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Currency Management
To Invest or To Hedge?
June 2014

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Clear and Independent

Has the Death of Currency

Institutional Investment Analysis

Management been greatly Exaggerated?

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Reports of the death of currency management are greatly exaggerated, says

James Wood-Collins, chief executive officer of Windsor-based Record Currency
Management.

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He would say that. Record is one of the oldest and renowned names in currency
management in the world. It built a sound reputation and business until 2008 when, like
so many other players in this field, it was damaged by highly contagious illiquidity in money
markets.
Superficially, Record has returned to pre-Crisis strength. Assets under management
are back over US$50bn for the first time in seven years. The firm has taken in US$12bn
in new mandates in the last twelve months. Wood-Collins maintains that interest from
prospects is picking up. There is even a smart beta angle: using Records methodology,
FTSE has launched the Forward Rate Bias 10 Index, which dynamically exploits the
tendency for currencies of higher interest-rates to outperform their lower-rate peers.
Given all this good news, why would investors ever think currency management had
disappeared forever? The truth is that, unlike Record, many currency specialists have
shuffled off this mortal coil entirely. Undoubtedly, the greatest was FX Concepts, once the
worlds biggest currency hedge fund, which died a death last year. Around the same time
London-listed Brevan Howard called time on a US$1bn currency fund. Five of the last
six calendar years have witnessed net outflows from currency hedge funds, according to
Hedge Fund Research.
If all this hedge fund news sounds superfluous to pension fund readers, they could ask
themselves where the support from influential pension fund consultants for currency
management went. Nine years ago, the likes of Russell and Mercer were championing
both hedging and active currency management. Since the crisis, the big four - Towers
Watson; Mercer; AonHewitt; and Hymans Robertson - have all found other aspects of
investment management to talk about (Russell has recently made a splash with its FX
trading platform for local authority pension schemes but this is much to do with efficient
execution rather than investment strategies).
I get very few enquiries from clients about active currency management, admits Alick
Stevenson, a senior investment consultant at AllenbridgeEpic and former treasurer of
Nortel UK.
Record itself, the go-to currency manager for UK pension schemes, sees its share price
languishing at one-fifth of its late-2007 launch high.
There is something ironic about a currency firm being quoted. One fundamental reason for
not allocating capital to currency management is that there are questionably - no assets
to be owned, unlike when you buy equities or property. Acquiring shares in Record itself
would gain exposure to the methods and strategies built up by Neil Record and latterly the
likes of Wood-Collins. So few solid possessions but instead brainpower, of the kind that
has had to adapt to life post-Crisis.
This adaptation has meant less active management and more hedging, a strategy which
even when employed dynamically earns lower fees and subsequently explains in part the
low share price.
Although an ex-merchant banker, Wood-Collins embraces the current mantra of
eschewing alpha fees for beta-like strategies heralded first and foremost by Towers
Watson - the FTSE Index is a perfect example of this.

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Which is not to say Record has given up full-blooded active management. Far from
it. Wood-Collins is quick to detail its various sources, and the struggle in the current
conditions caused by Quantitative Easing to generate income.
Borrowing rates are distorted; economic rationale has given way to experimentation;
volatility begins with the utterances of politicians.

Given all this

good news,
why would
investors ever
think currency
management
had disappeared
forever?

Managing Currency

Risk in Global Portfolios

As Jim Reid, head of global fundamental credit strategist at Deutsche Bank, noted in
February on this topic: Weve created a global debt monster thats now so big and so
crucial to the workings of the financial system and economy that defaults have been
increasingly minimised by uber-aggressive policy responses.
The debt monster and its policing lie behind much of the disappointment with active
currency management. But not all funds have suffered or been killed during the saga.

The size of returns

is in part explained
by leverage
maximum five
times notional
although Doupe
reckons the
gearing rarely
exceeds 2.5

London-based Emerging Markets specialist, the Cambridge Strategy has achieved

gross annual returns of 7%, 29%, 7%, 13%, 12% and 2.5% in its Emerging Markets
Alpha Programme for the years 2008 to 2013. Among its attractions, head of marketing
Derek Doupe notes the fund has a correlation of just 0.1 with Emerging Markets equities
so investors would not be doubling up by adding this strategy to their roster.
The low correlation, however, is much explained by the fact that it is a long-short
programme, which is free to go long developed currencies like the dollar and short EM
money.
The size of returns is in part explained by leverage maximum five times notional
although Doupe reckons the gearing rarely exceeds 2.5.

