FOR about a decade before the crisis, institutional investors were happy to accept that the currency markets were an area where active fund managers could add value. But they lost their faith in the asset class during 2008 when many currency managers lost money. Some of those managers who were running quantitative strategies and who were relying on the continuation of the carry trade were particularly badly burned. Carry trade strategies tend to suffer at times of heightened market uncertainty and volatility as investors pull out of risky currencies.
Although investors are now likely to be operating on a once-bitten, twice-shy basis, they should be reconsidering currency as a stand-alone asset class even though volatility is higher than it was before the crisis. Vineer Bhansali, managing director and portfolio manager at Pimco, explains: “Greater volatility – as well as political factors involving conflicting geographic blocks – creates risk, certainly, but also creates a lot of opportunity and that means now is a potentially attractive time to invest in currencies.”
He adds: “Certainly, volatility going forward is likely to be higher than it was in 2005, 2006, and early 2007. Our best estimate is that currency volatility is probably going to return to where it was in the mid to early part of the last decade – oscillating in the neighbourhood of 10 per cent.”
The FX markets are also still liquid and highly transparent. Currency markets retained their liquidity when other financial markets seized up in late 2008. Furthermore, at a time when equity volumes are still reduced and investors are still keeping some cash on the sidelines, FX is looking increasingly appealing. Amos Galvin, head of strategy at Macro Currency Group, says that there has been a renewed interest in foreign exchange because investors now have a greater appetite for liquidity and transparency.
Macro Currency Group is primarily suited for institutional investors but head of distribution Ashley Shaw says that the group has seen growing interest from private banks, big wealth managers and smaller pension schemes. The firm, which is part of Principal Global Investors, has a Ucits fund with a minimum investment of £10,000 slated for the first quarter of 2011.
Even more appealing at the moment is foreign exchange’s lack of correlation with other asset classes. Research from BarclayHedge, a US-based provider of alternative investment performance data, shows that the correlations between currencies and various asset classes is still extremely low.
The BarclayHedge currency management index between its inception in 1987 and the first quarter of 2010 shows that the highest positive correlation is only 0.26 – with hedge funds – while currency returns have not moved at all with equities over this period. (See chart.)
But while they are not currently highly correlated with other asset classes, you can use currencies to access other assets. For example, Henderson’s head of currency Bob Arends points out that through currencies, you have very strong access to emerging markets. “Of the performance in emerging market equities and local currency denominated debt, 80 to 100 per cent can come from foreign exchange,” he explains.
Institutional investors should try to put the difficulties of 2008 behind them but they must be aware of the range of approaches used by fund managers ranging from the purely quantitative and algorithmic to a highly discretionary macro approach. For example, Macro Currency Group has never had any allocation to carry and takes a directional view rather than having targets. In contrast at Henderson, Arends’ Horizon Global Currency fund focuses on delivering absolute returns throughout the market cycle and employs a disciplined carry trade investment strategy. “What we have seen from academic research is that the major source of return comes from carry and trend. If you combine these two into a strategy you will generate performance over market cycles,” he says. Pimco seeks intelligent carry, which it defines as carry that it can understand from a macro basis, but also monitors momentum and valuation.
In the search for liquidity and uncorrelated returns, the need for due diligence on the fund to understand the investment strategy cannot be greater.