FOCUSING ON RISK MANAGEMENT & INVESTMENT OPPORTUNITIES IN FX

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From strategies to style buckets: searching for weakness in the investment process

By Gerry O'Kane

Mike Harris, Campbell & Company

"Investment objectives are an important determinant of how an investor participates in currency trading ..."

Since the changes brought about by the Credit Crunch, with respect to both the structure of portfolios (especially in the US) and expected returns, institutions are having to pay greater attention to currencies. "There may be remaining doubts about currencies as an asset class in some quarters," says Ulf J. Lindahl, Chief Investment Officer at A. G. Bisset & Co., "but their relative performance has done well. Pensions typically have about 40 per cent of their portfolios in overseas assets and about half of that US dollar-denominated. Even a two per cent swing in the value of the dollar with equity return expectations standing at up to eight per cent means that you can lose 25 per cent of your expected portfolio returns."

"Investment objectives are an important determinant of how an investor participates in currency trading - it can be an attractive, independent source of investment alpha, which often has a low correlation with other investment returns, or it can be used to manage the currency exposure that results from investing globally in other asset classes," says Mike Harris, Director of Trading at Campbell & Company.

Identifying the aims

It is also important for clients to identify what their aims ought to be. "They should split their desires," advises Lindahl, "They need to look at their currency risk because a declining currency over three years can have a considerable impact on a portfolio. Your objective ought to be to hedge against currency declines and remove the risk with a repeated shorter term investment cycle." "However," he warns, "You have to be aware that this sort of cyclical currency overlay is unlikely to provide added value when the currencies go up."

But as with ever-lasting debate of what exactly constitutes beta and alpha, the description and labelling of strategies can vary between managers although more often on the minutiae rather than the generalities.

You have investors seeking to pursue an active approach in either hedging the currency risk in their property, commodity, fixed income or equity holdings. They might have the same objectives using a passive approach.

Then you have those seeking alpha, doing better than simply reflecting market movements, whether seeking absolute returns or not. Primarily the approach requires active management.

Matthew Roberts

"You've got managers focused on the carry trade, managers interested in value type signals and those interested in the momentum signals and finally those interested in volatility trading,"

Strategy formats

According to Matt Roberts, senior investment consultant specialising in currencies with Towers Watson, whatever the format of overlay or hedge fund the strategies generally fall into four formats, and the one that encompasses all of them.

"You've got managers focused on the carry trade, managers interested in value type signals and those interested in the momentum signals and finally those interested in volatility trading," lists Roberts. Then there are those using quantitative, discretionary, fundamental, technical discretionary and so the combination of lists continues.

"Typically managers promote themselves with a list of characteristics, like systematic or discretionary, however often these characteristics do not help a lot at all. And more commonly it'll be a more specific strategy declaration like carry, fundamental, break-out or momentum, mean-reverting and volatility," says Thomas Suter, CEO of Swiss-based Quaesta Capital. "Some definitions help us a bit more, but they still aren't giving highly transparent information for the investor such that he would know in which environment he would earn or lose money, for example," he adds.

Indeed, identifying the weaknesses of these strategies or styles goes beyond their individual characteristics but also encompasses how risk factors should be considered and how contemporary currency products might make certain styles redundant.

Roberts, for example, points out that many UK institutional clients had opted only for the passive currency hedging route, typically as a risk management method. According to him: "We haven't felt positively inclined towards and number of strategies that are available within the active currency arena [in hedging]. One of the reasons are the high fees charged by many of these managers."

He argues hedge fund type fees of two per cent of asset value and 20 per cent on out-performance are high when many of the styles offer little more that a crude combination of the basic carry, value, volatility or momentum styles. As he and other managers point out this comes back to the argument of alpha and beta and definitions.

The argument goes that if you are replicating a pure carry strategy - long high-yielding currencies through funding by the low-yielding currencies, should this not be defined as beta? And if it is, why are you paying a premium for it?

Of course even that discussion is not straight-forward as Dori Levanoni, a partner at First Quadrant and the global macro strategies manager explains: "Let's look at carry trade, it's a well-defined theory, but if you take 10 managers saying they do carry, the correlation of their performance would be less than 100 per cent and in some cases less than 25 per cent and that's the problem with beta; a divergence of opinion leads to a divergence in performance."

On top of that, according to others, some of the more basic styles might easily be replicated through cheaper products such as exchange traded notes.

