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  'Currency wars' and emerging inflation risks

Performance analytics - helping to bring transparency to the FX pricing process

Gerry O'Kane

What woke them all up was the news that the State of California had taken legal action against its custodian in late 2009, suing for $200 million for illegal overcharging of the state's two largest pension funds, CalPERS and CalSTRS. The custodian involved, with $15.9 trillion in assets under custody, the lawsuit alleged, consistently charged the highest daily rates for currency trading. To add insult to injury said the suit, the bank then tried to conceal data to prevent a full forensic audit.

For Neil Record it came as little surprise. The founder and chairman of Record Currency Management and former Bank of England economist said he warned CalPERs in 2003 that they were being overcharged on their currency deals after being asked to look at their forex trading.

He still warns that trustees and managers do not pay enough attention to trade execution and pricing performance. "It should be the first question - how good is the execution for my currency deals and is there a methodology for doing that?" advises Record.

Handling currencies

There are three ways currencies can be handled by investment managers on behalf of their clients. One is building and running their own currency trading desk, a rare route to be taken by investment houses primarily because of cost and experience, but also because it is regarded as moving away from core business. Another is to build preferred relationships with counter-party banks and manage it, with all the work that involves or pay to use an agent. Most common is to outsource FX trading to the custodian bank.

For all trading, however, knowing how to get best value can be achieved with currency performance attribution. So the issue of the custodial banks has served to highlight an industry-wide flaw.

TCA

Evidently the managers were not monitoring things closely enough. One of the best-known tools in measuring pricing performance is transaction cost analysis (TCA), something that has been around for at least 20 years in the equities space. Over that time and now almost ubiquitous, most buy-side institutions spent considerable time and resources to measure just how cost-effectively they executed on their stock trades. It is a concept almost entirely alien to the majority of investment managers who handle currency in the background, although interest is now piqued.

It is also the first step in making your currency pricing more transparent and identifying the cost of buying your currencies - not as easy a feat as it first seems.

"In 2004 when we looked at this area, the managers generally didn't have any grasp on TCA, but I think the industry was shocked when CalPERs revealed the charges and how much they were paying their custodian," says Michael DuCharme, head of foreign exchange business development at Russell Investments. "But it's a gradual change, and I think that managers are becoming more aware of the issue and that TCA isn't overly expensive. The fact is that you can't manage what you don't measure," he adds.

For Jimmy McGeehan, the CEO at FX Transparency, a company specialising in currency TCA, it's a mantra he keeps repeating to prospective clients. "TCA is the starting point for performance analytics on pricing," he says.

But can straightforward daily currency trading by custodians hurt a fund's bottom-line that much and how could it happen?

While all these horror stories are now common knowledge amongst investment managers and pension funds, consultant Russell Investments had warned the industry something was amiss back in 2004 with a report, "It's time for more choice in FX." It repeated the study again in 2008/2009 on the cost of transacting currencies. Both studies showed that prices clients received were skewed to inferior execution, resulting in unfavorable cost outcomes for the client.

"Overall both studies saw the average cost [the shortfall between the exchange rate and the midpoint daily price] was nine basis points, higher than the one to three basis points considered the industry average for developed market currencies," reveals DuCharme.

Now while it remains a challenge to equity managers to think in basis points, these currency price discrepancies can appear all over the portfolio. "Looking at figures over time we've found that even the act of dividend repatriation which might run at between 3-10% of currency volumes, will dictate 30-50% of your overall currency costs," highlights McGeehan.

Neil Record

"It should be the first question - how good is the execution for my currency deals and is there a methodology for doing that."

Fiduciary responsibility

One of the reasons McGeehan identifies for a lack of price performance analysis was naivety. "After the cases in the press, many asset owners learned the custodian didn't act as the fiduciary, which came as a surprise," he explains. "The global custodian offers multiple services, and acts as fiduciary in the vast majority, but when it comes to FX in many cases the contract is silent. After inquiry investors later discover custodians act as principal rather than fiduciary," he adds.

