Active Currency Management Research Articles

Practical Applications of Currency Crowdedness Generated by Global Bond Funds

Practical Applications Summary “There has been a great deal of research on factor investing in equities, but far less on the fixed income side,” says Gueorgui Konstantinov of LBBW Asset Management. In Currency Crowdedness Generated by Global Bond Funds, he works to rectify that gap, demonstrating that nearly half of the variance in global bond manager returns can be attributed to five currency factors. He also sends a clear practical message: many highly skilled bond managers are not good at active currency management, but rely heavily on these currency factor “betas,” resulting in crowded trades and greater risk. “Investors should keep a close eye on their managers’ style exposures,” cautions Konstantinov. He spoke with Institutional Investor Journals about his research and the original article was published in the Winter 2017 issue of The Journal of Portfolio Management.

Currency Hedging Policy

Based on recently available evidence, a fairly broad consensus on hedging policy appears to be emerging. We have included a copy and commentaries on four key currency hedging policy articles. Also included is a critique on Black's Universal Hedging Formula and a paper on short-term investing. The focus of this discussion is on defining an appropriate currency hedging policy, and not on the benefits of actively managing currencies. These two decisions are independent. Hedging policy defines the desired benchmark for a passive currency management program as well as for measuring active currency management performance, much as equity market indexes are typically utilized as benchmarks.

Is There Skill or Alpha in Currency Investing?

In this paper, we provide an overview of the main features of active currency management programs, highlighting the mandates and the types of trading strategies that are often used. The traditional benchmark used to measure skill or alpha in currency investing is that the expected excess rate of return is zero. We offer an alternative standard where the expected rate of return is related to naive style factors based on strategies that an investor could adopt assuming no special expertise. We review empirical evidence on the performance of both individual currency fund managers and indices of managers using the alternative benchmark. We find that a large percentage of variation in currency fund returns can be attributed to style indices. As a result, performance measures and rankings of currency funds may vary greatly depending on the benchmark used. We review related empirical evidence on fund management styles and survivorship and discuss the implications for currency management strategy and setting currency fund management fees.

Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle

A major puzzle in international finance is that high interest rate currencies tend to appreciate (forward discount puzzle). Motivated by the fact that only a small fraction of foreign currency holdings is actively managed, we calibrate a two-country model in which agents make infrequent portfolio decisions. We show that the model can account for the forward discount puzzle. It can also account for several related empirical phenomena, including that of “delayed overshooting.” We also show that making infrequent portfolio decisions is optimal as the welfare gain from active currency management is smaller than the corresponding fees. (JEL F31, G11, G15)

The Continuum from Passive to Active Currency Management

In international portfolios, currency risk represents an exposure not wanted, and investors have been passively hedging this exposure for years. Although investors may have been successful at reducing their portfolios’ volatility, they also may have been inadvertently increasing their downside risk. Active currency strategies offer the opportunity both to enhance a portfolio’s return and to reduce its downside risk.

Active Currency Management

Exploitable opportunities within the currency market exist and as such, for those clients who are comfortable with the inherent risks associated with this investment opportunity, they should consider allocating a portion of their risk budget to this area of the market. Active currency management, which is uncoupled from the investor’s underlying portfolio, is a viable strategy for potentially adding return and diversifying total portfolio volatility. Of course, an investor has to be comfortable with the associated risks. In this paper, we put forth the notion of “beta” within active currency management. We are careful not to call the total return generated by a manager alpha, because that gives a connotation that extraordinary investment skill is present. Unfortunately, the current situation in the marketplace is such that no investable benchmark by which to gain beta exposure exists. This obscures relative performance assessment, as measured by the information ratio (the most useful performance metric for an active currency manager), and makes benchmarking a difficult, but not an impossible task. We believe active currency managers can produce sustainable long-term positive returns. Over certain periods of time negative returns should be expected from active currency managers which is exacerbated by the fact that the investor (in a separate account structure) has to “cut a check” to cover these losses. Those clients averse to unplanned cash flows may want to consider a prefunded, commingled vehicle format. Maintaining a long-term investment horizon will prove beneficial as it relates to active currency management.

Is active currency management effective for international equity portfolios involving managed futures and hedge funds?

We assessed the potential benefit of using active currency management on international equity portfolio investment from Japan, British, Switzerland and the euro-regions that include bonds, managed futures and hedge funds assets in their respective international equity portfolios. Initially, these are US dollar-based portfolios. Our empirical studies using data from 2001 to 2006 show that active currency management converts US dollar back to Japanese yen better, and produce better average annual returns for the JPY portfolio. However, active currency management does not work well for the other European currency-based portfolios. It seems that using currency conversion by forward contract generates better local average annual portfolio returns for these other European portfolios. Regarding the effectiveness of including alternative investments and bond assets within the international equity portfolios, hedge funds appear to generate better average annual portfolio returns, followed by managed futures and then the bond index. We also observed using forward contracts on international equity portfolio included with hedge funds produce the best maximum annual returns.

Using Currency to Add Value to Global Fixed-Income Returns

Institutional investors are under pressure to enhance returns. And active currency management is an attractive source of value-added, particularly because no incremental capital investment is needed. Such returns are available and sustainable, but they are not as high as some analysts have implied. In addition, currency returns are highly episodic. Nevertheless, active currency management can enhance return and reduce risk.

Currency Management Style through the Ages

The use of active currency management as a source of return has risen rapidly in recent years. This article seeks to explore whether that growth is justified, looking both at the returns themselves in isolation as well as part of a wider diversified portfolio. This is done by replicating some of the inefficiencies that currency managers typically seek to exploit. The different inefficiencies can be equated to different currency management styles. The rationale being that if one can understand how the returns are generated, it can be accurately determined whether they are sustainable. The inefficiencies are replicated using simple simulations that seek to exploit them. In addition, correlations of these returns are examined to determine whether diversification between currency managers and other asset classes are meaningful. These relationships are investigated using data since the mid-1970s.

Pursuing the Debate on Active Currency Management

Pursuing the Debate on Active Currency Management

Pursuing the Debate on Active Currency Management

This article investigates the performance of active currency programs either as an asset class or as an overlay. The authors find that managed currency funds have produced positive returns over the years that are mainly due to the presence of trends in the foreign exchange markets. An active currency overlay program has the potential to beat both hedged and unhedged benchmarks in terms of absolute and risk-adjusted returns

Practical Active Currency Management for Global Equity Portfolios

1. Tod F. Reinert 1. Aa senior analyst for the Department of the Navy, based in Ankara, Turkey. For global equity portfolios, a number of active currency management strategies have consistently dominated both unhedged and passively hedged strategies. The author shows that for portfolios broadly diversified across major equity markets (including the U.S., the U.K., France, Germany, and Japan), a single technically based active currency management strategy yielded the highest risk–adjusted return in all rolling ten–year periods and in twenty–one of twenty–four rolling five–year periods during 1972–1999. Although equity managers may not be in the business of foreign exchange management, they should not be blind to significant currency trends that could be detrimental to portfolio performance. The author suggests some practical techniques to address these trends.