Foreign exchange has been a rare source of positive return
recently, but investors shouldn’t expect a dazzling choice of managers, writes
The Cambridge Strategy’s chief executive PETE HENRICKS. One of the few asset
classes to perform in recent times has been foreign exchange. Managers in this
space have delivered positive returns to investors, whether wholesale or
retail. In particular, it has been institutional investors that chose to opt
for this “asset class” that have warmly welcomed the positive returns,
especially in last year’s volatile investment climate.
But is foreign exchange
an asset class in its own right or is it a derivative of an asset class that’s
acquired by investing in foreign equities or fixed income? The jury is still
out. For those investors that opt for the former position – foreign exchange as
a distinct asset class – the aim is to generate alpha by buying or selling a
variety of currencies. In the past five years, in particular, trading in this
asset class has certainly become more sophisticated with specialist firms
creating customised solutions for clients; the most common approach has been
overlay programs that go long or short in a currency against a pre-determined
That benchmark can either be passive, where the investor decides to simply
hedge the currency to prevent foreign exchange losses, or active, where the aim
is to outperform the benchmark, either by “under-hedging” currency in the
belief it will under-perform or “over-hedging” in the belief it will outperform.
How does this work in practice ? Assume a superannuation fund has a one billion
Euro equity and fixed interest portfolio. If the Aussie dollar starts rising
against the Euro and the fund fails to act then its absolute returns will fall
because of the losses that will be sustained when those Euros are converted back
into Australian dollars.
In this situation the overlay manager would buy Aussie
dollars and sell Euros forward to manage that hedge, so if the Euro depreciated
against the dollar then the hedge would start generating profit to offset the
losses on the underlying foreign currency assets. In these markets, positions
have to be constantly reviewed. An excellent example is the Aussie dollar when it
started to rapidly come off its highs against the US dollar last year. Investors
with a passive hedge quickly discovered that although the foreign currency
assets might have been generating profits, the hedge is generating losses that
have to be funded. Indeed, some funds were forced to sell assets to meet margin
calls on the hedge – hardly a desirable situation.
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.
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.