Global investing implies foreign currency exposure. Yet currency management has often been an after-thought for investors in the decision-making process. Foreign holdings comprised more than 30% of Canadian mutual fund assets and more than 20% of Canadian pension plan assets as of the beginning of 2011, a significant exposure. With this exposure to international investments comes currency risk.
Unlike the expected return implied in the risk premium for assets such as equities and bonds, investors cannot expect a return from purely passive holdings of currencies. Equities pay dividends and corporate profits will typically grow with the economy, such that a passively-held market portfolio of stocks can be expected to generate positive returns over longer horizons. Similarly, bonds have fixed coupons and a well-diversified portfolio of bonds can also be expected to provide positive returns over time. A similar strategy of holding a portfolio of foreign currencies has no analogous pay off: the expected return of passively-held portfolios of foreign currency is generally zero. Not only do currencies have no expected passive return, they also generate a large amount of risk due to volatility. It could be said that currencies are a form of “return-less risk” when held passively.
Given the volatility of currencies, unhedged international bond and equity returns can easily be dominated by adverse currency moves. For example, in 2010 European equities returned a positive 11.8% in Euro terms, but showed a negative 0.7% return in Canadian dollar terms due to the weakness of the Euro.
The typical approach utilized for currency risk reduction is partial hedging of foreign assets to the base currency. However, much more can be done: Currency managers as a group have generally added value through active management.
A recent study1 by Pojarliev and Levich of the Barclay’s Currency Traders’ Index data over the seventeen year period from January 1990 through December 2006 finds that currency managers as a group (106 funds as of 2006) had excess returns of 0.25% per month (or 3% annualized) with a standard deviation of 3.04% per month (or 10.5% annualized). This provides evidence that currency managers did add value, though the information ratio for the group at 0.28 was not overly impressive (yet more attractive than the often negative results found for large samples of active equity managers).
In a follow-up paper2, Pojarliev and Levich show that it makes sense to allocate to currency managers by selecting a group based on any of four different methods of selection. This study demonstrates that even though the overall group of currency managers does not provide impressive risk-adjusted excess return, the four methods used in the second paper show success in selecting solid portfolios of active currency managers, each with different investment approaches for adding value, and each with much more attractive information ratios (from 0.77 to 2.80, in fact). The authors found that investment styles and performance persisted from the “in-sample” selection period to the subsequent “out-of-sample” period ‑ a notable finding that provides some evidence of sustainability of excess return generation and skill from one period to the next.
These studies and others provide evidence that active currency management can be expected to provide attractive excess returns over time. They can guide and give comfort to pension funds and other investors seeking to earn a return from the foreign currency risk that otherwise lies uncompensated within their portfolios.
Adnan Akant is Head of currencies, Fischer Francis Trees & Watts and Simon Segall is CEO, BNP Paribas Investment Partners Canada Ltd.
Notes
1 Pojarliev, M. and Levich, R.M. 2007. “Do Professional Currency Managers Beat the Benchmark?” NBER working paper
2 Pojarliev, M. and Levich, R.M. 2010. “Are All Currency Managers Equal?” NYU finance working paper