A more active approach to managing portfolio-wide currency risks, and in particular a greater appetite for active currency overlays, is being shown by institutional investors, driven by divergence in European and US interest rates, geopolitical unrest and greater scrutiny of costs.
That’s according to the latest market Intelligence report from bfinance, ‘Managing Currency Risk in a Two-Speed World’, which also finds that a highly tailored provider assessment framework is essential with currency overlays and institutional asset owners looking to pursue active overlay strategies should carefully consider both upfront fees and transaction costs as there is a wide disparity in both.
The paper notes three major drivers of change and the greater adoption of active currency overlays, the hybrid blend of currency hedging and modest active return targets. Firstly, an emergence of a ‘two-speed world’ as interest rates in the US and Europe diverge, which is creating a more supportive climate for trend-following currency strategies after a decade of poor performance. Secondly, closer scrutiny of both active and passive currency management costs due to the more fee-conscious investment landscape and the anticipation of more stringent cost reporting requirements under Mifid II. Thirdly, more frequent geopolitical macro events have boosted FX volatility.
Dynamic hedging and multi-strategy are now the primary styles of active currency overlay
Two primary styles of active FX currency overlay are currently prevalent – dynamic hedging and multi-strategy. Dynamic hedging, is a pure trend-following strategy where practitioners ‘dynamically’ adjust hedge ratios to under-hedge stronger and over-hedge weaker currencies: such strategies only perform well when currencies ‘trend’. The advent of a ‘two-speed world’ as interest rates diverge with those in Europe remaining low and US rates rising has created a more supportive environment for these approaches.
Multi-strategy styles theoretically deliver excess return regardless of whether currencies ‘trend’ and apply a range of more fundamental models alongside momentum signals. The main examples of this are value, which is often purchasing power parity (PPP) based, carry, which is the most widely applied currency factor and macro, which examines economic fundamentals.
The hidden costs in currency management have also been identified and, while front-end fees are widely dispersed with the more expensive providers being twice as high as the cheaper offerings, transaction costs vary by more than 400 per cent and are harder to assess in a transparent common framework. Over the long term, better transaction costs can mean paying less than 3 per cent of overall AuM in currency trading, in comparison with losing 15 per cent or even 25 per cent through poorer practices, as shown through an example portfolio representing the average UK pension pot.
Managers offering lower headline charges have proved to have higher average transaction costs and vice versa, making it even more vital not to take fees at face value and consider the overall package of expenses. These differences are strongly correlated with the type of provider with banks generally offering principal relationships, executing all trades through their own institutions, while others operated on an agency basis with open architecture for execution.
Investors need to take into account their whole portfolio when selecting suitable FX managers as active currency management has been playing an increasingly critical role in other asset classes. This includes alternative risk premia strategies, now considered a mainstream asset class, where currency represents a key source of returns alongside equities, fixed income and commodities; CTAs, which have surged in popularity thanks to their diversification profile against more traditional risk assets also now incorporate a strong element of currency; and active fixed income managers which have increasingly been expected to use currency as a key source of return while yields have remained depressed.
Active currency overlay strategies fall into two main families: dynamic hedging and multi-strategy with the latter offering a more all-weather approach but with greater complexity. Investors should avoid one-size-fits-all ratings. A manager assessment framework that is highly tailored to the client is essential in the active overlay sector. Transaction costs are highly significant in both active and passive currency management and conventional assessment methods are flawed.
Toby Goodworth, head of diversifying strategies at bfinance, says: “This paper gives considerable insight into the re-emergence of active currency management and the strategic choices available to investors when considering active currency overlays. Investors are now looking to take advantage of the divergence of interest rates and we have seen a significant increase of interest in active overlays in particular. Fees and transaction costs should also be scrutinised closely. We have been very pleased to work with New Change FX to provide clients with independent, rigorous transaction cost analysis in this sector. We also found that a highly tailored manager assessment framework is essential in the active overlay sector due to portfolio-specific performance outcomes, regional reporting requirements and the fit with other providers such as custodians.”
Kathryn Saklatvala (pictured), Global Content Director and the report’s author, says: “Today’s investment climate raises new FX-related headaches for investors, provoking a rethink of previous decisions to hedge currency exposures, leave them unhedged or delegate such decisions to fixed income and equity managers. 2017 is far too early to predict a return to the heyday of active currency management – a sector which experienced a dramatic cull after the financial crisis when the return of volatility undermined widely-used carry strategies. There was a large shift towards passive currency management strategies. But this uptick in appetite for active currency overlays is potentially very significant. After 2010 many consultants appeared to have determined that active currency management had no place in a risk-reducing hedging programme; this attitude is now clearly undergoing a rethink. The question of more tactical currency management and its role in institutional portfolios is now more pertinent than ever.”
Andy Woolmer, CEO, New Change FX, says: “While FX usually contributes the highest volume of trading of any asset class within a portfolio, it is almost always the most neglected. FX flows are treated as a back office function rather than an important component of cost and an asset which can be sold to the market. Banks, traders and brokers spend millions on ensuring that they profit handsomely from this neglect. Any bank’s balance sheet will show 20 per cent of income from FX. These profits are rarely a result of taking trading risk, but rather come directly from the pockets of the unaware which goes some way to explain why fees are so disparate. When analysing potential partners for passive hedging or active overlays, it is important to assess each manager’s ability to navigate the treacherous shoals of the FX markets on a fair and quant-driven basis.”
