The Currency Management Forum London 2008 took place on 4 June 2008 at the Hilton London Tower Bridge
"Currencies essentially aren't where they should be," stated Michael Metcalfe, senior managing director and head of macro strategy at State Street Global Markets, in the opening session. "Valuations and current account imbalances are stretched like never before."
Metcalfe explained the "surge" in cross-border investment seen over the past five years had meant currencies were unable to keep up.
Other factors contributing to skewed currency valuations were the increase in the number of people managing currency for profit and the growth in central bank reserves.
Metcalfe stated the credit crunch had briefly seen institutional investors repatriate capital from September 2007. Nonetheless, cross-border capital flows picked up again in January of this year when the US Federal Reserve stepped in to address the crisis.
Introduction to currency management
Gary Klopfenstein, senior managing director, Mesirow Financial Investment Management, outlined the history of currency management, which began in the mid-1980s and was initially risk-focused. An alpha focus emerged in the early 2000s, Klopfenstein said.
He pointed out that while globally US$800bn is managed by currency managers today, different geographical regions have their own distinct take on currency management.
Nowadays, Klopfenstein said the industry was moving away from constrained programmes and a risk focus, towards alpha-seeking programmes. However, he did make the point that while only a year ago people were saying risk management had had it's day, to say the same thing in the current climate would clearly be "nonsensical".
Currency management as part of a modern portfolio
Elizabeth Para, currency strategist, Overlay Asset Management, opened by stating dollar depreciation had cost sterling-based investors 5% in real returns over the past five years, while euro-based investors had suffered even greater losses.
She argued that in most cases at least a partial hedge was warranted and leaving currency exposure unhedged or unmanaged implied an active decision on currencies. Para argued an active overlay was a little "constrained" and that a pure alpha strategy combined with a passive hedge took all the constraints out of the picture.
Traditional overlay: should currency be hedged? In what way?
In the last part of her speech, Amy Middleton, vice president, Bank of America, focused on the choice of benchmark for the currency overlay manager, stating she felt "passionately" benchmark constraints weren't considered enough.
She emphasised the choice of benchmark would have wide implications on the performance of the overlay manager and that you could not do both absolute and relative returns.
Stating a benchmark of 0% or 100% placed constraints on a manager, she suggested a 50% hedge might be fairest. However, she also questioned whether unconstrained might not be the future for currency overlay.
Managing currency in a volatile environment
Michael Shilling, chief executive officer, Pareto Investment Management, opened with the question: a re volatility and risk the same?
His answer was "not necessarily", since he suggested volatility might in fact be a good thing. He pointed out volatility meant different things to different people and really depended on what timeframe you were talking about.
When it came to risk and choosing the appropriate benchmark for a hedging programme, Shilling said each pension fund was different and needed a different answer.
On the topic of styles of currency management, Shilling said since the different strategies were all so well known, the real skill of the currency manager lay in deciding how to allocate risk between them.
Performance and attribution for currency portfolios
Nick Rogers, senior technical specialist, performance & risk analytics, BNY Mellon Asset Management, used an impressive array of statistics as a basis to raise some pertinent questions about performance measurement.
The questions he posed included: Should we be looking at relative or absolute returns? What is the remit of pension funds? Is it okay if managers lose money?
Should we be looking at managers according to their style or instead according to how they correlate with each other? How do you measure outperformance?
He summarised by saying the three approaches currently used for performance measurement (excess returns; composite analysis of total returns; and universe analysis) all had their limitations, leaving the audience with a final question: Do we need to push the Investment Performance Council for guidance?
Return generation via currency: how to get smooth and sustainable returns with currencies
Daniel Szor, managing director, FX Concepts, said one key consideration was the tendency for currency markets to trend.
He pointed to the forward rate bias, where currencies with high interest rates appreciate against low interest currencies, and the tendency for buying options to be overpriced by hedgers willing to pay a premium to insure against risk as examples of this. He said investors could generate a natural return using each of these strategies.
He added one of the largest barriers to generating returns with currency was the tendency to stick to a basket of G10 nations, which led to 45 possible combinations of trades. Widening out the basket to 33, including emerging markets, allowed for 528 possible trades with a much greater scope for alpha generation, he said.
Panel debate: the long and short of currency alpha
The panel debate between key members of the currency management community revealed differences in investor attitudes to currency across the world.
In Europe, there had been a sharp decline in the number of currency managers appointed, while GTAA had grown in popularity. Some questioned the need to have both currency and GTAA strategies in a portfolio, but said currency remained popular elsewhere in the world and was actually growing in popularity, although some had concerns over the strength of the US dollar.
There was a general consensus that client expectations and a rising demand for currency alpha would force managers to raise their game and deliver higher quality returns.
Currency alpha: measuring alpha when it is portable
Chirag Patel, assistant vice president, State Street Associates, said the biggest problem with portable alpha strategies was that it was impossible to determine a rate of return because there was no return denominator to divide into the P&L.
The problem with this approach, he said, was that without a rate of return or an arbitrary figure, you couldn't measure alpha and the strategy fell apart.
With some simple maths, Patel demonstrated the folly of this approach and argued using Value at Risk (VaR) was preferable. The VaR approach allowed investors to limit the strategy based on the probability of incurring set losses in the portfolio throughout its lifespan.
By doing this, Patel argued, investors could dynamically react to increase or decrease positions throughout the life of the mandate.
How to select the best currency managers: different styles of currency management Diane Miller, principal at Mercer, outlined the firm's process for rating currency managers. Mercer's initial screening of currency managers includes performance, along with other information such as feedback from previous Mercer research and market intelligence. Miller said while past performance was no guide to the future, it did give useful information. On selection, Miller said the key was the identification of good currency managers. She said it was important to look for a sustainable edge, and different styles and low correlations could make manager combinations effective.
What is the right benchmark for currency managers?
Momtchil Pojarliev, head of currencies, Hermes Pensions Management, looked at benchmarks for currency managers, and defined alpha as only excess return that could not be explained. He used data to show that four styles of currency investing (carry, trend, value and volatility beta) explained a significant part of the returns of currency managers. According to Pojarliev's research, the average alpha has remained almost the same in the 1990s and post-2000, with a decline only in beta, despite claims that recent years had been more challenging. He also suggested there were other ways to construct a benchmark other than the conventional standard, in order to show alpha.
What is next in currency management? Multi-manager currency funds
Bill Muysken, fund manager at Thames River Capital, argued past performance was not a good predictor of future returns when it came to currency management, using data collected from currency managers to demonstrate his point. Muysken said while performance of currency managers generally in 2007 had been disappointing, it was particularly the case for managers who had been top quartile in the previous three years. Thames River analysis showed pension funds that only looked at top quartile managers were likely to have been impacted the most. Muysken said one reason for this was that carry had a bad year in 2007, so managers relying on such strategies had been impacted.
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