Currency Debate (July 2007) - No free lunch

Chairman
Clay Lambiotte
Senior investment consultant
Lane Clark & Peacock
Lambiotte graduated in mathematics from the College of William and Mary in 1997. He joined LCP, moving to the UK from USA, in August 2004. He has specialised in institutional investment consulting since joining LCP, and is responsible for providing advice on investment strategy and structure.

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.

Bernd Scherer
Global head of quantitative structured products
Morgan Stanley
Scherer joined Morgan Stanley in 2007 and has 13 years of investment experience. Prior to joining the firm Bernd worked at Deutsche Bank Asset Management as head of the quantitative strategies group's research Centre, as well as head of portfolio engineering in New York.


Lambiotte: There are various theories concerning why the currency market should offer pension schemes excess returns, including structural inefficiencies in currency forward markets and an explicit risk premium for higher yielding currencies. What is your view?

Lindahl: One explanation is that there are non-profit-oriented participants in the currency market (central banks, corporations and tourists), who create opportunities for currency managers to generate returns. However, that theory is likely faulty since price-changes in currencies and equities have statistical distributions that are normal or “bell-shaped”.
Since the statistical profiles are identical for equities and currencies, non-profit participants in the foreign exchange market cannot be the reason the average currency overlay manager adds value to a benchmark while the average equity manager does not.
Bisset believes it is the different investment styles and time horizons over which currency and equity managers invest that permit currency managers to outperform their benchmarks. Equity managers use fundamental information to buy stocks they believe will outperform a benchmark over the long term – “buy and hold” investing. The securities are selected from a large universe and the probability of unpredictable events occurring and altering the anticipated performance is high, and it increases with time. It is therefore difficult to find securities that will outperform when the future is unknown.
Currency managers are generally trend-followers, and buy and sell over short time horizons of a few weeks or months – a process of “market-timing” often executed with models that have no fundamental economic input.
Since short-term price trends tend to remain in place, and unexpected events are rather uncommon, the probability of making money on a short-term currency position is much higher than that of making money on a security held over the long term when several unexpected events can alter the outcome. As a result, by making serial short-term bets, currency managers avoid surprises most of the time while they are also able to cut losses when a trend does not unfold as expected. Equity managers do not have that luxury.
Although high interest rates in the UK have permitted investors to earn the interest rate differential in recent years, it has not always been the case. In the two decades before 1995 the major currencies rose persistently against sterling. A passive hedge placed to earn the interest rate premium would have been regularly unprofitable and associated with very large negative cashflows at times.
Historically, currencies with low inflation and interest rates rise, while those with high interest rates fall. It is likely that the currency cycle is about to turn against sterling. Losses on passive hedges could become significant over the next few years. Passive hedging is not a free lunch!

Scherer: The forward rate bias is one of the oldest anomalies in financial markets. It essentially states that higher yielding currencies do not depreciate as much as they should in order to offset the interest rate advantage that comes from borrowing in lower yielding currencies and investing into higher yielding currencies. Academics unsuccessfully tried for many years to explain the excess return that comes with such a strategy as an equilibrium compensation for risk. Hence the forward rate bias is often called the forward rate puzzle.
In many respects this is not very much different to the value premium puzzle that is heavily used in active and passive equity management. This is, however, not the only inefficiency in currency markets. Momentum strategies (buying winning currencies of the past) are also successful in generating excess returns. This is no surprise as they are well based in behavioral finance and as such should work best where fair value is most difficult to find.


Lambiotte: How would you measure the amount of gearing (or leverage) within an active currency fund and how should trustees decide on the appropriate level of gearing when investing in an active currency strategy?

Lindahl: Strategies that combine passive hedging of pre-existing currency exposures in a fund with a leveraged currency fund to generate alpha may not deliver as expected in the next two to three years. If the currency cycle turns against sterling, the passive hedge may generate large negative cashflows that may not be offset by gains from the fund. Trustees need to focus on the pre-existing currency risk and how it is managed before adding more currency risk by buying a fund.

Scherer: The concern about gearing is a bit like the story about feathers and stones. If you ask a five-year-old which is heavier – a pound of stones or a pound of feathers, you are likely to get the answer that a pound of stones is heavier. The same applies to leverage. What do you think is riskier: a portfolio with a leverage of two and a risk of 5pc, or a portfolio with a leverage of four and a risk of 5pc.
Trivially, risk is the measure of diversification. Leverage follows implicitly, and so both portfolios are equally risky. To put the above into perspective: the currency risk that comes with an unhedged US bond (about 8-10pc) fund is twice as large as the currency risk of an active currency fund with a 120pc leverage and a tracking error of 4pc.


Lambiotte: With increased pension scheme investment in active currency strategies, what do you expect the impact of increased profit seekers in the currency market will be on the ability of currency managers to add value?

Lindahl: The impact can be predicted to be negligible. Currency price changes have been normally distributed for decades in the major currencies. Since price changes in equities have been normally distributed for over a century, the normal distribution can be expect to remain in place. As a result there will always be tails in the distribution of the currency movements that can be captured with trend-following techniques.

Scherer: Profit opportunities will eventually disappear if too many are chasing them. This is nothing special to currencies but universal to all forms of investing. While there is a capacity limit to all strategies, the exception is that the volume of the currency market is so large (about 20 times the volume of all equity markets combined), while at the same time the fraction of profit motivated players is small such that capacity limits seem very distant. However, investors are well-advised to move earlier than their competition.


Lambiotte: How important is it for schemes to diversify their active currency investment across different managers or styles?

Lindahl: Around 80pc of the pre-existing currency exposure in a typical pension fund invested overseas is in the dollar, the euro and the yen. To limit the risk of one manager hedging one of those currencies incorrectly, it is very important to have a minimum of two managers.

Scherer: As I have mentioned previously, conviction is the enemy of diversification. I would advice investors that unless the frictional costs of diversification (manager search, evaluation, fees as related to size) become large, it always makes sense to diversify.
I would also advise investors to be thoughtful about their diversification efforts. If one of your managers has a long volatility exposure – essentially trying to buy “underpriced FX volatility” – it is probably a good idea to add another manager with a short volatility exposure, such as a typical forward rate bias investor.