Foreign exchange is a bittersweet asset class. On the one hand, it cries out for downside protection; on the other, it can provide a handy source of alpha.
Sunsuper investment manager, fixed income, Justin Lo, summed up the conundrum: “We look at currency both as an exposure that we want to hedge from a risk-management angle [and] as an opportunity to obtain some return [that] typically has a low correlation to traditional markets.”
Lo made his comments during a session at the 2017 Investment Magazine Fixed Income, Cash and Currency Forum, held in Healesville, Victoria, in July. The discussion topic was, Currency: A risk to hedge or a source of alpha?
AMP Capital investment strategist Angus Nicholson said the $179 billion asset manager sees currency risk as a useful source of alpha.
“We take active alpha plays on currencies that we think are undervalued and have a bit more upside,” Nicholson said.
As an example of this, he described a trade that played out well for AMP Capital in the first half of this year.
“Our fund was long Japanese equities since around third quarter last year, and similar with European equities, so we had short positions in the Japanese yen, which just further enhanced the active returns we were getting from that rally in Japanese stocks – because you’re also getting a sell-off in the yen there as well.”
AustralianSuper currency performance attribution specialist Trent Brandie said the $130 billion industry super fund’s internal investment team has an alpha target on its foreign exchange portfolio.
“The team has risk limits on edge currency, so the way they actually manage the alpha component is it’s net zero and all currencies are in scope,” Brandie said. “So, they can directly do pairs if they want, they can go US dollar-vs-euro, they can do tilts between emerging markets and developed markets, and they can do triangular trades as well.”
He said AustralianSuper’s alpha program has two parts to it.
“One is a top-down macro view and the other part is a quant-factor model, which has the very typical factors of, I guess, momentum, carry and value,” he said.
Investors must cope with the macroeconomic and exogenous factors that constantly buffet currency markets, such as protectionist policies and political gridlock, and take these into account when hunting alpha.
“Some of the big questions are whether we’re in a reflation ‘Trumpflation’ regime or whether we’re just in more of a late-cycle curve flattening regime. And what sort of asset allocation would benefit most from that,” Nicholson said.
A macro influence of special importance to Australia is the effect of China on commodity prices.
“We track the Chinese economy very closely,” Nicholson said. “Chinese interest rates have a strangely strong correlation with exactly where commodity prices move, so as financial conditions have tightened this year, we’ve been seeing the iron-ore price get hammered and then, since they’ve eased off, in June, iron ore’s really back up. You do have to take a very strong position on China.”