Considering currency

Raquel Pichardo-Allison: Neil, if you can just tell us a little bit about the index, how it works and why it was developed.

Neil Record: The index originally was a brainchild of ours. People were asking me, “Well, if the forward rate bias is as effective and reliable as you claim, what does it look like in ancient history?” Although we’ve been in the business since the early ‘80s, we weren’t operating anything in the forward rate bias in the ‘80s or indeed in most of the ‘90s, so the answer is, “Well, we don’t really know.” We can model things but why don’t we just design a concept from first principles without looking at the answers? 

The first principle is that if the nominal interest rate differential is a good indicator signal of the real rate differential, why don’t we have the simplest possible rule, which is why we take the five major currencies for which we have good spot and forward data for the last 30 years. 

If you have 100 units of investment, divide it into equal weightings of the ten pair combinations we can make out of the five currencies, and for each of the pair combinations each month just do a simple test – which of the currencies in the pair has the higher interest rate, and therefore by deduction, which has the lower? Buy the high interest rate half of the pair and sell the low interest rate half of the pair in a one month forward contract, wait a month, calculate the profit or loss at the end of the month – there’ll be a cash flow – and reapply the test, and mostly it will be the same direction in successive months because of the direction of the interest rate differential. 

Raquel Pichardo-Allison: Imogen, what was your original reaction when they came to you with this?

Imogen Dillon Hatcher: When we look at any potential partnership index, we’re looking for something that is easily replicable and is very clearly rules-based as well. With FTSE you don’t get any black boxes but good fundamental data. So, as you rightly said, we can push this index back 30 years. It’s rules-based and so ideal to form the basis of investment products, with a performance story that’s evident too. So you get the equity-like returns and bond-like volatility providing the investor with essential diversification benefits.

Raquel Pichardo-Allison: Underlying the creation of this is the belief that there is beta in currency. Matt, what’s your view?

Matthew Roberts: I think there are some betas in the currency markets. I think one of the things that I would say is that in the currency world, as it is today, you have overlay management and absolute return management. In the absolute return world, managers tend to use a variety of different styles. You could call those betas if you like. One of those might be the forward rate bias, one of those might be momentum, one of those might be value. They tend to extract that beta, if you like, and then try and outperform it with augmentations to those strategies. You might try using different weightings or different currencies in the sense of using a carry index.

Neil Record: But is that true? I think they try and outperform cash. In reality I don’t think clients measure us against these indices.

Matthew Roberts: Historically, that’s true. Until today, all absolute return currency managers have been measured against cash, but if this is a beta, then arguably they should be managed against the beta. I would suggest that performance fees should be measured against this index or something similar to it in the future. 

Neil Record: I think beta is a pretty high test. It’s got to be a pretty classy outfit to be a beta, pretty mechanical.

Matthew Roberts: That was an interesting topic, because there are a number of style indices available and what one could do is say, “There’s a risk premia associated with carry or forward rate bias,” and then say, “There are lots of styles of management within currency.” We only have one risk premia in equities, we only have one risk premia in credit, so it probably makes sense to only have one in currency too.

Neil Record: If you think about it from a manager’s perspective, we’ve been living in a world where everything we did was skill-based with alpha. We come across a thing which looks quite like a beta, because of all the criteria we apply, and it’s a big issue because if we say, “Well, actually, we were charging you on alpha but we think it’s a beta,” then there’s a big trade-off we have to think about before we go down this route. The trade-off is, do we want this to be an asset class with all the positives that brings? People like you guys will start thinking: “I can put this in the portfolio construction machine, press the button, it will say I’ll have 10% of the portfolio in this,” versus the significant reduction in fees. We’re not a beta manager at the moment at all, and we thought long and hard and decided that if currency is to survive as a serious activity in institutional investment, it probably needs to have a beta.

Scott Jamieson: Why?

Neil Record: Let’s call it human nature. I think in human nature, the standard way these things go is there is high quality but rather complex modelling of these alphas, there is over-optimism about what can be achieved by managers. Managers will partially achieve those and then they won’t, and then there’s a loss of confidence in the manager by the consultant and the client. Then there’ll be a new manager with some slightly different ideas and you roll round. 

That happens in the active space in every asset class, but the asset class remains secure. We don’t chuck equities in the bin, we just say: “This manager’s value style doesn’t work, it’s old-fashioned. Of course, he’ll come round later.”