Investors need to recognise the currency risk embedded in their international

portfolios and implement a currency management approach based on their
beliefs and objectives.
The motivation to invest outside home markets are well-understood and well-established,
and amongst other factors include diversification of risk and an increased opportunity set
for generating returns.
However, one aspect of international investing that is often neglected is the currency
exposure and the risk that is a by-product. Currency exposure can have a significant
impact on the overall risk and return profile of a global portfolio. It is estimated that for
bond-only portfolios, unhedged exposure to currencies is responsible for in excess of 70%
of the total portfolio volatility - this is not surprising, given the very low levels of volatility
exhibited by bonds relative to currencies. On the other hand, for equity-only portfolios, the
total portfolio volatility explained by unhedged currency exposure is often above 30%.
These figures highlight that currency risk shouldnt be ignored and that decisions on
whether to retain or eliminate it (and in what proportions) should be an integral part of the
formal investment decision making process and should be made deliberately and for the
right reasons.

Most remarkable is Cambridges finding that when decomposed into factor attribution
in FX (carry, momentum, value (ie purchasing power parity), volatility and alpha, ie skill),
85% of the Emerging Markets programmes returns come from alpha.

Consequently, investors have two options:

This is food for thought; a reminder of how different active currency management and
hedge funds are to traditional investing where beta always dominates. But Doupe is
keen to stress that this is not all due to black-box quantitative techniques.

First of all, doing nothing is actually a misnomer. Usually, the choice not to implement
any sort of currency management can be arrived at through the investor believing that
either currencies will strengthen relative to its home currency and by leaving the exposure
in place is expressing that view or that over the long run, the ability to reduce portfolio
volatility by way of hedging is minimal.

He gives the example last November of the Czech central banks trailed announcement
that it would intervene to provide a floor for the koruna versus the euro. You cant
incorporate such messages from central bankers into a pure quant strategy, he says.
In spite of the all the analysis and explanation, AllenbridgeEpics Stevenson remains
unmoved. He believes currencies are essentially volatile and while in the long term they
revert, attempting to exploit variations over shorter periods is not a reliable activity. I
dont believe in active currency management. Currency is a long-term play, a bit like
property, and if you can afford to invest over at least two economic cycles, then it is
worth consideration, he says.
At least all three interviewees agree that currency as a standalone is worthwhile. The
question remains: how many clients are prepared to leave any of their strategies alone
for at least two economic cycles? As Stevenson recommends, both Record Currency
Management and The Cambridge Strategy would happily sign up to such a term. But
while pension plans in their entirety live through multiple economic cycles, they are
proving increasingly short-term in temperament and myopic when it comes to risks and
returns.

Written by
Brendan Maton

Do Nothing

Integrating Currency Risk: Implementing an Overlay

An investor who wishes to explicitly manage their currency risk will frequently choose to
manage this separately from the underlying investment through what is commonly known
as a currency overlay. Although an investor can choose to do this in-house, it is common
to appoint a currency manager who has specialist expertise to provide this service in a
cost effective manner.
The overlay will be specifically tailored to the investor, their objectives, risk preferences
and constraints. The spectrum of what is available to investors is wide and very flexible
to accommodate various needs; however, mandates can typically be divided into distinct
categories: passive, dynamic and active. Which is implemented will largely be driven by
beliefs about currency market efficiency.

Written by
Derek Doupe,
The Cambridge Strategy

One aspect of
international
investing that is
often neglected
is the currency
exposure and
the risk that is a
by-product

Conscious Currency

Management

RECORD
...EXPERTISE IS OUR CURRENCY

Currency managers are adamant that the various monies of the world have
a fair value. That should be heartening to any investor seeking to hedge their
currency exposure.
The bad news is that those fair values tend to become evident only over long periods
of time, measured in decades rather than years. So at once we have an argument as to
why currency hedging ought to be taken seriously and a reason why investors tend to
push it down the list of the priorities.
Managers express a degree of sympathy for this relegation: People struggle with asset
classes that are choppy and for which there is no predictable framework for consensus
valuation, says Mark Farrington, portfolio manager and head of Macro Currency Group,
a subsidiary of Principal Global Investors.
As this article is more about risk than return, here are a few serious reasons why
currency decisions should not get dropped or delayed merely because they are difficult.
First, currency movements can account for a greater portion of overall returns than the
underlying securities themselves, even in the case of equities. Taking global equities
hedged back to the Australian dollar, Jeppe Ladekarl, director of research at First
Quadrant, found that the gap between a fully hedged and fully unhedged portfolio was
bigger than the return from the basket of equities itself close to one in every three years.
In ten years out of the 24 studied, the difference between a hedged and unhedged
portfolio was more than 10%.
Moreover, the two strategies swapped positions dramatically: fully hedged trounced
unhedged in 1996, then returned more than 15% less for the following two years,
reversed that performance in 1999 before doing considerably worse again during the
crash of 2000.
Both the quantum and volatility of these results should make currency a huge
consideration globally (the Australian dollar is not a special case). Instead the argument
typically gets turned on its head: if currencies are wild in the short- and medium-term,
best leave them to play out over time and eventually enjoy their reversion to fair value.
Ladekarl, unsurprisingly for a currency manager, takes the opposing view. His
pitch is that static hedging alone is not the best fix. A substantial number of funds
might disagree. Klaus Paesler, EMEA head of currency overlay services at Russell
Investments, says most of the clients and prospects he deals with in Northern Europe
have static rather than dynamic hedging on their international holdings.
He adds that the choices vary from 0% to 100% but 50% is the most popular ratio.
Indeed, Ladekarls own research demonstrates that a 50% hedge on international
equities brings simple, demonstrable and reliable mitigation of volatility.

