Changes in FX Market May Cause Shakeout

By Chidem Kurdas, New York Bureau Chief
Wednesday, April 05, 2006

NEW YORK (HedgeWorld.com) - Currency used to be an afterthought for institutional investors. It was a market that received attention mainly because fluctuations in exchange rates affect the value of international assets. Nowadays, however, people are more likely to suggest currency strategies as a way to diversify one's portfolio and boost the return.

Institutions like pensions became familiar with FX as they increased their global investments and used overlays to hedge the currency risk. But with other markets lackluster in recent years, these investors became more interested in FX as a separate asset class.

Large institutional players are starting to make long-term allocations to actively managed currency funds. At the same time, the sector is drawing new managers. A search in the TASS database yielded many currency funds of recent vintage. Their returns vary widely.

Managers are coming in, some from other sectors where there's no longer as much opportunity, said Bill Lipschutz, portfolio manager at Hathersage Capital Management LLC and a trader in currencies for 25 year years.

He's observed major developments in the past two or three years. A transformation that people have talked about for a long time may now be in progress: turning currency into a broadly accepted asset class.

The entry of long-term big investors is one change. Current institutional participation is small as a percentage of the total assets these organizations control, but there appear to be more mandates for active currency managers than was the case five years ago. Also, some funds of hedge funds want to have exposure to FX in order to diversify their portfolio.

Technology is another element that has evolved. Twenty-five years ago you couldn't do the pattern recognition and analytics you can do today, said Mr. Lipschutz. There was neither as much computing power nor data. In the past, information came in hard-won dribs and drabs-one had to have contacts, make a lot calls.

With readily available databases and computing ability, trading models have become more sophisticated. They have also become ubiquitous, with the result that technical trading dominates FX funds.

Mr. Lipschutz isn't a technical trend follower, but even as a discretionary trader he finds it useful to model what in the past used to be intuitive perceptions. It's a time saver to have models that comb the world and filter data to identify trade ideas, he said. Moreover, with electronic exchanges, implementing trades is much easier.

As he sees it, there are always economic or political events that cause dislocations in currency prices, creating trade opportunities. But there's now more money, new players, and different methods to take advantage of openings in this biggest and most liquid of all markets.

That does not mean plying the market is easy. The entry of many managers, some of them light on FX experience, suggests there will be a weeding out process. Trend-following funds tend to incur big losses when the market stops trending. Many quantitative funds got clobbered last year when the U.S. dollar failed to decline as predicted by models.

Mr. Lipschutz, who was one of the traders interviewed by Jack Schwager in The New Market Wizards, said he uses very strict loss limits, closing out positions that lose more than a certain amount. The flagship program he's managed since 1991 has returned over 20% annually on average with relatively low volatility. It mostly makes between1% to 2% a month, he said.

He expects that managers whose approach causes high volatility won't get institutional allocations. That's certainly going to be a major factor in determining which currency funds thrive and which don't.

CKurdas@HedgeWorld.com