Thomas Suter

"Typically managers promote themselves with a list of characteristics, like systematic or discretionary, however often these those characteristics do not help a lot at all."

Mix and match

The reality is that very few institutions or boutique investment houses would boast that they based their process on a single strategy, most talk of a mix-and-match activity, what's best for the market environment. And there's little doubt that the set of style buckets, using these multiple strategies is what's expected. "Like most other markets, currencies are impacted by both broad macro-economic factors and by narrower market-specific factors," says Mike Harris. "Consequently no single investment style can be successful in all market conditions. For this reason it is important to invest either with a manager that trades multiple styles, or with several different managers who employ different investment styles."

From Lindahl's point of view, while managers might move between styles, trend following or the momentum strategy is probably one of the most common investment styles, certainly among currency trading advisers. While it might be called trend investment there are elements of fundamental research. "It's important that when the managers see a change in the economic winds, you can suitably trim your sails. The trends will continue to unfold but might be based of different fundamental conditions: in the 80s, for example, issues of money supply and inflation were key factors," outlines Lindahl.

Adam Olive

"what tends to happen is that people down-weight certain strategies when they've done poorly, like the carry, rather than before they have done poorly and without a lot of foresight,"

But whatever the managers call their styles or how they mix-and-match them, clients must understand the underlying weaknesses of each methodology that goes into the manager's 'bucket'. "Managers are often guilty of using these phrases but are poor at explaining them and are imprecise in how the process works," says Levanoni.

While the carry trade became the doyen of the currency sales pitch in the mid-2000s, its fall from grace caused a stutter in the use of currencies either as an asset class or in risk mitigation. "The carry strategy did very well until summer 2007, but afterwards for about two years the exact same strategy just lost money. Does this now mean that the strategy is bad and not working? No, it doesn't really, it just means that it's the wrong strategy for a certain environment," argues Suter.

"Unfortunately, like most of these things, what tends to happen is that people down-weight certain strategies when they've done poorly, like the carry, rather than before they have done poorly and without a lot of foresight," observes Adam Olive, a co-manager of HSBC's GIF Global Currency Fund. "One of the carry trades biggest risk is you can have very sudden and abrupt draw-downs."

"If a manager is just making the decision to go long that high yielding currency and short the funding currency based on the yield differentials, then if everybody is doing that, the higher the long currency goes and it gets very expensive based on fair value. When the correction comes you are obviously positioned the wrong way when everybody tries to unwind the trade," he warns.

Then the market realise the fundamental value of the currency, perhaps based on purchasing power parity (PPP), has skewed the currency away from fair value.

And when it has downturns, it has serious downturns. The RBS FXY index (carry) shows that in the first three months of 1980 the strategy returned 4.56%, 8.04% and 16.38% but in April you would have lost a whopping 20.75%. Similarly in 2008 August, September, October and November, the carry strategy would have lost you 10.62%, 10.26%, 15.88% and 3.99% respectively.

But it's not just holding a carry trade at the wrong time and incurring losses. It has other implications to a portfolio.

Ulf J. Lindahl

"There may be remaining doubts about currencies as an asset class in some quarters, but their relative performance has done well."

"In reality the carry trade acts like you're buying risky assets and selling safe assets increasing your exposure to risk, so when risk rises it can hit your portfolio. So many of these currency strategies act similarly to other asset classes which are much simpler or cheaper to buy," observes Levanoni. He also argues that if you do examine the returns of carry indices to the MSCI World Index or FTSE there is a fairly strong correlation between the two numbers. "It varies over time but it is not zero," he says.

It's a viewpoint with which Matt Roberts at Towers Watson agrees. "If you take an historical analysis and look back at the carry trade, it has left tail properties and the distribution of returns of the carry trade has a skewed profile. So you get large negative events, but you don't get to very large positive events... When equities have a very bad time, so can the carry trade, although not always. That would be one reason why it could not be a seen as a diversified return source."

Often the position is leveraged and in 2007 institutions had to find the cash to pay off their positions, often having to sell equities which had also plummeted. It acted as a 'double-whammy', since institutions would also lose whatever upside the equities might have made in the coming market recovery. "So what you have, especially with the passive hedge done in this way is not the just the immediate costs but losses on future gains translating into cash-flow risk," summarises Lindahl.

