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FUND MANAGERS ARE beginning to take advantage of increased investor interest in currencies by capitalizing on their currency overlay teams to offer higher risk/return currency investments in the form of hedge funds. But some investors are sceptical about what these currency hedge funds have to offer other than an increase in fees.
Gartmore, Barclays Global Investors and GAM have all recently launched currency hedge funds. State Street Global Advisors is planning to do so in the second quarter of this year. Although several other currency managers, such as JPMorgan Fleming, Rhicon Currency Management and Bridgewater Associates, have offered such alpha-generating, absolute-return funds to investors for many years, the asset class is attracting renewed interest from investors and currency overlay managers.
As a result, the number of currency funds generally has been rising. The number of funds in The Barclay Group’s Currency Traders Index has peaked this year at 72. This compares with 55 in 2003, 49 in 2002 and 47 in 2001. Sol Waksman, president of The Barclay Group, says: “The number of currency-only programmes included in our index has blossomed due to money flowing into the entire managed futures sector. Assets of the total managed futures sector in 2003 increased by around 70%.” He adds: “Interest [in managed currency futures] peaked in 1995, then trailed off for eight years and now it’s back up.”
The assets invested in currency funds has also increased. In the third quarter of 2003, the 49 managers in the Parker FX Index had around $9 million in assets under management. By the middle of last month, the assets of those managers had grown to $11 million.
Currency management began as a way to deal with the currency risk created by investing in foreign assets. Then, about 10 years ago, investors began to ask their currency overlay managers to increase the alpha generation within these risk management programmes. Investors now seem to be interested in investing in stand-alone currency funds. Paul Duncombe, head of currency management at SSgA, says: “Currency overlay usually has about 3% active risk. A currency hedge fund has about 10% to 12% risk, and is about 3 to 3.5 times leveraged.” Paul Skinner, head of fixed-income business development at Gartmore, says: “In order to get that sort of volatility (10% to 15%) you have to have leverage. Above about a 5% to 6% tracking error you have to start using leverage to get the returns.”
Although currency overlay funds are restricted by the parameters of a client’s account, currency hedge funds enjoy more freedom. “Every time you free up a manager, the information ratio improves. That’s proven,” says Skinner.
The significant dollar decline over the past few years has awakened investor interest in currencies in general at a time when equity markets have struggled and bond yields have been low. Thanos Papasavvos, currency strategist at Credit Suisse Asset Management, says the trend in the market over the past few years has meant managers have done well.
For the full year 2003, The Barclay Group’s Currency Traders Index was up 11.06%. This was its best performance since 1997 when it was up 11.35% for the year. In 2002 it was up 6.29% and the index has posted positive returns for the past nine years. The Parker FX Index was up 19.06% for the 12-month period to the end of January. In comparison, the S&P 500 DRI Index was up 28.55% in 2003 but was down 22.19% in 2002 and down 11.89% in 2001.
In fact, the average manager in the Frank Russell universe with a five-year track record has outperformed. This is partly because currencies are so liquid, with a total daily turnover of $1.2 trillion, which means the costs of dealing are very low. In addition, non-profit maximizers, such as tourists, corporates and central banks, account for more than 75% of that daily volume. Another manager says: “In no other asset class do people just deal at the price they’re given. They’re willing losers, which allows us pros to make money out of them.”
Investors have also been attracted by the lack of correlation that the asset class has with equities and bonds. Mark Rzepczynski, president and CIO of John W Henry – an alternative asset manager that is one of the largest managed futures advisers in the world – says: “The advantage of currencies is that the set of factors that could affect currencies are different for equities and fixed income.” He adds: “For example, in the fourth quarter of 2003 the [US] dollar declined at the same time as there was a rally in fixed-income markets. Just because you say there’s a connection between currencies and interest rates doesn’t mean they affect performance.”
As a result, managers feel that clients are ready to invest in pure, high-alpha-generating currency funds. “The progression from risk management to alpha generation has now gone to the stage where people are looking for high-level-alpha generation,” says Skinner. “This is where the funds come in.”
Most investors in currency hedge funds are funds of hedge funds. In fact, some managers have created dedicated currency funds of funds. For example, Julius Baer launched its Global Currency Opportunity Fund last November.
