Investable FX Indices: extending access to uncorrelated and sustainable Currency Returns

By Gerry O'Kane

The bull market of 2000 saw Europe take a greater interest as managers strived to match their benchmarks and squeeze whatever extra basis point return they could. More recently there has been an industry drum "banging out" the message that well-designed Indices could produce reliable returns, especially in the world of currencies. The inelegantly described, 'Investable FX Indices', were based on the concept that currency markets delivered consistent excess returns over time, especially if investment strategies were continuously tweaked. The argument goes that in spite of being the most liquid of markets, FX retains very significant inefficiencies which can be exploited by investors.

Currency Indices offer a portfolio approach to investing which tracks the performance of a specific currency against a pre-defined group of other currencies. Whereas a traditional currency pair is based simply on the relationship between one currency and another, Currency Indices are based on several of these relationships. They have been designed to enable investors to achieve currency exposure without either buying into a currency fund or trading directly in one or more currency pairs. Many Indices are based on currencies from a specific geographic area, so they can provide an useful way to take a view on the economic performance of a particular region and of course factors that might influence the performance of a normal currency pair may be less likely to have such a large effect on the diversified trade afforded by a Currency Index.

Index Revolution

"There's no doubt there's been a revolution in the world of Indices over the last 10 years," agrees Philip Brass, a director and a member of the Value Added Products management team also responsible for creating and marketing Investable FX products for Citi. "These products were exciting and they introduced currency as a way to make money based on simple strategies like carry which produced some return. In the second-generation of currency Index development the sector tried to understand better ways to do the carry strategy and contextualise it against the potential risk factors".

However straight-forward the world of currency Indices may appear to be, their development underlies a longer struggle to get investors to appreciate both the fundamental investment possibilities of currencies and the complexity of some of the alpha Index models.

"You must remember that currency trading in the institutional investor space has only really taken off since the end of the fixed exchange rate agreement of Bretton Woods in 1973, and even then it was dominated by corporates and asset managers seeking to hedge risk," points out Tom Lee, lead consultant on FX strategy at Capco, a consultancy and technology firm specialising in financial services. For years afterwards, investors were still restricted to a handful of funds and managed programmes. Overlay managers dominated as both institutional investors and corporates continued to identify FX as a source of risk on foreign securities and something to be hedged. Managers were limited to trading individual currency pairs primarily with forward contracts.

"Since then we've had numerous ups, downs, recessions and recoveries in the major currency pairs, and growing numbers of hedge funds and banks' FX desks have had many years to assess whether or not FX as an asset class in its own right presents a genuine source of consistent return," adds Lee

Philip Brass

"In the second-generation of currency Index development the sector tried to understand better ways to do the carry strategy and contextualise it against the potential risk factors".

Performance and development

It has always proved difficult to measure the performance of currency strategies and this was particularly so in the past when Indices were few and far between. "There are issues of data availability-one oddity about the currency market is that there is relatively little independent third-party data that one can have access to that goes back much beyond 1998," confides James Wood-Collins, a director and head of the client team at Record Currency Management.

Even measuring beta has not been easy and arguably something that is necessary to measure any alpha Index. Today some commentators continue to argue that the market remains mostly interested in the growing development of Indices that reflect beta plays and cost-effective hedging and that these are the true 'Investable Indices' in so far as they meet the greatest demands of investors.

"I'd break down the current development of currency Indices into a a few key areas, some being more popular than the others as far as we can see," argues Srikant Dash, S&P's Managing Director for research and design. "The most popular are the beta Indices reflecting the movement of one currency against another often appearing in the form of ETFs. Demand for something like the S&P Chinese Renminbi Index designed as a tradable Index that replicates the performance of the Renminbi versus the US dollar obviously has an attraction in the global economy."

He points to currency hedging Indices as currently the fastest growing sector. "For example an Index that uses a currency overlay against an Index like the S&P 500 means that managers can get rid of the currency risk on the dollar if their view is that the Index will rise," observes Dash.

James Wood-Collins

"..one oddity about the currency market is that there is relatively little independent third- party data that one can have access to that goes back much beyond 1998."

Institutional demand

"We could see some time ago that there was an institutional requirement for currency Index products as investors knew it was an important uncorrelated asset, but they did not necessarily have the time or knowledge to run a currency mandate," says Ritika Dharmija, head product manager in FX structures at Barclays Capital. "Just capturing the directional view on FX beta is useful since currencies are always a relative play," she adds.

But what financial institutions also recognised was they had been gathering data over a sufficient time-scale to produce Indices around which products could be wrapped to produce sustainable returns.