If you do that in currency without a beta, without an asset class, you’ll have the industry lose confidence in currency as a vehicle for investment return, and to us as a leading manager in this space, it’s critical that doesn’t happen. I’m being realistic. The carry has had two very weak years cyclically and we have a dominant element, not solely, but a dominant element of carry in our return-seeking products, and I don’t want us as a business to have a consultant say “Well, it was a good idea but it didn’t work.” 

Scott Jamieson: It can be an acceptable investment universe without it being an asset class. Given the proliferation of cross-border investments currency is clearly an unavoidable risk exposure. That’s an investable universe. It doesn’t mean it’s an asset class.

Raquel Pichardo-Allison: Colin, is this index something you would consider within your portfolio?

Colin Hammond: The $6m question. I think it is more of a persuader when you see historical data, but then again the problem for pension funds is we’re always in danger of investing backwards if we’re not careful.

Neil Record: Returns have been weak for the last two years. It’s a buying opportunity. 

Colin Hammond: Those are the times where you start thinking, “Well, it’s not done well recently. Is it going to come back?” Then you have to try and understand why it hasn’t done well over the last two years and whether, it’s because something fundamental has changed and it’s not going to return, or whether things have normalised and this will recover. 

John MacDonald: It’s not like a normal asset which, when it goes down in value it becomes cheap because of some inherent value.

Neil Record: Why not? Is the pound cheap or expensive?

John MacDonald: Because a normal asset like an equity has a return stream theoretically, dividends or – 

Neil Record: And it gives high yield.

John MacDonald: – which you can value.

Neil Record: That’s true. So equities will give high yield as they get weak and currencies won’t, but what they will do is they’ll produce cheaper goods. So you do have the negative feedback. 

John MacDonald: Rather than saying that the pound is cheap and therefore has inherent value, I’m saying that carry as a strategy, because it’s gone down in the last two years, has not suddenly become cheap. I don’t think you can say that. There’s no inherent value to “carry” as an “asset class”. 

Neil Record: I think there is. I think if you have an investment currency that’s weak and a funding currency that’s strong, if they don’t flip their positions then you can have an elastic band” that attaches equities to what you might call some fair equity value and it will have long-term mean reversion. I think you’ll definitely have long-term mean reversion in this. You’ll have a beaten-up currency. At some point it will bounce and then it will be very strong. 

Raquel Pichardo-Allison: John, is this something you would recommend to your clients to have some kind of passive exposure to currency?

John MacDonald: I don’t see why not. I think from a governance point of view it’s something you can just leave to run in the background. The number of manager meetings you would have would be reduced substantially because you wouldn’t have to talk about strategy. You know what’s going on. It’s just running away in the background. I can see the value in that. And as Colin says, historically performance is good.

Raquel Pichardo-Allison: How would the return and risk profile of a product that tracks this index compare to the return and risk profile of more traditional assets?

Neil Record: We will be happy to have any mandate let to us with this index as a benchmark, and we will offer our clients an excess return over this benchmark and information ratio over this benchmark. We’re happy to judge performance fees over or under this benchmark. 

We’re also happy if the client says “No, no, this is all rubbish, I don’t understand what this is about, just make me some money”. But it is my hope, and my guess, that some clients will come in with their advisers who say, “Invest in this asset class and choose passive or active.” If it is passive it will probably go to an ETF or maybe large passive mandates, and if active it will go to the usual suspects and the usual suspects will have to think on their feet pretty damn fast about how they’re going to incorporate this. 

Raquel Pichardo-Allison: Stephen, would you anticipate a lot of managers picking up products based around this index?

Stephen Saint-Leger: First of all, let me preface that everything I say is in a personal capacity. My experience is that managers pick up products where they see demand from clients, and so it’s a little bit of a chicken and egg. 

Imogen Dillon Hatcher: We recognise that investors need time to be comfortable with new and innovative investment options. These things normally take between 12 to 18 months before you see significant pick up, but we’re optimistic.

Stephen Saint-Leger: I’m sure you have done your homework but again I would caution that it’s like consumer confidence readings. There is quite often a divergence between how people say they feel or what their intentions are and actually what they do. I remember not so long ago there were similar new products that came on, the so-called 130/30-type products, for which there seemed to be a lot of interest and positive feedback. These don’t seem to have translated into such a large amount of products or business as was originally polled, I would say.

Raquel Pichardo-Allison: Stephen, will this change the way that you evaluate active currency managers?

Stephen Saint-Leger: I don’t know. I think our approach is to try to do our homework very thoroughly rather than take anything for granted. We would want to spend the time to do the research without wanting to reinvent the wheel but to go back a long period of time to analyse things. In our traditional models we use data going back to 1900 for the established asset classes, so I think we would need to do our homework.

