FOCUSING ON RISK MANAGEMENT & INVESTMENT OPPORTUNITIES IN FX
How does an investor choose a currency manager? At the last count, we had over 150 managers with over 200 currency products listed on our database. That's quite a lot to look through. We need to narrow it down.
How do you identify a manager that's going to add value for investors? How much do you need to take account of performance, the manager's approach, risk controls and organisational structure? I'll look at each of these in turn.
One way could be to just go for the top performers. After all, a manager who's done well recently can't be that bad, can he?
The trouble is that currency manager performance can be volatile and just because a manager did well last year, doesn't mean that it will do well this year. Investors could end up chasing last year's performance which sounds like a recipe for disaster. A shorter term period to evaluate managers would mean more changes and be even worse.
That's what the risk warnings always say. We think that past performance can give useful information so it would be silly to discard it completely.
However, we have to remember that even a good manager with above average skill can experience a period of disappointing results. Equally, a bad manager can produce good results if he gets lucky. Maybe there is a point to those risk warnings after all.
Some investors like to appoint a manager who has just had several poor years in the expectation that things are likely to get better.
Currency managers report performance in lots of different ways - as overlay returns for investors with a range of specific constraints; as absolute return funds with different base currencies and different risk levels; and before or after deduction of fees.
You have to use a level playing field to evaluate performance and compare managers. We prefer to look at performance for unconstrained portfolios before deduction of fees and we use excess returns to remove the impact of different base currencies. This allows us to look at the pure added value from active currency management. We can review the pattern of returns and look for any features that stand out. There's one more step that we need to take when comparing managers and that is to risk adjust the returns to give the information ratio or Sharpe ratio. Currency managers can easily scale risk up or down, so if we adjust for risk we can compare returns for an overlay account with 2% risk against a fund running 15% risk.
There are almost as many different approaches as there are currency managers. I exaggerate, but you get the picture.
Take carry for example. This is where managers structure their process to favour higher interest rate currencies at the expense of lower interest rate currencies. It has been a profitable strategy for long periods of time even though the theory says that the currency movement should cancel out the interest rate differential. Some managers apply carry to developed market currencies only, or even to a small subset of these and others include emerging markets and possibly even so-called frontier markets. Carry might be used on its own, combined with a trend-based measure or have an allocation as part of a broader strategy that takes in valuation and macroeconomic factors. Carry may have a fixed allocation or one that varies according to signals from other parameters, such as risk measures, or may even be subject to a discretionary overlay.
Carry can lose money too. It has been likened to picking up the pennies in front of a steamroller as it tends to generate a series of modest returns but can be subject to large losses from time to time. These can be big enough to be very painful.
So any evaluation of a manager who uses carry as a way to add value has to understand how the manager structures the process to benefit while minimising the losses when the carry trade reverses.
There is no simple answer. Each manager will have its own strengths and weaknesses. Spending time with the key individuals to understand the process will help indentify whether it offers more than average. We look for evidence of insights that offer something more than the rest of the field.
If the process is judgemental, then there is a need to know what the sources of information are and how ideas originate. Is there a single decision maker or a team that works together? Is the manager very fundamental in approach and driven by economic data or do trades really reflect a view of markets and price behaviour (technical analysis)? How does the manager see beyond the noise?
If the process is quantitative, how were the models developed? Are they grounded in fundamental reasoning or does the approach rely on analysing price trends? What is the background of the individuals involved? Do they convey a good understanding of investment markets? What are plans for further development and what is the process for bringing new ideas into the process?
It is not enough to have a manager with process that generates good performance when everything goes well. Finding a manager with a sustainable edge is also about controlling the losses. And that means spending time understanding risk management.
How are positions sized? Are stop losses used? Are they used at the position level or only at the overall portfolio level? If it's a quantitative process, does the manager ever intervene to override the process? Is there a procedure in place for this? If it is a judgemental process, who takes the decisions when the manager is out the office?
Seeing how a manager performs at times of stress can often provide good insights into the quality of risk management.
Currency dealing costs are very low but managers trade frequently and use leverage so costs can mount up. Even if the manager has an edge at the level of idea generation, attention has to be paid to dealing efficiently to hang on to those gains. That means not overtrading and controlling exposure to less liquid currencies that may involve greater dealing costs - or at least being aware of the potential costs in deciding what trades to carry out.
Costs can become more of an issue as assets grow, so a successful manager that allows the business to grow too far may struggle to maintain its success. We like to see that managers have a clear idea of how much they can manage given the process they use.
Don't forget to pay attention to the way the business is managed. Well managed organisations are better able to attract and retain good people. Well managed businesses also allow the individuals responsible for the currency strategy to focus on the job in hand and producing good performance.
Look too at operational matters to ensure that there are the right checks and balances in place. Investors don't want to find the manager they once thought had an edge is now sunning himself on a far away island at their expense.
At the end of the day, there is no single right answer. It is what works for the people and process involved. Performance can help evaluate the success or otherwise of the manager's approach but there is much more to identifying currency managers with sustainable edge. And what worked yesterday might not be right for today's markets so investors need to be prepared to re-evaluate managers over time.