Download - Currency Investor Magazine Autumn 2010

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Telephone calls may be recorded for training and quality assurance purposes. Issued by Investec Asset Management, October 2010.

Currency managementcomes naturally to usWith over 30 years’ experience in active currency management, a multi-strategyapproach and access to a universe of over 50 currencies, we offer a broad rangeof currency solutions designed to complement an investment portfolio.

For more information call +44 (0)20 7497 1900 or visitwww.investecassetmanagement.com

This edition of Currency Investor comes out following the publication of the Triennial

Survey of the Foreign Exchange and Derivatives Market, from the Bank for International Settlements (BIS). Rather than bringing forth a yawn from the investment community, its report provides useful ammunition for managers in their battle to demonstrate that currencies are an investable asset class. The liquidity of the market and opportunities for currency investment over the last 3 years have stood the test of (theoretically) the worst economic crisis since the 1930s.

An analysis of the BIS report by Record Currency Management for this issue, highlights the healthy growth of spot and forwards trading, hand-in hand with a fall in the trading of options and swaps – hardly surprising considering the panic at the time of the ! nancial crisis about counter-party risk following the failure of Lehman Brothers’.

Probably the most obvious conclusion that can be drawn from the report is the gradual and increasing importance of emerging markets, but Asia in particular. The ! gures show not only rising levels of cross-border transactions, but also that the Yen is still seen as the safe currency, that Singapore has pushed Switzerland out to become the fourth biggest currency trading centre and the Australian dollar has overtaken the Swiss franc as one of the globe’s most traded currencies.

We intend to run a regular Regional Report feature in this magazine focusing on Currency Management and Investment activities within speci! c global hotspots. We start in this edition with an in-depth overview of how the Asian markets are currently structured and the opportunities and dangers that race around this diverse region. Seppo Leskinen of SEB warns that while current account surpluses continue and investment " ows into the region, the risk of intervention remains. And, it seems, absolute currency return strategies are currently out of favour there.

Finally, many thanks for the kind words sent by industry doyens after our ! rst edition of Currency Investor. We are always open to hearing opinions, new ideas and suggestions about how we can improve our coverage of this exciting, dynamic and fast changing industry.

Gerry O’KaneEditor

AUTUMN 2010

Gerry O’Kane [email protected] [email protected] [email protected] DirectorCharles [email protected] Manager

Helen [email protected] ManagerMichael [email protected] ManagerDavid [email protected] ManagerSimon [email protected] Manager

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DisclaimerASP Media Ltd and its respective of! cers, directors and employees does not recommend, or endorse any of the securities, commodities or investments appearing in this magazine. The views expressed in Currency Investor magazine are not necessarily those of ASP Media Ltd, which is not a ! nancial advisor and does not give investment advice. ASP Media Ltd is not an investment management company, a licensed ! nancial advisor, registered investment adviser or registered broker-dealer and does not provide investment or ! nancial advice or make investment recommendations. Although every effort has been made to ensure the accuracy of the information contained in this publication, the publishers can accept no liabilities for inaccuracies that may appear. Readers are advised to consult a professional investment advisor before undertaking any investment activities associated with currencies.

The entire contents of Currency Investor are protected by copyright and all rights are reserved.

02 Currency Investor | Autumn 2010

COMPANIES IN THIS ISSUEA A.G.Bisset & Co page 45Alpha Financial Technologies page 4B Bank For International page 11 Settlements Baring Asset Management page 9BNP Paribas page 4BNY Mellon page 7C Campbell & Company page 45D Deutsche Bank page 75DTCC page 9E ETF Securities page 71

F First Quadrant page 46

H Hathersage Capital Management page 16HSBC Global Asset Management page 52I Investec Asset Management Inside Front CoverISDA page 51J JP Morgan page 40John Hancock Funds page 10JSE page 10

L London Stock Exchange page 5M Macro Currency Group page 6

Merk Investments page 64Morgan Stanley page 5N Nomura page 8Nykredit Asset Management page 6O Overlay Asset Management page 4P Pareto Investment Management page 7Parker Blacktree page 80PIMCO page 19Principal Global Investors page 6Q QP Capital LLC page 72Quaesta Capital page 46R Record Currency Management page 11Rhicon Currency Management page 20S SEB page 56State Street Global Markets Outside Back CoverSwing Capital page 19T TD Ameritrade page 10The Shipkevich Law Firm page 34Threadneedle page 6Towers Watson page 45Trinity Fund Administration page 30U UBS Investment Bank Inside Back CoverW Windham Capital Management page 5WisdomTree page 4

