February 2010

FOREIGN EXCHANGE: safest investment in the world?

imageBetter returns and new ways of measuring alpha make currencies more attractive as an asset class, finds Nick Fitzpatrick. And as fund managers look for alpha, emerging markets are attracting attention...
banknotes.jpgMany investors probably wish they had bought all or some of the following assets in the past two years: shares in Barclays Bank; corporate bonds issued by other banks; and gold. It might not have spelt an end to pension deficits, but a portfolio like that would have lightened spirits at the beginning of January.

The market meltdown since 2008 has also created opportunities in currencies. A series of interest rate hikes in Australia last year designed to curb inflation saw the Australian dollar increase sharply in value against other major currencies.

The ‘Aussie’ benefited from the so-called carry trade – a strategy where foreign exchange (FX) traders borrow money in a country with low interest rates and buy currency in a country with higher rates, typically to stick it in high-yielding government bonds.

For institutional investors, accessing Barclays shares, bank bonds and gold is straightforward enough, but an opportunity like the carry trade in the Australian dollar is more difficult to exploit.

Institutions and their advisers expect active currency managers to demonstrate consistent, positive returns, and the carry trade smacks too much of speculation.

Funds with an institutional focus that actively invest in currencies will employ more than just the carry strategy in order to provide an absolute return. Other strategies can be based on macroeconomic drivers, valuations, market price behavior, and market volatility.

Thanos Papasavvas, head of currency management at Investec Asset Management, says the carry trade accounts for an 8% weight in its currency funds, which target institutions.

Returns from active currency investment in certain strategies have disappointed in the past couple of years, as of course have many other asset classes. Volatility was too low pre-2007 to provide opportunities for good returns. Then the sharp rise in volatility caused other problems, especially for managers who relied too much on imperfect risk models.

“Active currency manager returns have been less good in the last five years than in the past, but they are starting to improve again,” says Diane Miller, principal and currency specialist at Mercer Investment Consulting, a major pension fund adviser, in London (see chart, p14).

In 2009 Deutsche Bank’s DBCR currency index returned 7% on a total-return basis. The index captures returns from three main currency strategies, including carry. Backtesting of the DBCR, which was launched in 2007, suggests currencies could be entering a four- to five-year positive run, says Torquil Wheatley, Deutsche Bank’s head of currency solutions for pension funds and insurers.

Institutional investors have traditionally believed that any gains in foreign currencies will be captured in their foreign equity or bond portfolios. In other words, if investors benefit from an increase in the yen by holding Japanese assets such as equities, why bother investing in yen-based FX separately too?

This view suggests a strong belief that foreign currencies and mainstream assets are correlated, but FX managers have striven to reverse that opinion.

As an adviser, Miller says that investors should take care to separate the two categories and she says there is a value to be added through active currency management.

Mercer has been advising pension fund clients about FX for over 15 years, both about currency hedging – which typically uses derivatives to hedge out exchange rate swings for investors repatriating investments from abroad into their home currency – and active currency investing.

In 2009 around 5% of its UK pension fund base had incorporated FX management into their portfolios.

“Active currency manager returns are not correlated with traditional asset classes and because liquidity is very high, dealing costs are low. It is an attractive option for pension funds,” Miller says.

Between 1998 and 2008, major countries with the best-performing equity market never had the best-performing currency. In fact they were more likely to have the best-performing currency when their equities performed worst, according to figures supplied by Investec.

Wheatley, at Deutsche Bank, says the aggregate returns of the carry, valuation and momentum strategies tracked by the DBCR Index show not only negative correlation with equities, but also that the three strategies are themselves negatively correlated.

“The disaster in 2008 helped people realise that currencies can make a contribution to portfolios as a source of uncorrelated returns,” he says.

Although the carry trade fell 33% in 2008, the valuation strategy went up by almost as much, he says, and momentum was also positive.

