This situation helps explain why more funds are giving foreign currency managers more discretion to attempt to generate a profit over and above the benchmark that they’re hedging that will offset, either partly or wholly, any potential margin calls that might be made on the assets. One aspect of this trend is the increasing number of markets that clients (and consultants) are asking currency managers to trade in the search for alpha. Historically, overlay mandates that have an alpha component have focussed on the developed economies and their currencies.
Now managers are seeking alpha outside these developed markets, and they are finding that developing markets are offering significant opportunities for alpha generation. But it is not easy. Specialist skills are required to be active in these markets, coupled with a risk management platform to mitigate against downside risk associated with these markets (particularly event and liquidity risk). This development is long overdue as, counterintuitively, these developing markets offer significant alpha potential, but with lower volatility than the developed markets due to the active intervention in these markets by governments and central banks to “manage” their currencies.
For clients, these mandates offer the scope to increase diversification by allocating risk between geographically distinct markets. While the hunt for alpha is important, risk mitigation in an overlay mandate is generally more important, and, as a consequence, investors prize a safe pair of hands. It means that about 10 large currency traders dominate this market, limiting the choices for institutional investors that are entering the market.
Increasingly, these overlay mandates are becoming more popular now, and Australia is at the forefront of this trend. It’s believed that more than 50 per cent of foreign currency assets in Australia are actually overlaid to one degree or another so the currency exposure is managed either to a greater or lesser degree depending on how passive or how active the mandate is. By contrast, it’s understood that only about 2 per cent of foreign currency assets in the US are overlaid.
This trend in Australia reflects a growing sophistication by the institutional market about using currency as an asset to generate alpha in a tough investment climate that isn’t reflected in many other developed economies. Given the returns currency asset managers are generating, that sophistication is paying dividends right now for these growing band of institutional investors. As with many developments in the Australian market, over time we expect them to be replicated in other markets.