Alpha Generation, Risk Management and Points in Between

With Jason A. Moore, Managing Director, State Street Global Markets

JASON A. MOOREJay, how long have you been working in the currency management business and why were you drawn to the industry?

I've been involved in foreign exchange in various roles for 12 years, including operations, trading, strategy, technology and as business head. As I suspect many have, I stumbled upon currency management by accident rather than design. In 2001, I was drawn to the opportunity to collaborate with some truly exceptional industry minds at State Street Global Markets (SSGM) that are pairing the resources, technology and market leadership of State Street, with the thought leadership and research discipline of Mark Kritzman at Windham Capital Management.

This unique group has developed some of the most sophisticated risk management and portfolio construction tools in the industry, as well as the most operationally robust currency management technology. This combination of research and technology has allowed State Street Global Markets to become a multi-dimensional currency manager servicing a broad range of clients and product types including passive and active currency strategies for both asset owners and investment managers.

The core focus of State Street Global Markets is the development of innovative portfolio construction and risk management techniques. How does your job function fit into that framework and what are your main day-to-day responsibilities within the firm?

State Street Global Markets supports a broad span of asset owners and investment managers ranging in size, risk profile, geographical location and levels of sophistication and invests considerable time understanding the needs of each of these clients when developing our products.

We believe that a balance between alpha generation and risk management is of critical importance. Depending on the type of mandate, clients may define risk management as minimizing overall portfolio volatility, maximizing alpha with the lowest amount of performance dispersion or minimizing the tracking error of a passive hedging policy against a particular benchmark. To meet these varied investment objectives, skilled individuals on our team design cutting-edge investment strategies and deliver those strategies through a well-designed investment process. My day-to-day responsibilities focus on managing the team to ensure the maintenance of this balance between alpha and risk.

Early entrants into currency management focused on mitigating risk. What factors do you think led to currency being seen as an asset class from which attractive returns could be generated?

By definition, a passive (strategic) currency hedging policy stands on risk management without any return expectation. But while clients may come to us with a request for passive management, many of our client meetings head towards a discussion of our views concerning the direction of the US dollar, the euro or other currencies. This suggests that investors are interested in both risk management and return enhancement. They seem to want the cash inflows that they derive from hedging depreciating currencies while avoiding the cash outflows from the alternative. When you have a forward hedge that results in a cash outflow (losses), there must be an offsetting gain. But many investors rarely acknowledge the offsetting gains of the underlying assets and measure their hedging decisions solely through cash flows. This implicit investor preference suggests there is a need for active currency management.

A passive currency hedge focuses on risk reduction. Given that passive hedging programmes, although frequently sophisticated, are fairly straightforward to implement, what issues do you think should influence how investors go about selecting a manager for these types of mandates?

There is a common misconception that passive overlay strategies are easily implemented, which often leads to investors making management decisions based primarily on fees. From an investor's perspective, the currency manager is responsible for implementation of the passive program and accountable for the operational risk associated with it. Every currency manager must be able to deliver this. But to be truly successful, currency managers must have more - and that's where transparency comes in as a differentiator.

No attribute is more important than transparency, and this means providing clients with insight into the importance of the various implementation decisions (contract tenor, rebalance frequency, trading filters, proxy currencies, etc.). A good manager should provide guidance on these decisions and also be able to measure their effectiveness through performance reporting tools.

What lessons about passive hedging of currency risk can both managers and investors - with or without alternative asset allocations - take away from the extraordinary global financial market crisis we have just been through?

The most obvious lesson from the global financial crisis was just how influential currencies can be on portfolio performance. Those adverse market conditions demonstrated the significance of currency hedging decisions for asset allocation and over the course of the crisis we saw a marked increase in interest for currency risk management.

Another less obvious implication of this volatility was the importance of some of the seemingly insignificant implementation decisions such as contract tenor. By nature, FX forward contracts (most commonly used to implement hedging strategies) defer gains and losses to a single settlement date in the future. All gains/losses incurred along the way are accrued in the form of "unrealized" P&L (effectively creating a cash receivable/payable). This cash component of the portfolio creates both credit risk and performance drag (or pull). With heightened concerns around credit risk (bilaterally) and the consequence of being levered (from deferred losses), this simple implementation decision was proven to have potentially severe implications, which must be managed thoughtfully.

Active currency overlay/hedging programs are designed to manage currency risk in order to add value to the overall portfolio. Apart from the enhanced returns that are made possible by the clever manipulation of hedging ratios, how would you summarise some of the other key benefits of these types of programmes?

Active overlay strategies are generally used to produce moderate return enhancement by actively tilting passive currency hedging policies in anticipation of currency fluctuations. So this structure provides only limited opportunity for alpha due to the constrained nature of the mandate. Although active overlay is not ideal from a return-generation perspective, there is often a progression from a standard passive hedge whereby both strategies retain the link between portfolio exposures and the hedging positions. For this reason, active overlay is generally less contested by investment committees and boards than an unconstrained currency alpha mandate.