Deutsche Bank considers Bilal Hafeez's article, "Currencies: Pension Saviour?", which was published in August 2006, as pioneering the idea to investors that real returns could be made with currencies. Although the market could achieve returns by the three widely practised strategies of carry, momentum and valuation, much of the over-performance was boosted by the track records of the better currency managers. But how could you prove that in the most liquid of global markets, fundamental inefficiencies existed that created profit opportunities and sustainable ones at that?

Currency market segmentation (conservative assumptions)

Source: Deutsche Bank

"Currency markets are highly liquid, and that often confuses investors, who think they must be highly efficient. But they aren't and to understand that involves knowing who are the participants in the FX market," explains Torquil Wheatley, head of currency solutions for pensions and insurance at Deutsche Bank.

He argues that one of the worst misconceptions put around in the market was that speculators dominated it. "That just doesn't hold water and we can only find evidence for between 10 and 30% of flows coming from currency speculators. Seventy to 90% of international investors are seeking to hedge portfolios or are central banks and corporates. There is something fairly interesting about those three types of investors - they're not looking to make money on their currency trades but using the markets as a utility function. If you have 70 to 90% of the market that effectively don't care about losing money professional investors should be able to extract money"

Srikant Dash

"..an Index that uses a currency overlay against an Index like the S&P 500 means that managers can get rid of the currency risk on the dollar if their view is that the Index will rise,"

Impact of financial crisis

But not all has gone well in persuading investors that currency plays will always bring profit. Between 2000 and 2007 there was low volatility among foreign currency rates and carry trade strategies dominated, borrowing in low interest currencies and going long in high interest currencies. But by 2008/2009 there was a demented shake-out in the carry strategy with too many interested parties following the same plays and over-valuing currencies.

According to Andrew Kaufmann, head of FX structuring at Barclays Capital, this shake-out had its benefits. While FX markets were hit partly due to preoccupations in other areas of the financial markets and credit harder to get, some FX strategies were more successful. "There has been much more interest in currency strategies than even five years ago. There was already a focus on it from consultants and distributors pre-crisis and despite the carry-trade problems, FX held up during the crisis and its liquidity stayed strong and as a result we are now we're seeing many more conversations from investors looking for strategies," he reveals.

While the credit disaster of the late 2000s was not the catalyst for creating FX Indices, those who had already spent time working on more complex products to capture alpha, found their work of interest again.

Constructing Indexes

"There are quite a few Indices being manufactured and they are primarily being produced by the investment banks, exhibiting more complexity in pair selections and baskets, weighting optimisation and taking other signals into account," explains James Wood-Collins.

Ritika Dharmija

"We could see some time ago that there was an institutional requirement for currency Index products as investors knew it was an important uncorrelated asset.."

"These Indices are better seen as being representative of investment processes intended to add value over the simple risk premia, instead of being a measure of the risk premium itself," clarifies Wood-Collins.

Record's preferred Index (the FTSE Currency FRB5) recently produced by the FTSE Group is based on the currency forward rate bias (FRB), the tendency of higher interest rate currencies to outperform lower interest rate currencies (carry trade). It reflects the issues of creating an Index, identifying how it should be described (beta or alpha) and how receptive markets are to FX Indices. The Index is rebalanced each month by buying the higher interest rate currency against the lower across five currencies and ten currency pairs.

Some might justifiably argue the construction of even this Index is more representative of an investment process but Wood-Collins reasons. "Leading investment consultants recognise FX is growing and they need the right independent tools to enable them to distinguish between alpha and beta. When this is based on carry strategies, they can now measure whether managers are producing beta returns while claiming to provide an alpha product. For the industry it's vital since consultants are typically the pioneers in thinking about new asset classes and risk premia and relaying that to the investment world."

The process that created the Deutsche Bank Currency Returns Index (dbCR) is fairly indicative of the industry, like Barclays' Intelligent Carry Index or the CitiFX Alpha Strategy - they all make use of historical signals that are always repeated (in theory) to rebalance an Index. Generally, benchmarks are regarded as a passive Index tracking performance but their rules of construction are far more active than appear from first impressions. There are a series of rules that govern the make up of the S&P 500, for example and a cap-weighting rule sees managers sell and buy shares to reflect the Index as their relative capitalisation changes based on share price. You also have some being excluded or included to the Index.

"We considered this to be more of a strategy than a rule and, in fact, it's momentum trading," explains Wheatley. The argument went that if momentum trading on the S&P 500 extracted value from the equity markets, then it could be used in FX, where it already existed. "And obviously in terms of strategies, the currency world is spoilt for choice - momentum, carry and value and these also have produced a vast amount of data research over the last 35 years," adds Wheatley.