Record Currency Management, a leading institutional currency manager, worked with FTSE last year to create the FTSE Currency Forward Rate Bias Index Series (FRB), which launched in September. Neil Record, founder of the currency firm, says: “Backtesting the FTSE FRB to 1978 shows that returns from the indices are not correlated to equity returns. The indices are also highly liquid and therefore we feel that pension fund consultants are becoming very interested in this area.”

The indices rolled out so far centre on major currencies. They track returns from carry trades on five of the most traded currency pairs: the US dollar, euro, yen, sterling and the Swiss franc.

Record adds: “With FTSE we’ve demonstrated over 30 years that if you hold these currencies in all possible combinations of pairs – selling the low interest rate currency, buying the higher one, and flipping them if rates reverse – a 3% per annum excess return over cash is achieved, including costs, with 6% volatility.”

The FTSE initiative, by using carry as a benchmark, is effectively describing carry as a beta return, or one generated with little skill. This might jar with FX carry traders who feel they do add skill.

But it is important to have a benchmark that reveals the minimum likely return from an asset class or strategy. FX funds are leveraged and charge outperformance fees. It is therefore necessary to agree about what is being outperformed. By using returns from the carry trade, were FX managers to rely on this strategy too much, the FTSE indices could be used to reduce their fees if pension funds refused to acknowledge carry as an alpha giver.

Miller says that although there has been a lot of interest in developing indices to represent long-term sources of currency returns, “most indices are not risk controlled and can be calculated in different ways even if attempting to capture the same sources of return”.

She also points out that a lot of them just take into account developed market currencies, while looking at emerging markets is currently providing a lot of potential for fund managers.

Emerging currencies
The Bank of America/Merrill Lynch Global Fund Manager Survey, carried out 8-14 January, notes that: “Gem [global emerging markets] retains a firm grip on the title of region of choice for [equity] investors.” (However, it warns that emerging market positioning is at an all-time high and any correction in global equities would be deeply felt in these markets.)

As global investors’ capital moves towards emerging economies like Asia, more FX managers are now looking at these markets as a possible source of longer-term currency gains that will find favour with institutions.

After all, a spin-off from the secular trend towards emerging market equities – which is partly reflected by the second largest UK private pension scheme, USS, expanding its internal emerging markets team recently with three senior hires – is that currencies in these countries may rise in value too as global investors generate more FX trades based on swapping Asian and major currencies.

The increase in Taiwan’s dollar to a three-month high in September last year was seen as a result of global investors finding Taiwanese company shares more attractive on the back of improving economic ties with China.

Taiwan is not the only emerging Asian country to see its currency rise on the back of global investment. Robert Stewart, head of currency group at JP Morgan Asset Management (JPMAM), says: “Asia and emerging markets will be very strong trends in the next few years with reasonably significant capital flows. This will see Asian currencies strengthen, which South Korea has already demonstrated.”

The case for emerging currencies is pressing enough for managers to launch dedicated funds. Investec launched the Investec GSF Emerging Markets Currency Alpha Fund last year, converting it to a Ucits III structure this year, while Record Currency Management has recently seeded its first emerging markets fund.

This month Investec is also transitioning an additional US$50m (€36.3m) into its Guernsey-based Investec Currency High Alpha Fund, which is a mix of developed and emerging currencies, for one European and two UK pension funds, bringing total assets to $220m.

Record, who founded Record Currency Management in 1983, says: “We are very interested in emerging market currencies, Latin American, Asian and Eastern European particularly, and we are long of them.”

However, like emerging market shares, emerging currencies present risks and complications due to, for example, dollar pegging.

“Many of them are controlled, China very heavily so,” says Record. “You have to be very careful how you gain exposure to the Chinese renminbi, for example, and we exclude that at the moment.”

The increasing amount of money chasing emerging market equities is itself a risk factor for FX investment in places like Asia. Capital flows have led central banks to intervene to stop their currencies appreciating too much against the dollar.

