Forecasting Currencies – A Difficult
Task
Currency markets have probably been one
of the more significant sources of disappointments
and frustrations for economists. Witness
to this higher degree of complexity relative
to other markets are the comments made by
Federal Reserve Chairman Alan Greenspan
whilst speaking at the Senate Banking Committee
on 16 July 2002: "We at the Federal
Reserve have spent an inordinate amount
of time trying to find models which could
successfully project exchange rates, not
only ours, but everyone else's. It is not
the most profitable investment we have made
in research time". It is clear that
currencies are indeed very different when
compared to other asset classes. First they
do not obey to the same set of fundamentals
as traditional assets such as bonds and
equities. Whereas for the latter there are
some well proven valuation models, this
clearly does not hold for exchange rates.
Currency valuation models at hand are generally
based on some kind of Purchasing Power Parity
theory and are well known for their high
degree of inaccuracy over time frames that
are of interest to most investors. Furthermore
currencies hardly apply as a strategic asset
class of its own which confuses many. Despite
having generally a relatively low correlation
with other asset classes, they principally
lack the required positive expected returns
and stable risk premium that bonds or equities
have exhibited over the long term. They
are tactical assets rather than strategic,
in other words, buy-and-hold does not work
for currencies. There is a need for some
kind of active management or tactical decision
to unlock the returns that may be generated
out of them.
Trend in Currency Management Mandates
Despite this, currencies have gradually
become recognised as potentially one of
the most significant sources of extra returns
in the institutional portfolio. This is
clearly supported by industry statistics,
assets and risks managed by both currency
overlay managers and currency hedge fund
managers, which have been clearly on the
rise throughout the last decade. There are
a number of reasons why currencies are making
their way to the forefront of the investment
scene. On the one hand, traditional asset
class returns have been poor over the last
few years with world equities yielding well
below their long-term historical returns,
whilst bonds holding rationale has been
questioned because of the globally very
low interest rate environment that could
make them unattractive when interest rates
start to rise. On the other hand, the investment
portfolio of institutional investors such
as pension funds and insurance companies
has drastically changed over the years.
There has been a significant quest for higher
returns and diversification through a higher
allocation to international assets. With
this came a new dimension of risk in the
institutional portfolio, namely currency
risk. At first considered as principally
a source of risk it has now evolved to be
considered as a significant source of returns.
This is mainly due to the fact that currency
managers have now had a track record of
credible length and risk-adjusted returns.
Also, investment consultants have done sterling
work in educating investors about the benefits
of currency in their portfolio.
What Makes Currencies Such an Interesting
Tactical Asset?
The first argument relies on the "heterogeneity"
of the market participants or, in simpler
words, how different their rationale is
to intervene in the foreign exchange markets.
Two of the largest market participants,
namely central banks and corporates, have
no direct motive of profits when acting
in the currency markets. The former uses
currency as an economic policy tool whereas
the latter uses the foreign exchange market
to translate revenues or hedge some costs
into its balance sheet. This clearly goes
against any theory of market efficiency
where all market participants are equally
informed, have the same degree of access
to market and have the same rationale of
profit opportunity across the same time
horizon. If foreign exchange markets are
inefficient it is therefore possible to
create a recurrent source of return out
of them. This clearly has been achieved
by a growing peer group of active currency
managers. Investment consultants report
an historical information ratio or risk-adjusted
excess return of the order of 0.5 for the
median manager. This does compares pretty
well to the median performance of active
equity or bond managers (Fig.1).
Fig.1: 10-year median information
ratios of active managers per sectors
Currency Management Investment Styles
To achieve this superior information ratio,
currency managers use a great variety of
styles that can be classified as a combination
of subjective or objective styles, in conjunction
with an approach that may vary from fundamental-
to time series model-driven decision processes.
As an example, we use a blended style at
ABN AMRO Asset Management (AAAM) that encompasses
both the use of a time series model and
also some degree of judgment in the selection
and allocation process of the strategies
generated by our model. The rationale for
using a blended style is that models tend
to be usually quite good at capturing returns
in the part of the returns distribution
which is close to a normal distribution,
however, judgmental processes tend to perform
better in the extreme part of the distribution
and possibly outperform models in capturing
rarer events. One of the reasons for this
is that they can capture information and
themes that may not be always discounted
by the market and therefore present in the
pricing structure. Having a blended style
is therefore recognition that both approaches
are complementary and result in a better
information ratio. Quite clearly this approach
has worked for AAAM who delivered an information
ratio in excess of one since it started
managing actively currency with its new
process in October 2000.
Capitalising on its experience and the robustness of its currency investment process, and the scalability of risk-adjusted returns in the currency markets, AAAM currency business has developed significantly in terms of its product range and assets under management. Although our currency investment process was principally designed as an alpha source for the global fixed income portfolio, it is now being used on a wide array of portfolios such as large balanced mandate funds tactical currency overlay. AAAM has also developed absolute return currency product that have provided investors with significant alpha (Fig. 2) and also potential diversification (Table 1).
Fig. 2: Cumulative return
JGB 10Y, Nikkei 225 and AAAM Currency Product
Source: ABN AMRO Asset Management
Ltd, Reuters
Table 1: Correlation between AAAM Currency Product1 and Japanese Assets
| Nikkei 225 | AAAM Currency Product | JGB 10Y | |
|---|---|---|---|
| Nikkei 225 | 1.00 | ||
| AAAM Currency Product | -0.14 | 1.00 | |
| JGB 10Y | -0.64 | 0.37 | 1.00 |
The demand that we see for such products has been great as both the returns generated by currency managers and the education provided by investment consultants have somehow convinced a greater number of investors about the usefulness of actively managed currencies in their portfolios. Quite clearly this has reflected in the size of the asset under management we now have. As an example, our currency absolute return product range which we started back in September 2002 has now grown to an impressive US$870 million under management at the end of June 2005. We believe that the features of currencies enunciated in the above as well as the strong trend in international investing will further support this growth and the rationale for currency investing in both retail and institutional product groups.
