FX, A New Asset on the Menu for Investors

Les Echos
February 18, 2008

FX has become an asset class in its own right, with specialized investment managers offering both hedging overlay and standard total return strategies to investing clients. The FX market, however, demands a high level of expertise, and only a minority of managers have been able to deliver a consistently superior performance over the years.

by Nessim Ait-Kacimi

Like other asset classes, FX has its investment wizards. Bill Lipschutz is among them. His hunting ground? The largest market on the planet, with 3,200 billion dollars of transactions every day. For some thirty years, Bill Lipschutz, the legendary Salomon Brothers trader, has been making money in this market. Lots of money.

From 1992 to 2007, the funds managed by Bill Lipschutz’ investment management company, Hathersage Capital Management, have generated between 12% and 18% annually to investors, or two to three times the 6.4% average annual performance of the Parker FX reference index. This out-performance is all the more exceptional in light of the noticeable downward trend in the returns of average FX managers since 1988, and the dearth of managers who outperform consistently for many years.

In the last two or three years, the FX asset class has attracted heightened interest, relative to equity and fixed income, in large measure because of the strong performance, until the start of the sub-prime crisis, of a high-visibility currency strategy called the “carry trade”. The flip side of this success, according to Armand Gerard, Director at Pareto Investment Management (BNY Mellon), is that it has attracted a number of other FX managers to employ it, thereby raising return correlations among currency managers.

Diversification is a second reason for heightened interest in the FX asset class. As a general rule, currencies show little to no performance correlation to other major asset classes such as equities and bonds. “But there are periods in which this independence breaks down”, notes Xavier Lefevre, portfolio manager at Overlay AM (BNP Paribas), “such as during last summer’s crisis, during which the performance of the carry trade showed a high degree of co-movement with that of equity markets.”

Nowadays, currency management brings both hedging and performance attributes. As Helie d’Hautefort, managing director of Overlay AM, explains, “some 80% of the volatility of an international bond fund with no currency protection can be attributed to changes in the values of underlying FX exposures, and that FX volatility contribution is lower, at approximately 30%, for a currency-unhedged international equity fund”. “We address the currency exposure management needs of our clients who, within their investment mandates, aim to immunize their portfolios against a depreciation in their home currencies”, adds d’Hautefort.

Wide Range of Performance Targets

At this latter, the range of annual return objectives for total return funds is between 2.5% and 25%, and the leverage employed varies from 0.5 to 4.5 times. Most fund portfolios have a few concentrated positions, typically 5, reflecting strong convictions in the direction of a few currency pairs such as Euro/Yen or Dollar/Yen. Mercer estimates that for calendar year 2006, currency strategies represented 2.2% of new fund investor transactions, but 8.3% of actual new capital invested, an indication of the growing acceptance of FX as an asset class. This growth in investor demand has been met by an increase in the number of dedicated-FX fund offerings. Among fund managers, a few have historically made currencies their sole investment focus, such as FX Concepts, Pareto, Overlay AM, Millennium, Record, and Hathersage Capital Management. Bridgewater Associates, a large hedge fund manager, specialized early in its life in offering currency overlay programs, and became one of the pioneers in that sector. And during the 1980s, institutions such as the World Bank, General Motors, and Kodak sought currency hedging solutions to protect the home-currency value of their portfolios. But it wasn't until much later, around year 2000, that investors started seeing currencies as an independent contributor of portfolio return, with its ups and downs. “While 2003 was a relatively easy year to trade currencies, with for instance, a pronounced dollar trend, the years 2005 and 2006 have been more challenging, with fewer strong trends and more erratic price patterns without clear directions” says Helie d’Hautefort. “Since the beginning of the sub-prime crisis in early summer 2007, the volatilities of G10 currencies have increased significantly”. d’Hautefort also notes that “having dropped nearly in half since 2000, these volatility levels had reached historical lows, which partly explained the weakening in some fund performance in that asset class”.

Aside from the “carry trade”, there are other methods employed to generate returns in the FX space, such as the “trend following” strategy. It consists of identifying and capturing a price trend in a currency, whether rising or falling, and betting that that trend will persist over a certain time period, powered by “momentum”. Since 2001, trend following has become less profitable, with currencies displaying more erratic, directionless patterns. Trend following strategies are still employed, and are usually executed using systematic models run on powerful computer systems.

A quantitative orientation now dominates the trading in currencies, with close to two thirds of traders employing such methods. For instance, “at Pareto, we employ a systematic, quantitative approach to managing foreign exchange and we rely on computer generated buy and sell signals that precede human actions” explains Arnaud Gerard. “In particular, we attempt to anticipate price reversals linked to exaggerated long or short positions tied to a particular strategy (e.g. carry trade), in order to position ourselves for a gain”. In Europe, certain institutional investors in countries such as Holland are the most advanced and sophisticated in utilizing FX for either hedging purposes or for stand-alone return generation. This sophistication results from the high degree of internationalization of their portfolios outside of the Euro zone, which has led these institutions, earlier than others with fewer FX exposures, to become sensitive to the range of issues associated with currency risks. In France, fund-of-funds and insurance companies seem to date to be the most open. How new clients will be won over will depend as much on manager performance as on changes in market conditions.

 
Translated into English from an article written in French by Nessim Ait-Kacimi for Les Echos on 18-Feb-2008, page 34.  This English translation has not been reviewed by the original author, and mistakes in translations, if any, are the responsibility of the translator.