Westpac Banking Corporation CEO, Gail Kelly opened the morning with some hard truths about the year ahead, noting that in this time, the financial services industry needs to focus on "back to basics," and keep their clients' needs firmly in mind.
Kelly, who had attended the World Economic Forum in Davos, Switzerland, noted that the event had included discussions on “excessive risk taking, too easy credit, over-exuberance, [and] blind faith in mathematical models,” and that part of the remedy for her is to focus on what the industry basics should be.
“One of the insights for me is how important it is for corporations - especially financial service companies - to examine their role in society and think long and hard about what they want to do.
Kelly said she believes this focus is implicit in the services Westpac provides, and noted that this extended to the bank’s currency trade services, even in October and November of last year, when the supply of US dollars (USD) dried up as the value of the Australian dollar plummeted.
“I’m sure you’ll recall the shortage of USD at that time,” she said. “We know that some banks actually stopped quoting. There were a few people around, and a few people were digging deep here. We sat through that and we were open for business the whole way through. The bank met the needs of every single one of its customers and its needs in this particular critical area of currency and foreign exchange.”
She added that while 2009 will be a “tough year”, with uncertainty on how long the economic downturn will last, “We certainly are delighted with the monetary policy response and the very significant cut in basis points over the five or six month period, and of course the fiscal stimulus that is now approved and will now start to support our economy,” she added.
Key economic themes 2009
With the world sitting in a “balance sheet recession”, and companies and the financial sector uninterested in stimulating growth, governments – including Australia – must be prepared to step into the breach with fiscal spending in 2009, said Westpac’s managing director, economics, Bill Evans.
“When we get balance sheet recessions, companies are much more focused upon paying down debt and restoring the quality of their balance sheets than they are about profit maximisation and growth.
Of course the financial sector sits very strongly in that position,” Evans said. “So what you get is that the interest rates fall very sharply, if people are only focused on their balance sheets and growth, then it doesn’t really stimulate the demand for funds, and of course if the lender is under balance sheet stress, then they will also be quite restrictive in their preparedness to lend, because they’d want to look after their balance sheet.”
Evans pointed to the woeful economic performance of Japan through most of the 1990s as an example of why it is vital for governments to roll out fiscal stimulus plans when the corporate sector focus is on rebuilding its balance sheet rather than borrowing to spur growth.
“The important point to be seen from the Japanese experience is if the government sector is dealing with a situation like that in Japan when the corporate sector effectively goes on strike, then the government sector has to play that role,” he said. “We shouldn’t be sitting back as the American Republican party are, or as we saw with our own opposition last week, and saying government spending is bad. It’s bad when the corporate sector is profit maximising. It is not bad when the corporate sector is rebuilding its balance sheets and the financial sector is making it that much more difficult for the corporate sector to act.”
The challenge for governments and central banks will be to realise when the balance sheet recession ends and companies are focused on expanding again, Evans noted. At that time, which he believes is “going to be a long time coming,” central banks and governments can move back to “neutral” policies.
“The whole art of policy in this situation is for the central banks and governments to realise the time when the world has moved away from balance sheet rebuilding to profit max and growth, because then all the things that we learn about in monetary policy become the rules again,” he said.
Panel discussion – lessons from 2008 and outlook for 2009
Global Trading Strategies’ principal Brett Allender, BT Investment Management head of macro strategies Joe Bracken and the Australian Treasury’s principal advisor financial markets Huw McKay, participated in this discussion of how the global financial crisis will unwind in 2009. It was chaired by Westpac’s Bill Evans.
Bracken noted that the “iceberg theme,” or information and events not yet seen will influence how financial markets will behave in 2009, such as the flow of lending from European countries like Austria to Eastern European economies and the state of Eastern European countries’ indebtedness. McKay pointed out that amid the financial insolvency in “core OEDC” countries, it is possible to pick out “favoured” countries. “We have a number of other economies outside of that group where monetary transmission is still working. Australia is one of those countries. Equally China is another,” he said.
For Allender, “default” was the big word for 2009 – “default of banks ... default of confidence and the ultimate legacy, default of governments,” and what impact these defaults will have on wealth creation.