Stewart, at JPMAM, which has an emerging market facility within its global managed currency funds, says: “Some emerging markets are trying to slow down the effects on their currencies exactly because of these large inflows of capital to their equities markets.”

Naturally, FX long investors would not want central banks to limit how much their currencies can appreciate, but with many of their currencies pegged to the dollar, upward pressure is a problem for central banks in these countries.

Emerging economies have bought up billions of dollars worth of foreign reserves in recent years to keep the exchange rate of their currencies with the dollar low.

A result of this is that China and others now own huge amounts of dollar-based assets, particularly US treasuries. International Monetary Fund figures show that Brazil has more usable FX reserves than the US does ­– $238.5bn at December 2009. Korea, India, Taiwan and a dozen more are in the same position. Russia, with over $400bn dollars, holds around the same amount as the UK, Europe and the US put together. Saudi Arabia owns even more.

In fact, all that these countries need to do is stop buying dollars and that would be enough to increase their currency values, says Jerome Booth, head of research at Ashmore, a specialist emerging market investment manager.

Booth says that the level of their dollar reserves now means that many emerging markets could allow their currencies to revalue.

“Emerging markets realise they have enough foreign currencies now and they could let exchange rates appreciate if they wanted to. With inflation coming through, although they could raise interest rates, it also makes sense to let exchange rates appreciate,” he says.

Thanos, at Investec, points out: “If Asia tightens its interest rates too much it could stall economic growth, although it could still be good for currency appreciation. But if its currencies appreciate too much it would hurt Asian exporters.”

As well as halting dollar purchases, Asia could also sell its dollar assets. Whether China might do this has been speculated on for some time, but Booth says emerging countries now realise that securities denominated in emerging market currencies could be a better place for their foreign exchange holdings than US treasuries.

“Emerging market central banks realise that US treasuries are not that good as a diversifier any longer. They own 50% of the treasuries market and if they wanted to sell them to meet their monetary requirements, there are virtually no other buyers and the market could collapse. Emerging market local currency bonds, however, have a much broader ownership pool so it makes more sense for central banks to own those.”

The financial crisis may have given more impetus for Asia to revalue its currencies in order to support local markets. Debt-burdened Americans are, arguably, no longer viable consumers for Asian exporters (although lower energy prices and interest rates recently may have eased the debt pain). Therefore Asian exporters may well look more at their less leveraged domestic and regional populations.

Booth says that should India, a relatively closed economy but one with inflationary pressure, float its currency early in the business cycle, this would also signal to domestic entrepreneurs to start focusing production on local, rather than export, markets.

Strengthening the case for emerging market currency exposure is possible deflation in developed markets. This, believes Booth, along with asset rallies and the need for bank recapitalisation, presents “a frighteningly similar dynamic to what happened in the 1930s”.

Therefore, he says: “Emerging market local-currency debt is arguably the safest asset class in the world. People should be putting money into emerging market currencies as these markets are not only a great investment, but a good insurance against a depression.”

Miller, at Mercers, says that FX managers that can use this group of currencies may be able to give pension funds added value. But she points out that liquidity is an issue.

The largest market in the world
Increased investment in emerging market equities and bonds in the coming years, if it happens, will represent an extension of globalisation and it is globalisation that has driven the FX market to become the biggest capital market in the world over the past 10 years, far outstripping equities.

Globalisation has also seen institutional investors’ portfolios become more diversified across geographies, but like central banks that are among other major agents in the FX market, investors normally see their FX transactions as an operational necessity, essentially a not-for-profit exercise.

However, being responsible for a large chunk of the $3 trillion average daily volumes in FX, it could be common sense for institutions to do more to try and capture some of the revenues they create in this market.

FX is still something of an alternative asset class, and emerging currencies are even more alternative still. But for all they know, pension funds could be ignoring one of the safest asset classes in the world.

©2010 Funds Europe

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