Pension funds and banks also invest in currency funds. Andrew Dales, director of currency research at BGI, says: “In the UK about 5% to 10% of pension funds are doing something with currencies on an active or passive basis.” However, pension funds are taking a bigger interest in currencies. Brian St John-Hall, associate at Hewitt, Bacon and Woodrow, says: “Two to three years ago, if you said ‘what about currencies?’ it wouldn’t have been in the top 10 of trustees’ lists. Now it probably is.”
One fund of hedge funds manager, says: “A lot of institutions give [currency hedge funds] money because it increases the volume through their FX desk. For example, [a hedge fund says] ‘Give us $20 million and we’ll trade it through your desk.’ They make money and benefit from the transaction costs too.”
Sceptical Despite the interest in currencies, some consultants are sceptical about fund managers launching currency hedge funds. One investment consultant says: “These are just fund managers thinking about how to make more money out of currencies.” He explains: “I think that it’s just simply, given these currency movements there’ll be some appetite by some investors for currency funds. The easy way to take advantage of increased appetite is to run a hedge fund because you’ve got a currency team and model. And if people buy it and your performance works and you get more investors, it’s very good for you because the fees are fantastic. They are four or five times the normal long-only mandates.”
One fund of hedge funds manager says: “Gartmore has got cash to flash around. They think there aren’t that many around so if they have a reasonable track record it’s a good proposition.” St John-Hall says: “The thing I really, really can’t stand about hedge funds is that I could probably get a currency manager to run a [similar] fund and not get charged the same fees.” An independent currency manager agrees: “There’s more money to be made from hedge funds. You get 20bp as a currency overlay manager and you’re restricted in what you can do. Hedge funds get a 2% management fee plus an incentive fee.”
It’s not surprising that some investors are sceptical about big fund management houses launching currency hedge funds as simply a way to add another feather to their hedge fund hat. But the fund managers say their efforts come from client demand. Gartmore’s Skinner says: “We responded to our clients as well as knowing that the culture at Gartmore is about growing hedge funds, building hedge funds, moving into that space.”
Some funds of funds prefer to invest in multi-strategy style funds that take advantage of opportunities in currencies, rather than pure currency plays. Andrew Gibson, investment manager at fund of hedge funds International Asset Management, says: “I find the multi-strategy approach is a more sustainable way to trade currencies. Currency activity is very cyclical … Opportunities might not be consistently there and short-term trading is very volatile.”
Craig Reeves is managing director at fund of hedge funds Platinum and has experience working with currencies. He says: “[Platinum has] never done a currency fund. We were going to do a Platinum multi-currency fund [about four years ago] but before we even launched it one of the managers blew up.”
At least one independent currency manager has made the decision not to launch a currency hedge fund – despite having to turn down money from eager investors – as a result of the lack of diversification offered by this type of fund. “We’ve passed on the business [of pure currency funds] because by limiting our positions to just currency markets you only get about 80% of the total alpha from our products.”
Regardless, fund managers Gartmore, BGI, GAM and SSgA have all decided to launch currency hedge funds that implement active currency management rather than an active or passive overlay for a client’s investment portfolio. Bill Muysken, global head of research at Mercer Investment Consulting says: “The client just invests in units in a currency fund and gets access to the active currency management that way. We think that makes sense. It’s probably a more efficient way to deliver the active currency management to the client [than active overlay].”
New funds At the beginning of February, Gartmore launched The AlphaGen Currency Fund to investors, making it the 12th in its hedge fund range. It invests in the G7 currencies and in March had $53 million in assets under management. Skinner says: “We’re getting a big inflow on April 1 which will take it up close to $75 million. We expect it to be up to $100 million fairly sharpish and then once you hit $100 million, growth accelerates because you become an investable size for a lot of funds of funds.” Gartmore plans to limit the fund’s size to $500 million. The hedge fund charges investors an annual management fee of 1.5% and a performance fee of 20% subject to a highwater mark, meaning that the firm doesn’t take it unless the fund makes an absolute return.