While Bracken said that the speed of response of central banks to the crisis has been “quite good,” he was disappointed by “the lack of ideas not only from the Fed, but from central banks around the world. One thing I’d ask is simply, given that rates are near zero, what next, what do we do now? I fear that the response will be a cold star. I would hope not. I just worry that the central bankers pretty much around the world are scratching their heads.”
In response to Evans’ question about how currencies around the world would perform in 2009, Bracken predicted that there will not be too much movement from the Australian dollar. He said the US dollar and yen would remain strong and the euro would come under pressure because of the “unfolding crisis” in Europe.
When asked if Asian countries – particularly China – will allow their currencies to appreciate, McKay said, “I can see the pragmatic argument for using funds which would’ve been captured by FX reserves and invested in buying Treasury Bonds. They may well see a reason to absorb those funds internally, which means they can’t continue.”
As a general statement about the currencies he looked favourably upon, Allender said, “I’m less optimistic on large current account deficit economies and I’m relatively more optimistic on those that have a capacity to finance themselves.”
Managing a portfolio of Asian currencies
Investors should consider investing in Asian currencies because there are market inefficiencies that present opportunities, a growing range of trading tools and liquidity, and the region offers opportunities for diversification away from “crowded” G10 currencies, according to Aberdeen Asset Management’s head of fixed income – Asia, Anthony Michael.
Because the region differs so widely in terms of political factors, the amount of control of currency, and the relative development of countries within the region, trading the currencies requires active fundamental/discretionary management, Michael said.
“The level of intervention in the currencies by the authorities depends on the policy objectives, the macro funding levels and the predominant capital flows at the time,” he said. “However, the authorities’ success or otherwise in these endeavours will also be driven by the level of foreign currency reserves and more by their rate of reserve depletion rather than by the rate of reserve stimulation. In other words, it tends to be asymmetric.”
To try to offset some of the risks in trading in Asian currencies, Aberdeen Asset Management used basket trades rather than paired trades, Michael said.
“We try to put together a basket of trades rather than one to one bilateral rates around the region,” he explained. “For example, one of the things we want to do through 2008 and we still want to do in terms of the way we manage our positions is to have a long position in China, Singapore and Malaysia , versus a basket short of Korea, India and Thailand.
“The reason we did this is because it helps smooth out the timing in terms of the entry of the trades and what’s going on in terms of volumes and liquidity in the market at the time. It also protects against some of the country-specific risks that crop up in the region at the time in terms of currency intervention.”
While Asian currencies present a diverse range of opportunities for exploiting potential return, Michael acknowledged that the volatility and potential for changes to risk regimes can affect the manager’s ability to realise that value.
“We’ve also seen in 2008 that it was an extraordinary year where risk regimes can change,” he said. “Even if we think the various Asian currencies present positive medium term fundamental value, and there is a great story in Asia, levels of risk aversion impact the realisation of that value from time to time. So expectations of future volatility also change, even in managed currency regimes, requiring a forward looking approach to managing a portfolio.”
Omega portfolio trading
Pension fund managers must rebalance their foreign currency exposures more frequently and with closer attention to liquidity and market impacts, or else risk wide deviations from return targets said QIC’s general manager – capital markets, Troy Rieck.
“You’ve got to worry about the things that can really hurt the fund’s level of returns in a meaningful sense, because those effects stay with you for a long period of time,” he said. This happens even if the events that give rise to those risks and return impacts only occur once every few years. Worrying about the small, the obvious, the manageable effects, is a waste of time. We have to get at the heart of the member experience, which is why we manage this money in the first place. We have to manage for that. It’s a much more difficult job than just taking a benchmark and managing around that (…), but the rewards to the fund are also much more valuable.”
To adequately address the risks implicit in foreign currency exposures, pension funds need to manage mid-month market exposure risk, the liquidity and market impacts and the collateral and counterparty risks, Rieck said.
QIC, an AU$70bn funds manager, manages the superannuation assets for clients including A$50bn Q Super, the superannuation fund for Queensland public employees.
Rieck pointed to data highlighting the volatility in foreign currency prices at the close of each month, which can dictate less favourable prices to pension funds that mandate an end-of-month rebalancing on hedged currency positions instead of a more frequent and flexible approach to rebalancing.