But an Index has to be objective and choosing one strategy that has had the best returns over 35 years is subjective and Deutsche put the three strategies into the pot and along with its rebalancing rules the dbCR has so far produced annualised GBP total returns of 8.4%.

Themes

There may be over 50 Indices but there appears to be only six or seven themes used in differing ways to create an Investable FX Index.

Torquil Wheatley

"If you have 70 to 90% of the market that effectively don't care about losing money professional investors should be able to extract money."

"On looking into the alpha space we identified a few key investment styles - the carry yield differential, technical analysis, valuation and volatility as long-term fundamentals, for example," says Dharmija. "Volatility is particularly useful in picking up inefficiencies, usually on a basket of currencies." And when the signals that underlie the Index say 'all change', like market capitalisation of a company in the S&P 500, the Index is rebalanced, although how often depends on the Index.

The combinations of currencies and the use of signals to rebalance an Index vary from product-to-product and house-to-house. But then you have to get the investors to buy the products that are wrapped around the Index.

"Obviously the Index is based on official currency prices, back-tested on historical data and performance-tested live and that needs to be done for some time and this process, along with good research, gives confidence," outlines Dharmija.

Tread with care

But there are warnings about the proliferation of both the Indices and even the products that offer to replicate their performance. "Investors have to consider questions which include: - are you quite comfortable with systematic strategies, - are you comfortable with currency risk, - are you seeking to hedge, - do you want to actively manage FX Index products and - what is the under-lying quality of research on a product," lists Jessica James, Managing Director and global head of Quantitative Investor Solutions at Citi.

Andrew Kaufman

"FX held up during the crisis and its liquidity stayed strong and as a result we are now we're seeing many more conversations from investors looking for strategies,"

There are also other concerns about these products. "Investors have to separate out an Index that becomes a marketing tool for an institution and its business and those that are fundamental," warns Srikant Dash. It's worth bearing in mind that in spite of back-tested data that supports the actual track record returns the prospectus will always include that haunting phrase, 'Past performance is not indicative of future performance'.

And while back-testing with long-dated streams of figures does help market the new Indices, even those at the heart of creating Index products have their reservations in using them to 'guarantee' any performance. "The reality is that I've yet to see a back-tested product that didn't work," observes Dash wryly. "Often these models have a tendency to blow apart at the most inconvenient times. It's implicit in the model that the market behaves in the same way in the future as in the past."

Jessica James

"It's not uncommon to have a client that likes a specific Index but might ask for an investment product that creates a more customised version of it, for example reducing a particular element of risk,"

It's a viewpoint that James Wood-Collins does not disagree with: "The other issues concerning any backward looking data is to understand whether the prices that are quoted would have actually been achieved?" He speculates that if strategies in the more complex Investable Indices had been popular could that intervention, even in a market the size of FX, have had an affect itself on the recorded data. The concept might be considered the Schrödinger's cat of currency trading. Others, like Tom Lee always warn investors to be aware of pricing issues and transaction costs when a product supporting an index uses both forwards and options.

Tailoring products to investment objectives

Kaufmann accepts that there is some scepticism in the market but argues that as there are good products out there managers need to be rigorous in understanding their own investment needs as well as the products. "You must understand the volatility, the risk and the liquidity of both the Index and the way it is wrapped. You must identify the relevance of currencies in your portfolios and overall strategy," he advises. "One other thing is to look at an Index's launch date and see how it has performed in live markets," he adds.

As for products supporting the Index: take your pick. All the major banks which offer these solutions are happy to wrap the Index in whatever OTC, or exchange traded product you prefer.

"It's not uncommon to have a client that likes a specific Index but might ask for an investment product that creates a more customised version of it, for example reducing a particular element of risk," explains James.

Tom Lee

"There's absolutely no doubt that demand exists in both retail and institutional sectors for many of the beta products, you just have to look at the number of ETFs that are emerging,"

There is little doubt throughout the industry that demand remains strong. "There's absolutely no doubt that demand exists in both retail and institutional sectors for many of the beta products, you just have to look at the number of ETFs that are emerging," offers Lee. "But for the most advanced of Investable Indices, it is still only really attractive to the sophisticated investor and institution."

"The market has different needs and desires which change at different speeds and circumstances," concludes James, "But FX as an asset class is becoming more mainstream, and while before, it would have been only slotted into the alternative part of a portfolio, you're now seeing it being considered alongside bonds and equities."

It's now possible to wrap the performance of currency managers into Investable Indices and given that some Indices may represent the "beta" of currency markets, while others the "alpha we may finally have a mechanism for obtaining a returns "benchmark" in currencies similar to those in other markets.