DuCharme agrees: "Of course custodial services usually come as a bundled package and it may be that the investment managers and clients don't realise that the currency element comes without the fiduciary responsibility found elsewhere in the contract."

In truth for custodians, long pressured to provide ever more services at lower costs over the past decade, the revenues from the currency trading side kept them profitable.

Many managers had thought best practice was inherent when using the custodian and those preaching TCA were preaching to those who had ultimate faith in their existing beliefs. But DuCharme also believes there was another reason for a lack of pricing transparency.

"On top of that the investment manager probably views the currency element of the trade as outside his area of expertise. As a result, the manager goes with a default contract and with the minimum amount of monitoring," says DuCharme.

Michael DuCharme

"Managers are becoming more aware of the issue and that TCA isn't overly expensive. The fact is that you can't manage what you don't measure."

Regulatory oversight

It was a problem accentuated by the fact that the sector had no regulation. The new Dodd-Frank financial reform bill left FX traders largely immune to regulatory federal oversight and punishment for cheating clients. The European Union's Markets in Financial Instruments Directive (MiFID) also contains best execution requirements, including time-stamping, but FX is simply not an asset under its provision.

Since foreign exchange traders earn money on their spread, the price at which they are prepared to sell a currency, rather than commission, there is a natural tendency to sell at the highest profit point if no one is paying attention to price. "The system places the traders' interest in direct opposition to the client's interest," the Russell Investments report said.

On top of that, investment managers more used to bond and equity markets, did not consider what was going to the currency elements of their deals.

"Managers' primary focus is on international asset selection, where the majority of return is determined, and the currency funding trades had less scrutiny, as the prevailing wisdom dictates the currency market is highly liquid and inexpensive to transact in. Our data challenges this notion for the trades delegated to the custodian under standing instructions," explains McGeehan.

It's another point of view with which DuCharme agrees: "If you said to a manager a couple of years ago that you could gain nine basis points, they'd just shrug and say they had bigger fish to fry. It wasn't worth the effort. Now it's different, and it makes sense to deal with the issue."

"That's why we're seeing the traders who now understand currency risk doing something about it - in difficult markets, where finding alpha is difficult, there is an even greater focus on retaining as much of that alpha as possible during the implementation process," offers Peter Eggleston, head of the Quantitative Solutions group at Morgan Stanley.

In addition, the default setting for handling the currency element was that it was considered an administrative task, and operationally it was easier to send it through to the custodian, especially to be certain the trade would not fail. One other reason for a lack of interest in TCA was that gathering data for the process was difficult. Unlike equities, there are no unified markets or trading venues in over-the-counter markets, so there is no unified execution tape. The disjointed nature of the FX market compounded managers' apathy. Liquidity and pricing is split across trading platforms and direct trades between counterparties.

Lack of time-stamping

Just to add further difficulty, unlike equity trading, many banks have no time-stamps on currency trades. Consequently many managers have asked whether that would make ensuring a reliable form of performance measurement too difficult.

"In order to perform an accurate transaction cost analysis you generally require key sets of data, including time-stamps. In many cases, we have found that institutions are not able to provide such time-stamps relating to the order flow and execution of currency trades. In addition, there is growing demand for standardisation of performance benchmarks," says Eggleston.

For many in the industry this lack of time-stamping, for example, is unbelievable. "We're stunned that it has been going on for so long," says DuCharme.

But the fact is, even with the obfuscation of these numbers, systems can still analyse the transaction costs. "You might not be able to provide the full analytical rigour as you would if time-stamps were available, but you can still provide indications of whether the execution is fair," warns Eggleston.

"Despite being an OTC market with little transparency, investors can get statistically significant execution cost results in the absence of time-stamps," explains McGeehan. "Based upon the clients' trading profile and data we then can choose the right benchmark that replicates their unique execution process," he adds.

The more recent result of these discoveries has been an increasing number of clients pressuring investment managers to show best practice and incorporate TCA into trading currencies whether dealing through an agency or a custodian.