“How can you tolerate a 10% deviation from your strategic target in foreign currency,” Rieck asked. “No fund in the country would tolerate that in their bonds or their equities in their active management programme. Why do they tolerate that in their foreign currency exposures?”
These kinds of swings – such as were seen in trade between the Australian dollar and other major currencies in October and November last year – can materially affect the cash position of the overall fund at a time when liquidity is at a premium, Rieck noted. QIC manages the foreign currency exposures of its clients as part of a broader risk management philosophy.
The evolution of manager selection
Although 2008 was a “tough” year to generate returns on active currency trading strategies, performance across Mercer‘s universe of rated currency managers differed widely. This pointed to the importance of selecting skilled managers who use the fittest strategies for the given environment, said Mercer’s senior associate, Chris Baker.
“It was certainly a tougher environment for alpha generation in active currency in a year when many asset classes fell,” Baker said. “There were still a larger proportion of funds that outperform in the Mercer currency manager database.”
Mercer monitors around 220 currency strategies globally, and rates around 150 of those strategies for clients. Of those rated, around 20 receive a rating of “A” or “A-”, meaning they have an above average probability of outperformance. Funds with a B+, B or B- rating have an average probability of outperformance, and funds rated C have a below average probability of outperformance.
In 2008, Mercer upgraded four strategies from one category to another, downgraded 13 funds and added 16 newly rated strategies. A further 22 strategies were moved to provisional, Baker added. Most of the downgraded funds saw their ratings lowered because of staff turnover, operational issues, and changes to their investment style. Of the 22 strategies moved to provisional, the major function was their exposure to risk, particularly counterparty risk.
Baker said that in 2008, “generally, qualitative factors were far more useful” in understanding investment style and differentiating between managers. These factors included the nature of the business, systematic or discretionary styles – or a mix therein, review of style based on manager process description, quantitative analysis and Mercer research, the universe of currencies analysed, the turnover an average holding period, and risk controls.
Baker pointed out that irrespective of their quartile placement, all of the managers evaluated by Mercer had positive returns on a risk adjusted basis over the last three years. According to their data, the lower quartile managers had returns of slightly less than 2%, median managers posted returns of under 4% and upper quartile managers had returns of more than 10%.
Experience and lessons from 2008 – perspectives from an institutional manager
In an “unprecedented” year – a word introduced and then quickly banned by State Street Global Advisers’ head of currency and asset allocation, Asia Pacific (ex Japan) Chris Loong – passive hedging and active currency management all faced challenges. Passive management required large cash payments to cover hedges, while on the active side, naive carry trades did not function as expected for the Australian and New Zealand dollars.
But 2008 had valuable lessons, including the need to consider using “enhanced passive” strategies, and the fact that some valuation measures gave warnings and indications of opportunities for active managers.
Currency managers can be hampered in their ability to add value to clients by the terms of the mandate and the currencies that clients allow them to use, particularly on passive or overlay mandates, Loong said.
“If you’re going to look at using an active manager, you should be using the whole spectrum of their universe, and not limit them to a certain range of currencies. Obviously you can set the risk parameters, but you should try to give them as much room to move as possible,” Loong said. “Active overlay can be difficult because you’re not giving your full range of currencies to manage to add value, and you’re limited by the underlying basket of assets. Passive is fairly straightforward, although the issue of what is your optimal long-run hedge ratio is still a difficult question. Maybe one solution to that is the ‘enhanced passive’ area, where a lot of managers ... even if they can decide on the long run strategic hedge ratio, to move that around from time to time, diversify risk, reduce that risk or even add value relative to the passive benchmark.”
Institutional investors that used passive hedges for currency exposures found in 2008 that their positions required large cash payments, particularly in October and November, which affected the underlying portfolio.
“Embarrassingly, we found that some investors had sort of forgotten that the Aussie dollar could go down and they would have to fund those losses at some stage. Added to that problem, some of the things we talked about this morning – the correlation between the Aussie and falling equity markets. This was almost a death spiral during the months of October and November.”
Difficulties were also exposed in the forwards markets, in terms of tenor and period mismatch and market spreads, Loong noted.
On the active management side, valuations such as looking at current account indebtedness and purchasing power parity “worked,” Loong said, particularly in regards to the Australian dollar and British pound in 2008. Some technical indicators were not useful in the second half of 2008, as simple moving average rules did not work in the second half of 2008.