DIANA PLES and BHAVESH TRIVEDILeader

Currencies - still most tradable asset class

ARNAUD GERARDCurrency ManagementAlternative approaches

JOHN MCCANNFund Operations

Letting an Administrator take the strain

FELIX SHIPKEVITCHRegulatory Roundup

Regulatory reports from selected markets

TIM MAXWELLFX Managed AccountsAchieving realistically

sustainable returns

AXEL MERKListed Currency

Vehicles

DR. MOMTCHIL POJARLIEV

De! ning Alpha in Currency Management

THANOS PAPASAVVASCI Interview

PHILIP POOLEViewpoint

‘Currency wars’ and emerging in" ation risks

MAGNUS PRIM and SEPPO LESKINENRegional Report

Asia - a market that can’t be ignored

Regional ReportAsia - a market that

can’t be ignred

FX Managed Accounts - Achieving realistically sustainable returns

Timing -How important is it for achieving Currency Alpha?

7220

The New Normal -De! ning Alpha in Currency Management

Currencies – Still the most liquid and tradable asset market

16

11

56

Autumn 2010 | Currency Investor 03

Autumn 2010 Contents

LEADER11. Currencies – still the most liquid and tradable asset market in the worldDiana Ples and Bhavesh Trivedi examine the results of the recent BIS Triennial survey into FX turnover which con! rmed that volumes traded daily on the foreign exchange market are now past the $4 trillion mark.

CURRENCY MANAGEMENT 16. The New Normal - de! ning alpha in Currency ManagementThe recession caused by the ! nancial crisis of! cially ended in June 2009 but the global economic outlook is still uncertain. PIMCO calls this new world the “New Normal” and Dr. Momtchil Pojarliev outlines what this could all mean for Institutional Investors.

20. Timing: - just how important is it for achieving currency alpha?Gerry O’Kane interviews a selection of leading currency managers to gather their views on the importance of timing the market as a means of seeking alpha.

26. Alternative approaches to Currency ManagementInternational investors hold two types of currency risk and confusion between these different types of risk can result in signi! cant currency losses. With this in mind Arnaud Gerard examines the normal method of controlling currency translation risk and highlights the challenges and weakness of de! ning a ! xed benchmark.

FUND OPERATIONS30. Currency Fund Operations – Why not let an administrator take the strain?John McCann discusses the process of fund administration and the bene! ts currency managers can obtain by selecting a properly quali! ed, service-oriented, third-party fund administrator, to assist them.

34. Regulatory RoundupFelix Shipkevich provides an overview of the latest global compliance and regulatory issues which have an impact on currency asset management operations.

CI INTERVIEW38. With Thanos Papasavvas, Head of Currency Management at Investec Asset Management.

INVESTOR PERSPECTIVES44. From strategies to style buckets: searching for weakness in the investment processGerry O’Kane sets out to help investors in the currency sector discover more about the strategies available in the marketplace and their relative strengths and weaknesses.

52. Viewpoint: ‘Currency wars’ and emerging in" ation risksSome commentators believe that the world is in the middle of a “currency war”. Philip Poole looks at the reasons behind this and the possible implications for investors as appreciation pressures continue to build up with many Emerging Market currencies.

REGIONAL REPORT56. Currency investment in Asia – a market that can’t be ignoredSeppo Leskinen and Magnus Prim pro! le the range of positive factors that continue to attract capital in" ows into Asia and examine the potential for future growth in the currency investment business within the region.

INVESTMENT PRODUCTS64. Listed currency vehicles – helping investors to make the right choicesAxel Merk highlights the many new currency mutual funds, currency ETFs and currency ETNs that have recently been launched and why investors should take time to understand the differences between them.

72. Achieving realistically sustainable returns with FX Managed AccountsAchieving sustainable success with Managed FX requires investors to go through a comprehensive process by questioning their advisor of choice. Timothy J. Maxwell outlines a practical guide to help them with this task.

PERFORMANCE SNAPSHOT80. October 2010 - The Parker Blacktree Currency Index (PBCI)The PBCI is comprised of two sub-indices: the Currency Managers Index (CMI) and the Investment Strategies Index (ISI). The CMI Index measures the alpha generated by active currency managers. The ISI Index is a portfolio of thematic rules-based trading strategies that decompose the marketinto tradable themes.

04 Currency Investor | Autumn 2010

NEWS

OAM developswealth preservationcurrency tool

Overlay Asset Management has announced the

launch of the BNPP/OAM Wealth Preservation Currency Index, a joint initiative with BNP Paribas Corporate and Investment Banking. The index will offer investors access to a ‘virtual world reserve currency’ and will help preserve the purchasing power of currency allocations. The BNPP/OAM Wealth Preservation Currency Index (WPCI) tracks the performance of the 15 largest currencies, representing 80% of the world’s economy. Currency allocations are determined by GDP then adjusted according to purchasing power parity, which boosts the weight of emerging market currencies. WPCI can be used for investment, hedging, or as a benchmark for currency exposure.