Many investors now prefer to take advantage of combined currency alpha and passive hedging programmes, which are designed to separate return enhancement from risk reduction objectives. In what ways does this combined approach overcome some of the shortcomings of pure active overlay programmes and is it suitable for all types of investors?

By definition, traditional active overlay is limited to hedging (or not hedging) only those FX exposures within a given portfolio. One implication of this is that we see a high concentration of investment decisions centered around a few major currencies such as the USD, EUR, GBP and JPY with little importance on the decisions applied to smaller exposures (AUD, CAD, NZD for example). This constraint often excludes many emerging markets currencies altogether.

A second limitation of active overlay is the influence of the specified benchmark imposed on the manager. For example, a single manager may have two clients, one with a fully hedged benchmark and another with an un-hedged benchmark. Because active overlay mandates are typically constrained to hedge between 0 and 100 percent of the exposure (no over-hedging or net long positions) the same investment strategy will perform very differently for each of those investors, depending on market direction.

Pure or "portable" alpha strategies provide managers with full discretion of the positions within the portfolio provided the aggregate portfolio risk is within the mandated parameters. This approach permits clients to address the strategic investment decision of a passive hedge as a risk management tool and treat active views on currencies as part of a diversified alpha program.

The path to accepting currency as an attractive investment has clearly been tortuous and although increasing numbers of funds now view currency as an opportunity, there are still obstacles that need to be overcome before alpha programmes can be implemented for many investors. What steps can organizations like SSGM take to educate fund trustees and help improve the way the industry communicates about currency management?

Foreign exchange investment provides many of the most important attributes that investors seek when investing in any asset class. Imagine the investment opportunity if emerging market equities were to trade at just a few basis points with no commissions. Or imagine what would have happened to institutional portfolios during the global financial crisis had correlations across their portfolios not approached one overnight or if their positions could have been easily unwound with less traumatic impact on asset prices.

Because the foreign exchange market trades at daily volumes that are multiples of any other asset class, FX trades can be executed at a fraction of the cost of the others. Even on the most turbulent trading days, the foreign exchange markets trade with minimal disruption. This gives currency managers the ability to nimbly manage portfolio risk on a much more continuous basis. Furthermore, many currency strategies generated strong returns through the challenging markets that we've seen since 2008, and also provided diversification when it was needed most. These messages need to be highlighted to trustees and investment committees to remove some of the mystery surrounding currency management. Once foreign exchange is thought of as a viable asset class, the performance numbers for currency management will make currency a natural choice within alternative portfolio allocations.

"There is a common misconception that passive overlay strategies are easily implemented, which often leads to investors making management decisions based primarily on fees.”

"There is a common misconception that passive overlay strategies are easily implemented, which often leads to investors making management decisions based primarily on fees."

How would you describe the investment philosophy that SSGM applies to currency management and what do you see as the key attributes that makes your firm the manager of choice for so many investors?

State Street Global Markets applies a research-focused, quantitative investment approach using unique optimization and risk management tools that give us a competitive advantage in the marketplace. This philosophy has remained unchanged since we began actively managing currencies over 20 years ago.

Our strategy is designed to systematically exploit the forward rate bias (carry) and momentum return attributes of currencies, while applying a proprietary measure of market turbulence, State Street's Turbulence Indicator, to scale risk in accordance with prevailing market conditions. Through a robust mathematical framework, the Turbulence Indicator provides an innovative way to differentiate between normal and turbulent periods in the FX markets. And because turbulence is persistent, State Street can detect shifts in risk regimes, allowing us to scale the relative weights of our alpha factors to significantly improve risk-adjusted performance. Simply conditioning exposure to the carry trade on FX turbulence provides material downside risk protection and enhanced returns.

Does size matter in this industry and what advantages do major global investment powerhouses like SSGM have over small boutique managers who, it's fair to say, can now offer a very high standard of trade execution coupled with wide access to liquidity thanks to the arrival of e-trading platforms?

Beyond the ability to execute an FX transaction at a fair price, State Street Global Markets' scale allows for significant benefits such as trade netting and operational efficiency. Having a broad range of client and mandate types allows us to identify opportunities to cross trades between portfolios, providing a mutually beneficial savings in transaction costs.

Operational scale can only be achieved through the development of robust and flexible systems and is only practical for managers with critical mass. Many managers continue to run and monitor significant assets through Excel-based "systems" that create excessive operational risk, impeding fund performance and leading to higher fees. SSGM has developed a suite of desktop applications exclusively for the purposes of passive and active currency management products, providing for an efficient implementation environment. These operational benefits are then passed on to clients through fewer errors and more competitive management fees.

We believe the currency management industry is set for sustained growth in the next few years. However, the vast majority of assets are currently managed by a dozen or so top managers globally. Should we be concerned about the dangers of concentration risk associated with this?

