| Currency alpha 101 |
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| 28/10/2007 | |
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Samarjit Shankar, Director Global Strategy at Bank of New York Mellon, answers this week's questions on currency alpha. 1. How do you achieve currency alpha? What tools do you employ to generate such alpha? Currency alpha can be generated by raising an investment portfolio's total return in two ways: a) active or dynamic currency hedging: generates excess return by adjusting currency exposures that are constrained by underlying foreign asset positions (such as international equity or international bond holdings). b) pure alpha: active currency positions can be taken independent of underlying asset holdings By optimising the time-series and oscillatory properties of investor flows, alpha can be generated consistently across both "up" and "down" markets, and by using both momentum and contrarian strategies. As a result, flow-based strategies have yielded high information ratios, or risk-adjusted returns that not only assist in active currency overlay, but also in absolute return strategies (where, for example, even the currency denomination of cash in a global bond portfolio becomes an active decision so as to generate alpha at low risk levels.) 2. Are there industry benchmarks to measure currency alpha? How have they fared historically? When looking at hedging international portfolios, the choice of benchmark ends up being based on various factors such as the base-currency of the portfolio, the domicile of the investor, the proportion of foreign currency exposure, the extent to which the investor wishes to manage currency risk, and the investor's view of long-term returns. Once a decision has been made to hedge a portfolio's international currency exposure, typical mandates allow the manager to vary the hedge ratio between 0% and 100%. Polar benchmarks of 0% (fully unhedged) or 100% (fully hedged) represent a tradeoff between minimizing transaction costs and risk reduction. When performance is measured against an unhedged benchmark, it is difficult to add value when the base-currency is falling. On the other hand, when performance is measured versus a fully hedged benchmark, adding value becomes difficult when the base-currency is rising. Consequently, managers often opt for a mid-point benchmark, such as 50% hedged that gives them opportunities to add value in both rising and falling foreign currency environments. When assessing the relative performance of various active overlay strategies, the constraints and benchmarks should be comparable across portfolios. In contrast, the benchmark for measuring pure alpha or absolute return strategies is usually LIBOR or a similar money-market index. Historically, active overlay strategies have targeted alpha of 1.5%-2%, while unconstrained pure alpha strategies can generate up to 4%-5% excess returns with no leverage. 3. What are the advantages and risks of a currency alpha strategy for pension funds? The key pros in favor of a currency alpha strategy for pension funds are that active currency management can exploit the inefficiencies in foreign exchange markets, while at the same time offering a source of return that appears to be uncorrelated with underlying investments in equity and bond markets. On the flip side, the key risks to guard against are excessive transaction costs and the possibility of cash-flow mismatches arising from hedging activity. As is evident from the trend in recent years, a growing number of pension funds worldwide are looking into alternative investment strategies that entail looking at currencies as a consistent source of pure alpha. When viewed from an overall portfolio perspective, not only does adding active currency strategies widen the opportunity set by introducing the possibility of additional returns with moderate volatility, but the lack of correlation with underlying assets reduces portfolio risk. In general, several studies have found that currency overlay strategies help not only to reduce currency losses, but also boost returns over time. A pension fund can choose whether to employ these strategies with respect to active hedging or as a source of pure alpha. 4. Why is currency alpha as a strategy gaining wider acceptance? The growing popularity and wider acceptance of currency alpha strategies can be attributed to two key factors: a) Recent years have seen increasing globalization and financial integration. As a result, the extent of exposure to foreign markets has increased and with this has grown the need to actively hedge these international equity and/or bond positions. b) Going forward, we are entering an environment wherein equity market returns are unlikely to be as heady as during the bull-run in recent years, while fixed-income yields have been wallowing near historic lows. As a result, global investors are increasingly seeking new and uncorrelated sources of alpha. Currency alpha strategies that look to enhanced overlays or pure alpha plays in the foreign exchange markets provide an appealing investment alternative. |
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Articles of the same Serie : 101 |
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