Gartmore’s hedge fund was seeded in April last year and posted a net return of 8.5% by the end of February 2004. It has a Sharpe ratio, or information ratio, of 1.79. This measures how good a manager is at turning each unit of risk into return. Skinner says, referring to a Frank Russell USD 50% Hedge Composite Universe chart for the five years ending December 31 2003: “Gartmore is one of the few that sits in the prime area of having an information ratio of above one.” He adds: “Equity managers, however good they are, tend to have an information ratio of about a third and bond managers half to a third.”
The fund has an annual volatility of 7% to 10%. “This means it’s going to generate returns of 10% to 15%,” says Skinner. In comparison, Gartmore’s currency overlay risk reduction product has an annual volatility of 2% and its currency overlay alpha generation product has an annual volatility of 2% to 3%. Gartmore also runs managed accounts at a volatility of 15%. “We do have more risky accounts run specifically for large institutions that want to make [around] 20%.”
The fund manager has been involved in currency management for 16 years and the currency hedge fund is run by Gartmore’s currency team, which Bob Jolly has led for 15 years.
Gartmore’s currency strategy is systematic with some discretion employed. Out of the three styles of quantitative management: long-term value management, trend following and return forecasting, Gartmore uses a combination of the last two. Skinner says: “The brilliant thing about combining those two is that they are very lowly correlated, or the correlation is about 0.17. So when you combine the two you get a lovely consistent return.” (see chart below) He adds: “We’re producing consistency out of an asset class that has periods of lumpy returns. That is, there are periods when currencies are really dull and boring and go sideways for four to five months and then you’ll have a period like we’ve just had where there are huge moves.”
Despite the robust quantitative model, Skinner says the team’s discretion is invaluable. For example: “Both of our models have been telling us to be short the dollar relative to the yen. And if we were pure quant people we would have followed that and we would have been hurt quite badly because the Bank of Japan has been intervening,” he says. “Our models are saying the dollar is a massive sell against the yen but we know that the Bank of Japan is going to stand in there so we’ve been overriding the model and not doing the trade. In that way we stop ourselves getting bounced around by the Bank of Japan.”
In August and September Gartmore took long positions in all currencies versus the weakening dollar and generated healthy profits. Bob Jolly, head of fixed-income portfolio construction at Gartmore, says: “We believed that the US dollar would periodically benefit from the stronger growth outlook. But, [we believed] a low interest rate, a highly valued stock market relative to the rest of the world and an unsustainably large current account deficit would result in a trend depreciation of the dollar.”
Gartmore is not the only currency investor that has been short the dollar. It’s been a crowded trade, which means there is greater sensitivity in the market if it moves the other way. “When you have a lot of people all going one way you get nasty whips,” says Skinner. “You gets nasty little short covering rallies and things like that. And, so you get intra-trend volatility that becomes more exaggerated.”
Gartmore has also bought the dollar this year to take advantage of rallies. In mid-December until mid-February Gartmore sold Canadian dollars – following the Bank of Canada’s decision to cut interest rates – and bought US dollars, to take advantage of the sharp dollar rally. Although Gartmore believes further dollar strength is possible in the short term, it believes the arguments for structural dollar weakness remain in place.
In August last year, BGI launched its own currency hedge fund called the BGI Currency Fund. This fund invests in 11 currencies and BGI plans to add a further eight emerging-market currencies in April this year. The size of the fund is around $30 million. The target performance is to deliver around 10% per annum with a risk target of 10% to 12%. In the seven months to the end of February the fund’s US share class was up 14.9%, with 11% volatility. The hedge fund charges investors a 1% management fee and a performance fee of 20%.
At the same time, BGI launched the BGI Ascent Currency Fund and a US equity sub-fund. The BGI Ascent Currency Fund and subfund are pooled, active overlay devices. BGI’s Dales says: “It has a 35% risk per annum [with a target return of 28% per annum] but only a very small part of the pension fund is invested. Being a pooled fund makes it easier for pension funds to invest in these things.” He explains that from an administrative point of view a pooled fund is simply a unit trust and the minimum fee can be a lot lower than it is for a hedge fund. The BGI Ascent Currency Fund invests in cash and currency forwards and the US equity subfund invests in the above mentioned fund as well as S&P equity futures. Together, these pooled funds have around $200 million in assets under management.