Record Currency Management Limited

Morgan House, Madeira Walk
Windsor, Berkshire , SL4 1EP
T: +44 (0) 1753 852 222
ClientTeam@recordcm.com
www.recordcm.com

Record is authorised and regulated by the Financial Conduct Authority in the UK, registered as an Investment Adviser with the Securities and Exchange Commission in the US, registered as a Commodity Trading Adviser (swaps only) with the US Commodity Futures Trading Commission, is an
Exempt International Adviser with the Ontario Securities Commission in Canada, is registered as exempt with the Australian Securities & Investment
Commission and is approved by the Irish Central Bank to act as promoter and investment manager to Irish authorised collective investment schemes.

So is static right or wrong? On this, the professionals are in agreement: the answer
depends on your competence. Paesler is careful not to describe 50% - or any other
figure as the best hedge or even the position of least regret. He may manage a lot
of fixed hedges but like First Quadrant and Macro Currency Group, Russell also offers
active currency management - its latest product line is Conscious Currency, a rather
bold term in money management which has echoes of Sigmund Freud or Bob Marley,
depending on your preferences.
All the three managers ask initially is that clients demonstrate some consciousness of
the role of currency in their total risks and returns rather than dismiss it heedlessly.

Currency
movements
can account
for a greater
portion of
overall returns
than the
underlying
securities
themselves,
even in the
case of
equities

Wake up to currency smart beta

Succeeding in dynamic hedging, however, is no small task. Factors these managers have
to evaluate includes macro economics at national and international level, political shocks
and manoeuvres; and evaluation of market sentiment. All of the above affect each other.
Moreover, Ladekarl admits that they mutate a lot over time:

Wait for
confirmation of
this trend and it
will be too late
the portfolio
damage will have
been done. Dont
say you havent
been warned

Looking across time, countries and hence their currencies, go through extended periods
during which they are, on a relative basis, high yielders and periods where they are low
yielders, he says. Yields are not the only economic characteristic impacting the way
a currency behaves. Current account deficits or surpluses, capital account surpluses
and deficits, balance sheet composition, reserve currency status, economic growth,
population growth, changes in reserve status, etc. are all characteristics that change over
time on a relative basis, and change the characteristics of the currencies with them.
Farrington believes assessing all these factors through time does not suit a rigid,
quantitative formula. Instead he believes currency managers need to adapt to conditions
and take fundamental judgements on what works in each particular environment. Macro
Currency Group eschews the systematic approaches on offer from rival managers,
including the exploitation of momentum. (Typically for this strategy, the hedge ratio
of a base currency to its pair is increased as the former appreciates. As with equity
momentum, the moves are isolated over consecutive time periods in order to capture the
aggregate trend).
Farrington doesnt believe such systematic strategies are without worth. His belief is
rather that none succeed persistently through all conditions. He believes markets delude
themselves after even a couple of quarters of any particular strategys success that this
time its different, ignoring the gaps since the previous bout of positive performance.
Russells combined Conscious Currency Index aims to redress this problem by equally
weighting exposure to a trio of big factors: momentum, value and carry from a basket of
major currencies, then rebalancing the three each month.

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A static hedge would not capture this fast-moving trend. But then, like First Quadrant,
MCG is not really into static hedging. Its preferred modus operandi is to have a dialogue
with clients so that they are ready to act in a timely fashion when conditions change.
And the big message from currency managers is that for investors in the above countries
with high international exposure to foreign currencies, change is likely soon. After a period
of remarkably low volatility among G10 currencies, rate rises will be a catalyst for their
divergence. Wait for confirmation of this trend and it will be too late the portfolio damage
will have been done. Dont say you havent been warned.

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But MCG believes instead that currency managers have to adapt and exploit conditions as
they are. A pragmatic example is the firms latest offer to institutional investors in peripheral
countries such as Switzerland, Norway, Sweden, the UK, Canada, Japan and Australia.
Even in the targeting there is a practical consideration: MCG believes these are likely to be
affected most by a rise in interest rates.
For some of these countries, like the Nordics, two-thirds of the currency effects in a
business cycle occur in the first two quarters, says Farrington.

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