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A Convergence of factors: Currency Management has it come of age

By Ulf J. Lindahl

In May 2000, Frank Russell, a pension consultant, published a comprehensive study of currency overlay manager returns. It concluded that currency managers had hedged currencies effectively and that they had added value. Follow-up studies by other consultants produced similar results.

Simultaneously, a debate simmered as to whether currency was an asset class and if currency had a place in institutional portfolios. As evidence accumulated that currency managers could produce attractive returns, and offerings of currency funds grew, investors and consultants came to accept that currency is an attractive asset class.

The evolution of electronic trading, coupled with relentless growth in global currency trading volumes, which grew from $880 billion per day in 1992, to $3.2 trillion per day in 2007, according to triennial FX surveys by the Bank for International Settlements, helped pave the way for currency managers to implement sophisticated strategies.

Measuring performance

One of the first indices to measure currency managers is the Barclay Currency Traders Index. It is a composite of equally weighted currency programs with combined assets of about $22 billion starting in 1987. The index has had a compound annual return of 7.7% since January 1987. Its worst draw-down was 15.3% while its worst annual decline was 5.96%, in 1994. Those are modest losses when compared to annual and overall declines in equity markets in recent years.

Although adoption of currency as an investment has been slow compared to the growth of funds flowing into other alternatives, the currency assets in the Barclay Currency Traders Index have doubled approximately every two years in recent years. This highlights the growing acceptance of currency as an asset class and that the growth can be expected to continue.

The road to accepting currency as an attractive investment has not been without bumps. The impact currencies had on investments and the role they played in the financial crisis of 2008 still reverberates.

Pension funds, particularly in the UK, adopted strategies in recent years that involved passively hedging portions of the currency exposure of their international investments. Some also invested in highly leveraged currency funds based on "carry" strategies in which currencies with low interest rates, such as the Japanese yen, were sold and currencies with high interest rates, like sterling and the Australian dollar, were bought.

Lesson from the crisis in 2008

When markets panicked in 2008 and assets were liquidated, the flight to safety caused the yen and the dollar to surge while other currencies plunged. Sterling and euro-based investors suffered massive hedging losses, while "carry" strategies failed - some would say catastrophically. Those losses led investors to re-evaluate how their exposures should be managed and whether to invest in currencies.

The crisis brutally revealed that the idea that passive hedging removes currency risk from a portfolio is false since these hedges merely convert the exchange-rate risk to cash-flow risk. Paying large hedging losses when currencies rise can be painful and can have high opportunity costs. Thus, investors looking to invest in currency must recognize that those passive hedging losses were unrelated to trading currencies for profit and that exposures need to be managed actively.

The failure of "carry" highlighted that particular trading strategies cannot be successful at all times and that losses can be very painful when high leverage is applied. Investors interested in currency as an asset class will recognize that prudent use of leverage is an important factor in a successful currency program.

However, the most important lesson from the crisis is that investors with allocations to alternative assets experienced losses that were generally less severe than those suffered by investors with low alternative asset allocations. Although many investors assumed their hedge funds would not decline when equities dropped, a large percentage of hedge funds employ strategies that involved equities, their returns were more correlated than anticipated. The crisis proved that diversifying into alternatives reduced risk and improved returns. That fact will accelerate the search for asset classes that have low correlations. Currency is one of those asset classes.

Conclusion

Currency returns have historically had a low correlation with equities and have usually correlated negatively when equities decline since currency managers exploit short-term trends and are unaffected by cycles in equities. Currency is also a transparent and liquid investment - highly desirable attributes in a post 2008 world that is risk averse.

The convergence of the factors discussed demonstrates that currency management has come of age and that currency is an asset class with attractive return and risk attributes: highly liquid, transparent, and uncorrelated with traditional asset classes.

Ulf J. Lindahl is Chief Investment Officer and Chief Executive Officer of A. G. Bisset He joined the company in 1981 to assist in developing the firm's currency advisory service and developed the firm's currency models that are at the core of the firm's Currency Overlay and Currency Alpha Programs. In 1980 Mr. Lindahl received a BA in Economics from the Stockholm School of Economics.