Momentum trading has similar disadvantages."If you have just been buying Aussie dollar because it is going up, it shows no awareness of where fair value is and as it becomes expensive relative to fair value and when there's a correction it will take a while before the momentum signal changes sign and you get out of the trade," warns Olive. Abrupt changes in the perceived risk premia can have a similar effect.

Impact of Greek crisis

The Greek crisis had implications on both the momentum and carry trading, and, to an extent volatility. As the perception of risk on the Euro increased as more and more bad news flooded out of Athens and you were playing it against the Swiss franc, for example, you got large exchange rate moves.

"And that's what happened in those currencies, triggered by the Greek problem. It was the perception of risk in the Euro currency - it isn't so much there would be chaos in the Euro region if Greece did default, since it only represents about two and a half per cent of the Euro's GDP, it's the perception," explains Olive.

On top of this is another weakness the client has to resolve. "With something like momentum you can highlight that your analysis is purely price-based with an intuition to move in and out of trends, but that can mean that the investor does not truly understand why a product has made or lost money," says Roberts.

Volatility trading has taken on a higher profile in recent months, benefiting from a perceived unstable global economy, with uncertain corporate earnings, GDP growth and high jobless rates. According to Suter, good volatility strategies can have many benefits. "Long/short volatility strategies may be capable of performing in every market environment, however, their weakness is the missing transparency and knowing whether the underlying strategy should have performed well or badly in the last few weeks, there's a difficulty in predicting performance figures of those programs," Thomas Suter points out. "Some investors may look at it and just say, I just want to have this investment over the long run that provides me with good uncorrelated positive returns."

But there is another issue with volatility strategies. Because of their nature they must use derivative products traded over-the-counter (OTC), like options rather than forwards or futures.

Dori Levanoni

"You have to ask, will the style avoid the elevator down?"

Increased risk

These OTC products create increased operational and settlement risk. "Something like an option can have very large changes in price because of the leverage and people shouldn't trade instruments if they are not capable of measuring the risk in them and managing it. So obviously somebody who's doing volatility trading will need a much better risk management system than somebody who was just trading spot or forwards," agrees Olive.

On top of that is counter-party risk and making sure your prime broker or under-lying counter-party doesn't go the way of Lehman Brothers. This is usually done through master netting agreements under the auspices of ISDA, multiple prime brokers and holding collateral and cash in separate accounts, often with a custodian. "Nearly everybody has ISDA netting agreements and anybody who isn't, is incompetent," warns Olive.

They are often also leveraged. "This can create capital efficiency, less assets put in to generate the same overall return, but the problems that we have found in the high more highly leveraged products are more about behaviour in nature," says Roberts "First of all, if you invest in a high volatility product then it really requires you to react in a rational way, i.e. a logical way. If a highly leveraged product experiences draw down, but you believe that it has good fundamental qualities, you should probably increase your allocation. But at such high levels of volatility, what you tend to see that when you get these draw-downs is that the product comes under pressure - you don't get rational behaviour."

And this behavioural factor extends to the value strategy, often based on more fundamental economic analysis. "Valuation factors like PPP can take a long time to come right, the same with any value strategy. It doesn't mean it doesn't work over time, but it can take a long time to come right over time, and consequently is open to behavioural issues, and clients might not stay the course to ultimately realise the benefits of that strategy," explains Roberts.

This style also has other drawbacks. "Value may not work when a powerful external force, like Central Bank intervention, is propelling markets," observes Mike Harris.

Conclusion

The reality is that all single strategies are open to criticism and houses have increasingly moved to multiple styles, moving from one to the other depending on the environment.

Over at Campbell & Company the trading bucket includes momentum (trend), value, carry, volatility and mean reversion. "We use quantitative models to trade all of these styles," explains Mike Harris, Director of Trading at Campbell. One style Campbell does not trade is arbitrage . "For us, arbitraging small price differences between different ECNs or market makers would negatively impact the pool of liquidity we depend on to trade all the other styles."

However the quantitative approach whether based on multiple styles or high frequency trading has its own drawbacks. They are only as good as the underlying model and understanding that is as much an issue in understanding the investment process, as it is with institutions swilling around in their style buckets.

One way to assess styles, according to Dori Levanoni, is to use consultants but he warns few of the smaller ones might have the necessary skill-set to understand all the methodologies in the market. "You have to ask, will the style avoid the elevator down? Look at whether it has a high frequency of positive returns coupled with a small frequency of large negative losses. Does it have a positive mean?"