Not just for hedgers

The past 12 months have been as awful for foreign exchange investing as we've seen in the past decade," grumbles Jeremy O'Friel, a partner at Dublin-based currency trader Appleton Capital Management. "Every time we thought a currency was ready to break out, it reversed course, stopping us out of our position."

Ever since mid-2004, in fact, when the euro began to weaken against the dollar, currencies have been trading sideways -- a situation that is anathema to forex traders, who make money when currencies trend up or down. The Barclay Group's currency traders index, which comprises 72 currency programs, was up a paltry 2.4 percent in 2004, and forex traders' difficulties carried over into this year's first quarter: The benchmark currency traders index was down 3.3 percent, trailing the Standard & Poor's 500 stock index by more than a percentage point.

Nonetheless, pension funds and other big investors are increasingly looking to currency trading as a source of hard-to-come-by alpha. "Currency management is more than a means to offset risk," contends Eric Busay, a California Public Employees' Retirement System portfolio manager who oversees international fixed-income and foreign exchange investments. "It's an opportunity -- with low execution costs -- to consistently enhance returns over the long run."

The long run is key. The Barclay index had three-year annualized returns of 6.86 percent through March, topping the S&P 500 by more than 4 percentage points. The forex index's five-year return was an annualized 4.8 percent, besting the S&P 500 by nearly 8 percentage points.

What's more, the forex programs delivered these superior results with less risk than stocks. Since Barclay Group began tracking currency traders in 1987, the forex index has had an average monthly standard deviation of 3.78, versus 4.46 for the S&P 500. During the past ten years, U.S. stocks outperformed currencies by roughly 5 percentage points a year, but at two and a half times the volatility.

As a diversification bonus for investors, currency returns do not jibe with those of stocks or bonds. Barclay says that since 1987 forex has shown virtually no correlation with the S&P 500, 0.08 with U.S. bonds and 0.13 with non-U.S. bonds.

"Institutional investors are constantly searching for new sources of uncorrelated alpha," points out Denis Bastin, director of the corporate and institutional banking practice at consulting firm Mercer Oliver Wyman in New York. "Currencies offer precisely that benefit." Bastin says that he has seen increased investment in forex as an asset class by his pension fund, foundation and endowment clients.

Mercer Investment Consulting in London reports that it assisted clients with $10 billion worth of currency-overlay mandates in 2004, compared with just $2.7 billion in 2003. Its search requests for currency specialists jumped from eight to 28 over the same time period.

As recently as a few years ago, currency overlay was predominantly a defensive strategy -- a way for investors and corporations to protect their foreign holdings against currency risk. But now, says Michael Sager, a portfolio manager at Putnam Investments' currency group, which has $35 billion in overlay programs, "clients are seeking to achieve additional returns without taking on substantial risk by enabling FX managers to act with more flexibility in their hedging." Currency specialists can throttle back on hedges when they think foreign currencies are trending up and increase hedges when the dollar looks poised to rally.

FX Concepts, a New York­based currency consulting firm, seeks to control risk by staying within 3 percentage points of the foreign currency performance underlying the MSCI Europe, Australasia and Far East index over any 12-month rolling period.

CalPERS employs its own staff of currency specialists and external experts to hedge 25 percent of its $36 billion in foreign equities. "We manage 20 percent of that overlay internally, completely hedging $1.8 billion," notes Busay. The $7.2 billion balance is managed by two outside firms, Pareto Partners and State Street Global Investors.

In a typical arrangement to generate alpha, CalPERS gave Pareto discretion to hedge any or all of its $5.3 billion chunk of the pension's foreign equities. During its 12 years as a CalPERS forex manager, the London-based firm has spun off a cumulative return of 14.6 percent. A fully hedged position would have returned just 4.4 percent. Thus Pareto produced 83 basis points of additional return per year over and above CalPERS's standard hedge. (An unhedged position would have done a bit better than the fully hedged one -- 5.4 percent -- because the dollar generally lost value over that time.)