Jimmy McGeehan

"Looking at figures over time we've found that even the act of dividend repatriation which might run at between 3-10% of currency volumes, will dictate 30-50% of your overall currency costs."

Currency performance attribution

The core of transaction cost analysis has developed other areas of price performance analytics, which remains specialised in gaining portfolio value.

Understanding the relationship between what securities a manager decides to invest in and the currency in which they are denominated can go deeper into performance analytics and the investment decision made. "We'd think about performance attribution in a global context as coming from two main sources. The first is the price appreciation of the asset in the local currency of denomination, the other comes from converting local asset values back to the base currency of the investor," outlines Jose Menchero, executive director, MSCI.

He points out that this approach basically follows the Singer-Karnosky framework. "We have made certain refinements to the Singer-Karnosky methodology, however, such as including a cross product term that explains the compounding effect between currencies and equities," explains Menchero.

Peter Eggleston

"…in difficult markets, where finding alpha is difficult, there is an even greater focus on retaining as much of that alpha as possible during the implementation process."

The combined currency and equity relationship is something that Neil Record believes is not considered properly in either understanding returns or pricing in the correct risk premia: "More fundamental at the moment is that few managers strip out in the correct way the currency effect from their underlying equities; they simply benchmark performance against something like the S&P," he says.

"Performance measurement is a long way behind the right way to value and net off your true currency risk," he warns.

The reality is that most managers only calculate the return on their equity portfolio against their benchmark index. They do not take account of the currency effect on the performance of their equities. "Since 2002, the MSCI EAFE index in U.S. dollars is up 48%, 43% of which has come from currency appreciation versus the dollar," according to Record.

But while these performance tools drill ever more deeply into the equity manager's backyard, the fact that managers are only now coming around to bog-standard TCA means these calculations will rarely be considered.

"The reality is that the cross product is probably the most difficult to understand from a performance attribution perspective. Fortunately, this term is typically quite small for most portfolios. It's probably not the kind of thing you want to spend a lot of time explaining to a pension board," acknowledges Menchero.

But other factors like slippage and liquidity are becoming ever more common elements in products like Morgan Stanley's FIX which provides algorithmic execution based on historical liquidity profiles.

"We've discovered that synchronicity of trading is important - e.g. if there is a significant lag between the execution of the underlying equity trades and resulting FX trades, this can result in unnecessary increases in tracking error ," describes Peter Eggleston.

Jose Menchero

"We'd think about performance attribution in a global context as coming from two main sources. The first is the price appreciation of the asset in the local currency of denomination, the other comes from converting local asset values back to the base currency of the investor."

Timing analysis

The timing issue of trading introduces risk. "Traditionally currency execution in London happens around 4 p.m. but the securities trade could have been done in the morning and can expose a portfolio to considerable price drift and slippage," explains Eggleston. "We analysed the effects of delayed execution in an international equity portfolio, taking into account all currencies in the MSCI World index, and found that the potential risk of delaying execution up to 36 hours could be as high as 500 basis points on an annualised basis."

Timing analysis goes further. "We've found that if you're in London and want to buy Mexican pesos then it is generally better to wait until New York opens. Similarly the liquidity of eastern European currencies falls off a cliff when London closes," Eggleston informs.

These issues of liquidity, having the currency availability when you want it, can be compounded by the impact of your deal on the market, the efficiency of the transaction and the increased or decreased risk premia.

But the new interest in performance metrics on both transaction costs or in innate fees, the spread, is beginning to gain some credence in the investment community. On the sell-side, the custodian banks are looking to win back some credibility; others use it as a way to demonstrate their market-making capabilities.

On the buy-side there's a growing realisation that managers have fallen down on their fiduciary responsibilities. They also need to improve investment margins, even by basis points, and even the threat of TCA tends to improve the forex price performance.

"My clients have generally seen a significant decrease in transaction costs after introducing TCA," reveals McGeehan.