A third institutional pooled currency fund launched by BGI is the BGI Sterling Currency Hedging Fund, which is a passive fund. The fund’s positions are long GBP and short international currencies. “It therefore acts as a hedging tool for UK institutions,” says Dales. “The fund also buys S&P futures. So, the fund returns are S&P plus hedging effects.”
Mercer’s Muysken says: “One [type of currency fund aims] to help clients implement passive hedging, which makes a lot of sense because one of the reasons that smaller clients haven’t been able to consider currency hedging up until now is that there hasn’t been any cost-effective means for them to do it. These pools make it possible for smaller clients to consider it.”
Taking advantage of market sentiment BGI’s currency management model is based on fundamental value, economic environment and market sentiment. One of the ways that BGI gains insight into market sentiment is by looking at international capital flows. “We’re one of the largest buy-side buyers of currencies. Therefore, we try to extract data and information such as capital flows across our counterpart’s desks,” says Dales. For example, BGI’s currency team made money on the Norwegian krone last year after it saw a lot of money flowing into Norway.
Another minor currency bet that BGI made last year was to go long the euro and short the Swiss franc. “It was not very volatile but the return per unit risk was one of the best,” says Dales. “We thought the Swiss franc got overvalued, and the central bank wanted to weaken the Swiss franc against the euro.”
Fund manager GAM also launched a currency hedge fund. The GAM Persaud Global Currency fund was launched in December 2003, but the manager declines to comment on it.
SSgA plans to launch a currency fund in in the second quarter of this year. “It will be based on our currency overlay product with the addition of an options strategy,” says SSgA’s CIO of hedge fund strategies Chris Woods. The fund will take bets across the G7 and emerging-market currencies and will aim for double-digit returns.
One of the key challenges for the currency strategy this year is that currency trends are not as clear as they have been. Christopher Brandon, co-founder of Rhicon Currency Management, says: “Generally last year was a good year for trend followers because there were pure identifiable trends. This year is a little more difficult because the trends are less clear.”
A measure of the level of uncertainty about movements in the markets is the fact that the currency team at CSAM went neutral in all currencies for the first time in three-and-a-half years on February 23 this year. In mid-March, Thanos Papasavvos, currency strategist at CSAM, says: “The big question is whether we’re going to continue to see a trending market or see changes. We could be in a period for 18 months where the market range trades between 1.50 and 1.30 [against the euro].”
The Japanese central bank has contributed to this with its currency interventions. However, in February the BoJ took a different tack. “Rather than just prevent the yen from rising they’ve been trying to prevent investors from making money on either side of the trend,” says Duncombe. “To break the pattern of expectations, the Bank of Japan has driven the dollar/yen up and then let it collapse.” CSAM’s Papasavvos says: “It’s harder to make money if it’s a ranging trend rather than trending.”
The trending market has given the illusion of low volatility, according to Barry Colvin, CIO of fund of hedge fund Tremont. “They’ll be surprised that volatility will pick up quite a bit when it starts trading range-bound,” he says. Brian Strange, vice-president and client portfolio manager at JPMF, says: “You want volatility in this market because you need movement to make money. The challenge is getting it right.”
Industry players are debating whether to be bearish on the dollar due to trade deficits in the US or whether it is beginning to look undervalued. Some feel the dollar has more downside and that it has been consolidating, while others feel the currency could begin to strengthen. In mid-March JPMF’s Strange said: “We lean more towards the dollar being [currently] undervalued.” BGI, on the other hand, remains negative on the dollar. “The dollar is beginning to find levels of fundamental value in particular against the European currencies. However, we believe that risks to holding US bonds and equities are relatively high and this means that the US will not be able to create enough investment demand to fund its very large trade deficit.”
The Asian currencies, in particular the yen, have also captured the attention of currency market players. Gartmore’s Skinner says: “It’s now all eyes to Asia and what happens in the coming year with the Asian currencies. Because, clearly we have the Asian economies that are really growing and going places and yet you’ve got the Bank of Japan that’s trying to stop the appreciation.”