CalPERS's investment committee has recommended easing hedging requirements for the fund's in-house managers so they can hunt (prudently) for alpha. Busay anticipates that within six months the fund will permit the managers to hedge as little as 20 percent to as much as 30 percent of their $1.8 billion foreign stock portfolio.

Whether investors are trying to limit risk or enhance returns, they have two strategic options -- systematic or discretionary. A systematic strategy takes the historical approach, relying on computer programs that track prices and volatility to determine the optimal points for entering and exiting the forex market. A discretionary approach, by contrast, uses not only price-tracking technology but also fundamental analysis of macroeconomic and political developments to make, if need be, hairpin turns in currencies.

Appleton is a systematic trader, relying exclusively on technical models to time its trades. "We don't believe there's any rhyme or reason to why markets behave the way they do," declares portfolio manager O'Friel. "So, contrary to what most fund managers may say about their deftness in understanding markets, we are ultimately managing uncertainty by focusing strictly on price, listening to what the market is telling us."

Appleton's flagship 25 Percent Risk Program has annualized returns through March of 9.3 percent for three years and 9.6 percent for five. This year's first quarter, though, was tough for the firm, as it was for most currency traders: The program was off 3.7 percent, owing largely to its being short euros. It would have been worse but for Appleton's 9.4 percent gain in March on a long Canadian dollar/yen position. "This pair showed small volatility and attractive price action for several weeks before we established a position," explains O'Friel.

Adnan Akant, head of forex at New York­based money manager Fischer Francis Trees & Watts, which manages $38 billion, sees a tug-of-war in the currency markets involving three contesting forces: the U.S.'s staggering current-account and budget deficits; the potential revaluation of Asian currencies (read: the Chinese renminbi); and the widening gap between U.S. interest rates and European and Asian interest rates. He reckons that by year-end the spread between the U.S. Federal Reserve Board's benchmark rate and that of the European Central Bank could be 2 percentage points.

Akant has been shorting the euro lately against both the dollar and the yen. "If Asian currencies do get revalued," he explains, "that will take a lot of pressure off the euro." Markets would probably revalue the European currency based on its own merits rather than just as an alternative to the dollar, he believes. Despite the possibility that the dollar will weaken against the yen and the renminbi, Akant concludes, the euro could depreciate even more against Asian currencies and the dollar. Of course other currency experts might flip that analysis around -- that's what makes markets.

A new forex product making a splash with alpha seekers is unfunded currency programs. "Qualified investors can gain exposure to our unfunded currency program, the Multi-Strategy Swap Product, without committing a dime," says Arun Muralidhar, head of client services and research at FX Concepts.

"This product was designed for funds looking to generate cash without committing assets while limiting total downside risk," explains Muralidhar. He says FX Concepts, which has $12 billion in assets, has attracted $250 million to unfunded programs in the first year.

Investors are not required to meet daily mark-to-market liabilities and can receive regular cash payments. Anticipated annualized volatility is between 12 percent and 15 percent. A funded version of the product has returned an annualized 18.3 percent over the three years through March, says Muralidhar.

Oil Group of Companies, a Bermuda-based energy industry insurer with $4.5 billion in assets, has $400 million in notional forex exposure, including an investment in one of FX Concept's unfunded currency programs; it has held the exposure since February 2003. (The insurer also has $600 million in unhedged foreign equities.) The program uses options writing to generate gains while cutting down on the number of negative-performing months.

Oil Group's CFO, Roger Paschke, says that he expects to add 1 to 1.5 percentage points of return from participating in the unfunded program. Last year Paschke's currency exposure yielded a 1.5 percent return.

"I wouldn't advise institutions to adopt a forex strategy if they avoid foreign exposure [altogether]," says Paschke. But for institutions that venture across borders, he adds, "a judicious allocation to currency can be a good, low-risk bet."