Currency and portable alpha
Despite the criticism currency alpha strategies have received in recent months, poor execution and management are more responsible for poor returns than the idea of currency alpha itself, said Hathersage, director of client services and new product development, Lynnelle Jones. Furthermore, institutional investors must consider currency risk and returns within the context of total portfolio risk/return and the separation of alpha and beta.
“Portable alpha, the separation of alpha and beta, risks and returns, is a precursor to risk budgeting and risk allocation,” Jones said. “It’s gotten horrible press. I don’t know bad idea, or bad execution of a good idea. You decide. ... I’ve put together the following topics to make my point that alpha/beta separation and FX risk/return separation leads to total portfolio or enterprise risk budgeting, something essential to survival.”
Using currency to gain alpha returns is a specialised skill set and institutional investors must select managers with care, and that it is possible to evaluate managers on a like for like basis. Jones pointed to a 2008 article, Do Professional Currency Managers Beat the Benchmark? by Momtchil Pojarliev and Richard M. Levich.
“Momtchil and Richard’s paper was refreshing for two separate reasons for me. Number one, it dispelled the myth that currency managers’ returns can’t be evaluated,” Jones said. Managers can be compared, and in an unfunded mandate, if you compare the notional amount and the volatility you can compare the managers. Also, and we heard a bit about the four styles [carry, trend, value and volatility] today – this paper examines the four styles. Whether or not you consider them core betas in the FX markets, or exotic betas, the paper shows that beta risks, or style risks, are rewarded to anyone willing to take it, while alpha risk is only rewarded when you select the right manager.”
Institutional investors must consider risk and return at a total portfolio level and not just rely on quantitative models, which, Jones said, fall apart in times of uncertainty.
“No quant model can assess probability when making decisions under uncertainty,” she said. “Because we live in a world of uncertainty, nobody can actually create a probability for things we couldn’t imagine. I’m sick of hearing, oh, it’s a 10 sigma event. We have 10 sigma events now every year. In October of last year, we had six and seven sigma moves in currency and volatility. We live in an uncertain world, just take it as fact and realise that taking the risk of using the wrong probability can be fatal.
“Risk management is finally getting the attention it deserves in the board room and this is what I am calling enterprise risk management – risk management at the highest level.”
The superannuation system “is strong, stable, and continues to deliver,” but nevertheless requires changes to its operations, structure and cost akin to “renovating the house”, Nick Sherry, minister for superannuation and corporate law, told the audience in the afternoon’s keynote address.
Sherry said lowering average superannuation account fees is one such change, and said that fees should come down by at least 20%.
“Superannuation account fees have a direct bearing on final retirement income,” he said. “The current average of 1.25% can and should be lowered over time to 1% or less. I would like to see Australia move towards a superannuation system with a more sustainable remuneration model, in which fees are more competitive by world standards.”
Sherry pointed to the superannuation clearing house, which will begin 1 July 2009, as another “renovation” to the system. The clearing house, which is funded by the government for A$16m over three years, will help employers with the administration of directing superannuation contributions to the fund of their choice.
“The introduction of a superannuation clearing house facility will deliver on our election commitment and will be cost free for employers with fewer than 20 staff,” Sherry said. “That means around 90% of employing businesses across Australia stand to benefit.”
Sherry also noted that a review of Australia’s tax system – to be released at the end of March – will examine superannuation and retirement income. The tax review panel, chaired by Dr. Ken Henry, is examining five objectives for the retirement system – that it be “broad and adequate”; “acceptable to individuals”; “robust” in dealing with investment, inflation and longevity risk; “simple and approachable;” and “sustainable”. To answer those objectives, the review has asked 12 questions designed to find out if the retirement income system has “the right structural elements,” the definition of “adequacy” in retirement income in retirement, if the system “adequately consider[s] the needs and preferences of individuals both before and after retirement”, and if the aged pension – the state system of pension provision – should be means tested and what means testing would mean for the system’s sustainability.
“The Henry Tax Review will set a pathway for reform,” Sherry said. “The government is conscious that there has been a lot of change in superannuation over the last 20 years. I expect that any further changes will occur over a reasonable timeframe, and balance the need for further reform against the need for certainty.”