Neil Record: There is an interesting issue for those of us who are familiar with the currency world, that there were some massive regime changes just prior to the period which we’re talking about, and the critical one is the breakdown of Bretton Woods, and prior to that, and prior to the Second World War, we had gold standards and the various comings and goings. So the data is discontinuous, really, prior to about 1971. Really going back beyond 1971, it will fall to pieces. 

Stephen Saint-Leger: I would hypothesise that currency management is probably coming back more into fashion in one way or another simply because the return outlook, or some people like to call it beta for the traditional asset classes, looks to be a lot less appealing for the next several years than it has been. So I think institutions are going to be looking for other areas where they can make money rather than the traditional asset classes. 

Matthew Roberts: Is an active currency approach on a stand-alone basis the best way to do that? I just wonder whether it is most optimal to invest in currency on a stand-alone basis or whether it makes more sense for a pension fund to do that as part of a broader strategy or part of a bigger asset class.

Raquel Pichardo-Allison: John, what do you think?

John MacDonald: I think currency as an asset class is relatively easy to understand and a lot of our clients already have it in their portfolio. Yes, you can access the risk premium of currency through these other routes, but in terms of explaining to clients the types of assets that are out there, you can say: “Look, there’s this asset class currency. Record does this. It’s very simple to explain. This is how the returns are generated and this is the historical performance. Why not consider it?” You can’t say that currency as an asset class will not survive

Matthew Roberts: I don’t suggest that it won’t necessarily survive and I think there are absolutely strong currency managers out there with interesting, differentiated approaches that would be additive to a pension fund’s line-up. However, having five or 10% of a pension scheme’s assets in one or two currency managers, I’m not necessarily sure that is the best way to go about it. If you look historically, a lot of the products in currency, the absolute return products in particular, are quite high volatility products and tend to use reasonable amounts of leverage and tend to charge reasonably high fees – might be up to two and 20-type fees for the high volatility products. If you have that situation, then that’s a hedge fund to me – lots of leverage, lots of high fees. That is a hedge fund. In particular, some of the structures associated with those fees are quite difficult to understand, so in that context I think you should compare it to other hedge funds, not necessarily as an additive thing to equities and bonds.

Raquel Pichardo-Allison: Colin, would you say that the fact that the index exists will make investors more comfortable with investing in currencies?

Colin Hammond: I think something like this index, where you can see whether investments have gained or lost, gives you some comfort, and should help people make a decision. I still think that there’s going to be an issue about how investment in a currency index is funded. Do I need to put money up for this or use leverage in the traditional way of managing currency? What is the manager going to be doing, and how would I invest in this index anyway? That’s the bit I don’t really understand at the moment. 

Alex Beveridge: Can I just jump in, because Imogen, you have obviously created indices for lots of different sectors and asset classes. Did you find that when you created an index it then brought more investment into that area as it made people more comfortable?

Imogen Dillon Hatcher: We believe so yes, because you’ve got something that is rules based, it’s nice and transparent and it essentially does what it says on the tin. If you then put that together with a strategy that is measurable and holds a low correlation to other asset classes, it provides an attractive option to investors. We know that in the current climate the investment community is aware of the importance of transparency and so accessing new markets through a passive tool like an index is appealing.

Raquel Pichardo-Allison: What kind of conversations have you had with pension funds about this and how have they been reacting?

Imogen Dillon Hatcher: We’ve been going out to investors, partly with Record and partly by ourselves in regions including Asia. We’ve had a good reaction in Hong Kong, Taiwan and Singapore because they see that currency could perhaps move away, or their strategies towards currency could move away, from being transaction only-based. 

Raquel Pichardo-Allison: Are they more receptive to it?

Imogen Dillon Hatcher: Yes. We are speaking to those we hold relationships with, so for example we’ve been holding dialogue in the States which has been quite successful and that’s a tough market to crack. In the UK and Europe, again there are some interesting conversations going on but it’s certainly receptive.

This is a base-line and will we add other currencies to the series? Will we look at other underlying mixes as well? Yes, we probably will. And what will happen is this will be the starting point and some people will adopt it and some people will want their own customised versions which we can create through our custom team.

Scott Jamieson: My concern is this is analogous to the FT30, and who uses that? Neil’s opportunity set is not comparable with the eligible universe within the proposed index and given the currencies missing, back testing will likely show it an easy index to beat.

Imogen Dillon Hatcher: It’s certainly a strong historical starting point. 