The currency management industry has actually seen a marked increase in the number of participants over the past few years. Many of the world's largest investment managers have developed strategies to compete in a market previously dominated by specialist currency managers. As with any other asset class, the key to selecting a good manager is to identify those managers that have remained true to their investment philosophy, continue to invest in both research and implementation and have a proven track record to demonstrate these efforts.

Commentators frequently remind us that the one constant in financial markets is change and this is certainly on the way with regard to regulation. What impact could significantly increased regulatory oversight throughout the capital markets have on the way the currency management industry operates and is likely to evolve?

As you know, many currency managers implement their strategies using FX forward contracts -- over-the-counter instruments that often require only a simple agreement between client and counterparty (typically in the form of an ISDA Agreement). This bilateral credit exposure is a point of regular discussion, particularly since the financial crisis in which counterparty credit moved to the forefront of investor concerns. Moreover, this credit is often agreed-upon without cash collateral, allowing for more efficient cash-managed portfolios. However, it should be recalled that potential deferred losses from FX positions can create significant liquidity issues at settlement, when portfolio managers may be forced to sell underlying assets to the detriment of the portfolio. While regulators may impose incremental oversight on the industry to address these concerns, it's up to market participants to provide their clients with process transparency that allows more continuous management of these issues.

What issues do you expect will place most pressure on the performance of currency managers over the next few years and how will SSGM be looking to meet these challenges?

Over the past three years, heightened volatility has wreaked havoc on traditional currency alpha strategies. The carry trade tends to underperform in turbulent markets characterized by spikes in volatility and changing correlations and perform well during periods of quiescence. This challenges currency managers, many with heavy carry components to their portfolios, to deliver consistent performance through various market conditions and demonstrate that currency management isn't a one trick pony.

There are two attributes of the Turbulence Indicator that lend themselves particularly well to address the issue of volatility. First, there is an intuitive and statistical relationship between market turbulence and the performance of the carry trade, demonstrating a significant negative correlation. Moreover, turbulent markets tend to be highly persistent. This affords the opportunity scale carry trade allocations in accordance with shifts in market regimes. These shifts are not designed specifically to respond to what has already happened, but to position the portfolio with the expectation that those conditions will continue for some time. This regime-detecting risk model enables SSGM to deliver more consistent alpha with minimal draw-downs.

To survive at the top in the wider investment management industry requires, amongst other things, constant technology innovation coupled with the application of increasingly specialized skill sets. Do you believe the currency management industry can meet these demands and still remain a business focused on people and relationships?

In many respects, currency management is no different from management of any other investment. Currency managers must maintain a balance between understanding the needs and concerns of investors, and staying ahead of the competition through innovation. Technology is clearly important to both research and product implementation, particularly for passive products in which performance is measured as tracking error in fractions of a basis point. And, providing clients with highly transparent strategies, execution and reporting is no longer considered a luxury.

There are many technology options available for managing traditional asset classes. But there are few, if any, solutions available for managing the complex requirements of an active or passive hedging program. We've made a considerable investment in our technology that provides us with scale to ensure that we are able to grow the business without sacrificing high-touch client relationships. Those of us in the industry who continue to take this blended approach should be well positioned to continue building awareness of and investment in all that currency managers have to offer.

“..the key to selecting a good manager is to identify those managers that have remained true to their investment philosophy, continue to invest in both research and implementation and have a proven track record to demonstrate these efforts.”

"..the key to selecting a good manager is to identify those managers that have remained true to their investment philosophy, continue to invest in both research and implementation and have a proven track record to demonstrate these efforts."

Looking ahead, where do you expect some of the biggest opportunities will lie for SSGM to deliver sustainable alpha in currency mandates?

The State Street Global Markets research process is a never-ending search for new and innovative ideas. These ideas not only come from within, but from on-going discussions with clients, consultants and leading academics and practitioners in the market. Through this approach we've produced a significant amount of research, most of which validates our current model. But occasionally (in our case only one significant enhancement and a handful of minor adjustments in over 20 years) an opportunity arises to deliver an enhancement that both aligns with our investment philosophy and provides significant, sustainable performance improvements through all types of market conditions. The Turbulence Indicator was such an enhancement; justified by a sound theoretical foundation and supported by many years of research prior to its introduction in 2008. Because of the research rigor that we invested in this enhancement, the strategy has performed brilliantly through one of the most difficult markets in history.

This research-based approach to our investment process prevents us from irrationally reacting to market changes. Hindsight is 20/20 and currency managers can occasionally develop an investment model that outperforms in a given market condition. But the true test is whether that improvement offers sustainable benefit in other market conditions. Generally this is not the case, as each market crisis is unique in its own way. I firmly believe that it's this investment philosophy that equips State Street with the most favorable opportunity to outperform through all markets and what may lie ahead.