Currency Debate (April 2007) - Snakes and ladders

Chris Callan
Vice-president
Morgan Stanley Investment
Management
Callan is a member of the structured products and derivatives team. He joined Morgan Stanley in 2004 and has nine years of investment industry experience. Callan joined the firm working with the FX quantitative trading strategy team before joining the SPD team in 2006. Prior to this, he worked at Nikko Europe, Sanwa International and Bear Stearns International.

Ulf Lindahl
Chief investment officer
AG Bisset
Lindahl joined AG Bisset in 1981 to assist in developing the firm’s currency advisory service. He developed the AG Bisset currency model (introduced in 1983), which is at the core of the firm’s currency overlay and currency alpha programmes. Lindahl became a principal in 1984 and chief investment officer in 1992. He has authored the AG Bisset research report, Review of Emerging Trends, since 1984, and directs the firm’s currency overlay and currency alpha programmes.


What conclusions can pension schemes draw from the recent global currency turmoil in relation to their own investments and currency management programmes?

Callan: Market turmoil can often teach us that prior assumptions concerning the correlation benefits of diversification both within and between asset classes do not always hold.
Diversification benefits are apparent in the low correlations we can observe during a stable environment but these benefits can all too often disappear when you need them most. Put simply, the perception of well-diversified risk on the way up may well hurt you on the way down.
Correlation is dynamic and in the context of currency management should play a serious role in the determination of benchmark hedge ratios in both active and passive hedging programmes.
For active alpha-generating programmes that promote diversification and low correlation to the underlying asset class, one should dig deeper to determine how stable this correlation is during periods of market stress.
Perhaps more importantly, pension schemes should ascertain what “active” risk controls are in place to mitigate downside risk in the event the “hedge” effect of these alpha sources changes dramatically and actually work against you.

Lindahl: The turmoil was not unusual. Currencies erupt on occasion, although there have been worse eruptions in the past.
This time they reacted to the Chinese market’s sell-off in February that triggered global declines. However, the upside reversal in the Japanese yen likely marked an important turning point with profound implications for pension funds with passive hedging programmes.
The yen has depreciated for seven years against sterling, dropping 35pc – the longest and second largest decline in three decades. The yen is now poised to rise over the next few years: in 1980-86 it surged 155pc, in 1990-95 it rose 102pc, and in 1998-2000 it gained 53pc. The dollar may also turn up in 2007 – it is near a 25-year low.
Passive hedging has delivered gains in recent years that have shielded investors against currency losses. However, in an environment where currencies rise, passive hedging prevents participation in gains while paying hedging losses can be painful. If the yen were to rise as in the past, a significant portion of underlying Japanese securities will need to be sold to pay hedging losses in a passive hedging program. As a result, a fund will end up owning fewer and fewer shares. The effect would be the same should the dollar begin to rise and it is kept fully hedged.
The conclusion to draw is that schemes with passive hedging programmes need to tactically review them, and must now move to active overlays for the next few years – to reap the benefits of the proven skills that active overlay managers have, both in hedging when currencies decline and in removing hedges when they rise to generate returns and cash-flow profiles superior to those of a passive hedge.
The rewards could be large.

It is often meaningless to focus on short-term events when setting long-term investment strategies. But would trustees be justified in registering serious concerns about taking on an increased amount of currency risk through overseas diversification in light of these developments?

Callan: How many short-term events does it take before there is meaningful consideration in the longer-term investment strategy?
To take the recent example, the so-called unwind of the “carry trade” and the risk-aversion theme that is starting to look like at least an annual event. Considering such events is important when selecting the appropriate currency management programme as an integral part of your overall investment strategy.
To ignore such events is going back to the old ways of assuming that all will be well as currency returns net out over the long run, assuming of course you know exactly how long this long run is. This long-run approach gives no consideration to interim currency risk which can and should be managed with the appropriate risk controls.
Overseas diversification can be an attractive source of return and the inherent currency risk is a fact of life. Trustees should not be looking to increase this risk in the absence of a currency management programme and as such, should be more concerned about the selection and review process for an appropriate currency manager.

Lindahl: Trustees should welcome international assets. However, they need to recognise that as overseas allocations expand, the overall currency risk increases. Since pension consultants agree currency specialists have skill and they mitigate risks while adding value, the aim is not to avoid overseas assets but to embrace active currency management as a normal tool in managing a scheme’s currency risks.
Although, at this time in the currency cycle, as mentioned, passive hedging needs to be avoided in favour of active strategies that can permit participation in potentially large currency gains. An active strategy in a rising currency market will be particularly important for schemes that are underfunded and need as much return as possible.
Active management, relying on a team of two-to-three overlay managers, may, in fact, be less risky than a one-sided passive hedge.

Should schemes be concerned that while volatility in equity and bond markets has decreased considerably in recent years, the downturn in currency market volatility has not been so strong? Are schemes underestimating currency risk?

Callan: Schemes are clearly underestimating currency risk. Currency volatility can on average be anywhere from 8pc to 12pc and is well known for its spikes/volatility clustering. To ignore this risk can dramatically impact returns on the underlying asset (for example, UK investors into US assets 2006).
Currency markets can also be an attractive source of return but the next generation of active currency managers should be active in both risk control as well as alpha generation. Active risk controls could, for example, consider a variety of risk factors when making the investment decisions and constantly monitor them, as well as utilising an active stop-loss framework once the investment allocations have been made.

Lindahl: Market volatilities fluctuate. Contrary to popular perception, currency volatility has also diminished in recent years. However, the currency risk that arises with overseas investments remains real and it must be managed professionally by currency specialists. Equity managers do not have the required skills.
Although a number of UK schemes have favoured passive hedging in recent years, the currency market is cyclical. After prolonged declines in the yen and the dollar (representing 50-60pc of most schemes’ currency exposure, and the euro another 23pc) passive hedging needs to be re-thought in favour of active strategies that can perform in both the bullish and bearish currency phases of two-to-four years.
Investors increasingly see currency as a source of uncorrelated returns that can lower a fund’s overall risk.
That is a logical extension of risk-diversification into other asset classes. However, trustees need to be aware that a strategy of adding a highly volatile pooled currency vehicle, while passively hedging underlying portfolio exposures, will have a dramatically different risk/return profile in an environment when currencies rise cyclically.
Gains from a pooled vehicle may now only offset losses on passive hedges resulting in overall sub-par performance.