Raquel Pichardo-Allison: Are five currencies enough to be a proper proxy?

Imogen Dillon Hatcher: As a starting point? Absolutely. We’ll respond to market demand, to additional research and we’ll build out from there. The point is innovation has to start somewhere; in this case it is with the world’s five largest traded currencies. It’s about providing investors with choice and then expanding on it.

Raquel Pichardo-Allison: Stephen, what’s your instinct on whether or not five currencies are enough as a proxy?

Stephen Saint-Leger: I think my personal concern is more to do with, as mentioned, the timescale of data. Another question that’s been touched on here, is the events of the last two years have been absolutely momentous, looking at it in the long historical context. I think it’s early yet to be able to draw the conclusions as to how the dust will settle. One possibility is that we are actually witnessing regime change in the markets of a kind that we don’t yet fully understand.

One can quite plausibly make the case that the outlook for the new regime could be something that looks a little bit perverse going forward. Namely we know that one of the causes at the root were the huge global imbalances between saving countries and over-spending countries, and it may be that these are not being addressed fully. We are trying to paper over the cracks. So you could quite easily envisage a new regime where the deficit countries are having to increase their interest rates or the yield on their government bonds is having to increase to be able to fund themselves at the same time as their currencies are depreciating. In other words, the market, in its desperation to try to close these imbalances, which is being resisted by the authorities and the governments, is really wanting to push down the higher yielding currencies to try to close these gaps, and the governments are trying to resist on the other side, and this push-me pull-you, we don’t know how it pans out.

Raquel Pichardo-Allison: If a pension fund is incorporating this index into their asset allocation, what role does it play within their asset allocation? Is it a risk diversifier, is it a return generator? 

John MacDonald: Both. Past performance figures show that the risk return calculation is good.

Neil Record: It’s good for an asset class. I think an asset class is a 0.2 or 0.3 information ratio for excess return over risk. Equities typically, 3% excess equity risk premium over 15%… that sort of number. That’s 0.2. This is 0.5. You might say 0.5 is excessive. I’m inclined to agree. I don’t think mechanical processes, risk premia, probably need to offer 0.5. Why has this offered this over 30 years? Because no one’s been exploiting it, not systematically. If the world gets this idea and says “Hmm, I like this”, the arbitrage may push it down to 0.2 but not below. 

Scott Jamieson: In a presentation to a pension scheme on currency, the first thing I was countered with was a recollection of what George Soros reputedly did to the pound during the ERM crisis; that’s how the members and trustees equated currency. Clearly this is a historic and somewhat biased interpretation of history, but they just felt that the currency market was a den of thieves, which of course is wrong, all markets are populated by thieves! 

I think the existence of this index, however flawed I might believe it to be, will make those who see currency as zero-sum or just a random walk, realise that “we’ve got to think about this.

Neil Record: It’s the strongest case in favour, because that comes from a sceptic about what I call the detail. I think that’s absolutely it. It’s Colin’s point. It will mean you can put something in front of a trustee who looks at it and says “Can I have this?” And somebody will say “Yes, you can have an ETF at ten basis points.” “Done, fine. Okay, I’ll put in X million and I’ll get what I get.”

Raquel Pichardo-Allison: John, are you concerned about the number of currencies? 

John MacDonald: I don’t think so. I think from one point of view I guess they account for something like 90%, 95%, of volume of the currency market globally anyway. If you went to less liquid currencies, I think the strategists might run the risk of – because you’re rolling on a certain date, rebalancing on a certain date – leaving yourself open to exploitation by other market participants. 

Neil Record: I would say it’s a problem of success. It’s a very big market. We think that when you have rule-based industries that become very large – such as anticipation of who’s coming into the FTSE 100, which is an absolute classic – you know it’s going to happen and the price goes up because you know the index trackers are going to buy. So then indexes try and finesse that a bit to get the same effect, and then the active managers say, “I have a great opportunity here”. So there might be a bit of that, but it’s a very, very big market with a lot of other stuff going on, so we’re going to use market standard. It will be quite hard for the exploiters to work out what the implications are going to be.

Matthew Roberts: I would say equal weighting is a concept that I could support. Look at some of the problems that you could associate with the bond indices. We would be big supporters of an equal weighted bond index (or at least not weighted by issuance). You get all sorts of problems with concentration in bond indices and have done for a number of years, and actually that came to a head again last year. So having five currencies which represent the highest by volume across the markets is good, but actually more of a diversification within that equal weighting construct makes sense.

Raquel Pichardo-Allison: One of the large investment trends that we’ve been seeing over the past few years is a separation of alpha and beta, and it almost seems like this is a continuation of that.