The Australian foreign exchange market
Despite sharp falls in the turnover on in other asset markets, turnover in Australian foreign exchange markets fell by relatively smaller amounts in 2008. It fell by 5% from April 2007 to April 2008, and fell a further 11% from April 2008 to October 2008, said Reserve Bank of Australia’s (RBA) head of international department, Chris Ryan.
Data collected by Ryan showed that not all currency trades fell equally in Australia during this time – the spot market “held up”, while swaps fell, he noted.
“Some of the arguments we were hearing at the Reserve Bank included repatriation of funds, for example, the unwinding of carry trades,” he said. “Portfolio rebalancing, which we’ve already heard a lot about, because of large asset price volatility meaning the rebalancing was becoming more pronounced than otherwise. And thirdly, some people have told us that to some extent, there was a shift to accessing USD away from the swap market towards the spot markets.”
The volatility, level of trades and bid-ask spreads on the Australian dollar versus other currencies spiked dramatically in October and November 2008 for a number of reasons, including investors selling Australian dollar denominated assets to offset other asset classes, and institutional investors reducing purchasing of Australian dollars as offshore investment value fell, Ryan said.
“Basically, this collapse in liquidity was compounding the volatility, increasing transaction costs and it was potentially raising the risk premium attached to Australian dollar assets,” he said. “We intervened at this time vis a vis, I’m not sure, half a dozen or 10 times in October, and a few times in November to a total amount of say, A$3.5bn, I think it was,” he said. “The important point I want to make about all this is that unlike some other occasions when we intervened, we did not intervene to try and achieve a particular level of exchange rate. It was very much the case that we were intervening to provide liquidity and just help market function.”
Data collected by the RBA during 2008 also shows that the value of the Australian dollar is highly correlated to global markets, and is highly sensitive to releases of information from institutions like central banks. Ryan presented a graph demonstrating that there was a high correlation between how the S&P500 moved in the last two hours of the US trading day and how the Australian dollar moved – which Ryan said demonstrated the unwinding of hedges, anticipation and the correlation between the Australian dollar and global cycles.
Defining risk profiles and appetites for pension funds
Currency risk exists in all pension fund portfolios and should be actively managed, and by managing currency risk, a fund can seek alpha elsewhere. However, currency alpha is not risk-free, returns are episodic and currency alpha returns have shown their downside of late, said Pareto Partners Australia CEO Margaret Waller.
“[Risk] really means that when the dollar is strong, you have negative currency returns diluting the underlying asset returns, and that is a big risk,” Waller said. “Just like when the dollar was weak, if you had high hedges on and you missed positive translations. We’ve had a couple of those this decade – we had one last year, we had one in 2001, when we’ve had 20% plus moves. So being in a fully hedged position can be a very big risk outcome for a fund.”
Waller also noted that during either a strong or a weak Australian dollar environment, having the wrong hedge in place could result in underperformance compared to peers, “and as we know in this industry, the peer group actually does set the benchmark a lot for the pension funds and super funds.”
As an example of how hedging currency can affect returns, Waller pointed out that for calendar year 2003, the hedged MSCI index had a 30% higher return than the unhedged MSCI index, while in the second half of 2008, the unhedged MSCI returned 20% higher than the hedged MSCI index.
Passive hedging cannot control all those risks, Waller said, and it is difficult to know where a fund’s peers are. Waller notes that actively managing risk can not only control for those risks, but it measures risk as “real” underperformance.
Seeking currency alpha is a different process to managing currency risk, and, in fact, introduces a new risk to the portfolio, Waller noted
“We think that if you have allocations of 30-50% you have to actually have a strong risk management policy, an active strategy on those exposures,” Waller said. “Alpha returns are episodic, so therefore you spend the risk on a diversified bucket of alpha strategies. Nothing is for free, and currency alpha certainly last year has shown its down side.”
Here are key takeaways from our 2019 Asset Allocation Outlook on how we are positioning asset allocation portfolios in light of our outlook for the global economy and markets.
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The Pearson Pension Plan has entered into a £500m pensioner buy-in with Legal & General (L&G) in the insurer's first deal of 2019.