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Tapping into Currency Alpha
Pierre Lequeux, Head of Currency Management
ABN AMRO Asset Management Ltd
November 2005

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
Nikkei 225
AAAM Currency Product
Source: ABN AMRO Asset Management Ltd, Reuters

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.

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