do you think new MIFID rules and increased regulatory oversight throughout the capital markets will encourage more investors to explore the use of currencies as a tactical asset class which can be leveraged for both institutional portfolio risk mitigation as well as diversification of personal investment strategies?

You’d need to ask a specialist in regulation about the impact of MIFID. Generally, more regulation is good if it protects investors better and encourages more interest in active currency. However, to the extent that regulation inhibits implementation of a manager’s best ideas, it is likely to detract from returns. Investors will only be interested if the vehicles offered by managers are able to add value without too much leakage due to costs and constraints of regulation and manager fees. 

11. Many investors are looking beyond developed markets to take advantage of opportunities in both emerging and frontier markets. Do you think recent Currency Wars, where fast growing countries take radical steps to prevent appreciation of their currencies, will dampen investor appetite for portfolio exposure to some regions?

Investors shouldn’t be too worried about currency wars as they often just delay the inevitable. Usually, if the pressure is for a revaluation (upwards or downwards), then dampening those pressures means they build up so that the eventual move still happens, but with more force.  But that’s why we want currency experts to manage the process for us.  

You ask if investors might be reluctant to have currency exposure to some regions. If they are unhappy about these exposures, investors can restrict their manager’s mandate or select a currency manager that specialises in a limited range of developed market currencies. Generally, we would advise imposing as few restrictions as possible. The manager’s approach will reflect the areas where it is strongest and we usually advocate exposure to the product that best reflects that manager’s skill, be it a narrower or broader range of currencies.  

12. Do you anticipate that the European Sovereign Debt crisis will end up having wider ramifications for both currency investment and currency management activities elsewhere?

It already has – just look at the overvaluation of the Swiss franc. If the pressures on the euro do prove unsustainable and the single currency collapses, then managers will have more currencies to trade again (which increases their opportunity set and may take us back to the days of super-strong returns), but I’m not forecasting that to happen in the foreseeable future.

13. Looking ahead over the next few years, what key factors are most likely to influence currency manager performance and shape the way the industry evolves?

We identify the main factors as the nature of currency markets, the impact of regulation and the returns that managers can deliver to investors. 

Currency managers usually do best when there is enough volatility in markets for them to make money but not so much that conditions become erratic and liquidity disappears. Economic divergence can help foster the right conditions and allow exchange rates to reflect the different themes. Currently, the risk on/risk off environment and the tensions between the highly indebted developed world and creditor developing markets dominate but financial markets are always changing and these themes are bound to evolve in ways that surprise. 

The threat of increased regulation is a potential dampener but currency managers seem to be less affected than many other categories. 

One caveat is that managers have tended to target lower risk than in the past, so their expected returns have also come down, but many still charge the same fees as they used to. They have to take care that they share enough of the value they generate with their investors. 
 

This article was first published in Currency Investor in their Autumn 2011 magazine.

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