Colin Hammond: My thoughts are that people have perhaps just seen it all as alpha previously, i.e. if you made money it was alpha and if you lost money, you didn’t stay! 

Neil Record: I think that’s a very telling observation. That’s exactly how the currency and indeed lots of active mandates work.

Colin Hammond: I think another issue will be the terms for investing. Is this a vehicle for limiting your down-side, is that how it’s going to work? In the past if you’ve been investing in active currency you could gain or lose an unknown amount. If you lose you have to find cash and if you gain you receive cash, which causes its own issues.

Neil Record: There are no risk controls in this process. This can go down and down and down but it won’t go to nought because of the way it’s constructed. We rebalance the scale of the activity every month, and every month, unless you have in one month one currency go to nought or infinity, this cannot go to nought, and therefore it will look like an equity. It will behave like an equity, it will have that convexity as it goes down and convexity as it goes up. That’s the way it works.

Scott Jamieson: My concern was actually that somehow investors who have a very global reach currently, might be deluded into thinking, “Well, I have dealt with my currency problem”. Actually the more interesting question is, if one accepts that globally, local currency equity correlations will remain high, does a local currency equity portfolio plus this, give you the same formal characteristics over global unhedged portfolio with less volatility? And it probably does on their basic assumption, but the real concern would be: I can actually go buy even more global equities and put some stuff into this and my currency issues have been dealt with. That would be a very, very dangerous position.

Neil Record: But, Scott, every consultant knows about international allocation currency risk. This conversation happened 15 years ago. One of the things they recommended their clients do was passive hedging plus currency alpha as an efficient way of getting your currency in the right place with high information ratios. So here you could have passive hedging and hold the index. No managers involved, no alpha, no high fees, all simple, and I’ve just moved myself up the efficiency curve.

Raquel Pichardo-Allison: Stephen, have you had managers approach you about currency as an asset class? Is this something that other managers have been talking about?

Stephen Saint-Leger: (My colleagues have) been approached by currency managers to show their wares. For full disclosure, I used to be a currency manager, a long, long time ago, and I went to many of the conferences relating to that. My impressionistic take is that it’s always had trouble gaining traction. It’s one of the fascinations of currency management, because it’s very, very difficult to find managers that are able to sustain skill or demonstrate skill. 

Neil Record: I think that’s very interesting. I think it’s also a very accurate assessment of the world’s view. 

Raquel Pichardo-Allison: What do you think has been the most prevalent long term change in the way investors have viewed currency since the global financial crisis?

Neil Record: I’m not sure. I think they have been surprised, as we have, that currency – call it investment currencies and equities – have become very highly correlated. 

Colin Hammond: We took a step back. We just took our money off the table. It was one of those occasions where you sit there and go, “I don’t understand what’s happening. It’s something I can take my money away from without risk, I suppose.” 

Raquel Pichardo-Allison: Is that a long term position then?

Colin Hammond: No, not necessarily. It might be. But that’s what we’ve done, and when we came into September last year when markets were in danger of just collapsing all around, we looked and said to the consultants, “Okay, what should we be doing to react here? Active currency investment has worked in the past but we don’t know what’s going to happen going forward, let’s come out.” 

Raquel Pichardo-Allison: What about you, Stephen?

Stephen Saint-Leger: I think it’s fear of the disintegration of value of the paper currencies of the major indebted countries which is prompting some thinking towards greater use of some of the so-called emerging market currencies as well as real assets.

Raquel Pichardo-Allison: Scott?

Scott Jamieson: I wish all the pension funds I met were that deep-thinking. Two thoughts arise. Firstly, given the range of issues funds have had to deal with, many consider currency to be the least of their problems. Secondly, and local to the UK, is the sense that: ‘this passive hedging is not all it’s cracked up to be’.

Matthew Roberts: I would say that I think it’s a recognition that value for money in active currency is hard to find.

John MacDonald: On the active side it was correlations going towards one, realising that it didn’t diversify just as much as everyone expected. On the passive side absolutely it was shock at the impact on cashflows as the pound declined.

Imogen Dillon Hatcher: I think there were two reactions from an index provider’s perspective. Firstly, there was a huge shift towards passive investment, as transparency and fees became an issue. 

The increased popularity of low cost exposure to an asset class meant there was a big resurgence in index tracked products. Secondly, diversification across the asset classes and looking beyond equities has become an important consideration. So it’s been important for the index provider to create that choice and innovation for the investor and that’s what we have done here.