bfinance: Interest Grows In Active Currency Management As Climate Improves

Jun 29 2017 | 11:25pm ET

Institutional investors are taking a more active approach to managing portfolio-wide currency risks, and in particular a greater appetite for active currency overlays, according to a new survey by investment consultancy bfinance.

This shift is being driven by a divergence in European and U.S. interest rates, geopolitical unrest and greater scrutiny of costs, the company’s research shows. 

A highly tailored provider assessment framework is essential with currency overlays and institutional asset owners looking to pursue active overlay strategies should carefully consider both upfront fees and transaction costs as there is a wide disparity in both, bfinance said in a statement. 

The research was presented in the company’s Managing Currency Risk in a Two-Speed World report, which also includes insight from FX transaction cost specialist New Change FX: Highlights:

1) Dynamic hedging and multi-strategy are now the primary styles of active currency overlay

Two primary styles of active FX currency overlay are currently prevalent – dynamic hedging and multi-strategy. Dynamic hedging is a pure trend-following strategy where practitioners ‘dynamically’ adjust hedge ratios to under-hedge stronger and over-hedge weaker currencies: such strategies only perform well when currencies ‘trend’. The advent of a ‘two-speed world’ as interest rates diverge with those in Europe remaining low and US rates rising has created a more supportive environment for these approaches.

Multi-strategy styles theoretically deliver excess return regardless of whether currencies ‘trend’ and apply a range of more fundamental models alongside momentum signals. The main examples of this are value, which is often based on purchasing power parity, carry, which is the most widely applied currency factor and macro, which examines economic fundamentals.  

2) Large disparity in fees and even greater differences in transaction costs revealed by independent assessment

The hidden costs in currency management have also been identified and, while front-end fees are widely dispersed with the more expensive providers being twice as high as the cheaper offerings, transaction costs vary by more than 400% and are harder to assess in a transparent common framework.  

Over the long term, better transaction costs can mean paying less than 3% of overall AuM in currency trading, in comparison with losing 15% or even 25% through poorer practices, as shown through an example portfolio representing the average UK pension pot. Managers offering lower headline charges have proved to have higher average transaction costs and vice versa, making it even more vital not to take fees at face value and consider the overall package of expenses. These differences are strongly correlated with the type of provider with banks generally offering principal relationships, executing all trades through their own institutions, while others operated on an agency basis with open architecture for execution.

3) Different forms of currency management

Investors need to take into account their whole portfolio when selecting suitable FX managers as active currency management has been playing an increasingly critical role in other asset classes.  This includes alternative risk premia strategies, now considered a mainstream asset class, where currency represents a key source of returns alongside equities, fixed income and commodities; CTAs, which have surged in popularity thanks to their diversification profile against more traditional risk assets also now incorporate a strong element of currency; and active fixed income managers which have increasingly been expected to use currency as a key source of return while yields have remained depressed.

Key takeaways for institutions from the report:

  • Active currency overlay strategies fall into two main families: dynamic hedging and multi-strategy with the latter offering a more all-weather approach but with greater complexity. 
  • Investors should avoid one-size-fits-all ratings. A manager assessment framework that is highly tailored to the client is essential in the active overlay sector. 
  • Transaction costs are highly significant in both active and passive currency management and conventional assessment methods are flawed.

The whitepaper provides considerable insight into the re-emergence of active currency management and the strategic choices available to investors when considering active currency overlays, according to Toby Goodworth, head of diversifying strategies at bfinance. "Investors are now looking to take advantage of the divergence of interest rates and we have seen a significant increase of interest in active overlays in particular. We also found that a highly tailored manager assessment framework is essential in the active overlay sector due to portfolio-specific performance outcomes, regional reporting requirements and the fit with other providers such as custodians.”

London-based bfinance is an investment consultancy providing specialist advisory solutions to institutional investors in 25 nations worldwide. These include strategic investment implementation, investment strategy design, investment manager search and selection, due diligence, analytics and monitoring.

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