Overlay Asset Management’s CIO Hélie d’Hautefort commented: “WPCI goes far beyond a standard currency overlay programme by providing exposures to currencies that are not linked to an investor’s underlying portfolio. Furthermore, the relatively high allocation to emerging market currencies – currently 40% of the index – taps into their superior growth potential.”

BRUCE LAVINE

WisdomTree has announced the Launch of what it believes to be the Industry’s ! rst U.S. Commodity Currency Basket ETF (CCX).

Bruce Lavine, WisdomTree President & COO, commented, “We believe commodity producing countries are well-positioned to bene! t from a global recovery and have developed CCX as an attractive multicurrency basket with exposure to this theme. In addition to presenting a distinct alternative to traditional currencies like the euro, yen and pound,

WisdomTree launches Commodity Currency Basket ETF

HÉLIE D’HAUTEFORT

VICTOR SPERANDEO

Alpha Financial Technologies has announced the launch of the FX Trends Index (FXTI). The FXTI is a long-short index designed to capture the

economic bene! t of price trends within the currency futures markets. “The launch of the FXTI is the result of AFT’s continued research and development, which expands our robust line of long-short index offerings,” said Victor Sperandeo, President and CEO of AFT. Sperandeo added, “The FXTI meets the market’s need for a long-short currency futures index that re" ects the directional movement of major currencies. Institutional investors have long realized the bene! ts of the currency markets as an alternative asset class, especially as a potential way to diversify and enhance traditional stock and bond portfolios over long-term periods. Given the recent price moves and volatility within the currency markets, we think now is an opportune time to bring to market a strategy like the FXTI. Continued dislocations in the currency markets will have the potential to create unique opportunities for trend-following strategies.”

AFT launches a Long-Short Currency Futures Index

exposure to commodity currencies has historically served to diversify a traditional portfolio.” CCX builds on the success of the WisdomTree Dreyfus Emerging Currency Fund (CEW) in providing investors with unique, less correlated asset class exposures. The Fund Seeks to Provide Exposure to Currencies of Commodity-producing Countries Across Major Export Groups and Geographic Regions and is designed to provide broad-based exposure to money market rates and currency movements.

Autumn 2010 | Currency Investor 05

NEWS

HSBC Global Asset Management has launched the HSBC GIF Global Macro II Fund, a levered version of the group’s " agship absolute return

portfolio, the HSBC GIF Global Macro Fund.

The HSBC GIF Global Macro II Fund, like its sister portfolio, is a UCITS III, Luxembourg-domiciled SICAV offering daily liquidity and is co-managed by Guillaume Rabault and Jim Dunsford. The fund seeks to exploit pricing anomalies using complementary quantitative and qualitative based strategies.

Charles Robinson, Head of Alternative Distribution, HSBC Global Asset Management, said: “This launch is very simply driven by client demand. Investors praise our team for their distinguished process and performance. But many macro investors seek higher returns and can stomach greater volatility so our base strategy is too conservative for these particular individuals to meet their needs. As we have prior experience in adjusting our capabilities to meet different return objectives, we were happy to engineer the same solution in our " agship UCITS III strategy.”

Windham Capital Management announced that it has launched the Windham Tactical Portfolio, an active asset allocation strategy

that uses proprietary risk measures to control exposures throughout market cycles. Through daily monitoring of the Windham Investment Risk Cycle™, portfolio managers adjust the investment mix of the portfolio to grow principal in times of low risk and to preserve principal in times of high risk.“Traditional strategies use costly hedges to reduce downside risk,” says Lucas

Turton, Windham Managing Partner and CIO. “The Windham Tactical Portfolio seeks enhanced returns with more ef! cient risk management and ! lls a gap in the investment options available today to individuals and small institutions.”

HSBC Global Asset Management launches absolute return fund

Windham announces launchof tactical portfolio

ETF Securities (ETFS), is planning to expand the world’s largest and Europe’s ! rst Exchange Traded Currency (Currency ETCs) platform with

the launch of four emerging market and 18 GBP-based Currency ETCs on London Stock Exchange (LSE) in the coming weeks.

For the ! rst time in Europe, investors will have access to emerging market Currency ETCs which enable investors to go long or short the Chinese Renminbi (CNY) or the Indian Rupee (INR). Since launching its Currency ETC platform, ETF Securities has received signi! cant interest for emerging market currencies such as the Chinese Renminbi and the Indian Rupee, which are traditionally dif! cult to access for non-domestic investors.

Nik Bienkowski, Chief Operating Of! cer, commenting on the launch, said. “Over the past ten years, we’ve seen that investors are looking for liquid and transparent markets and thus currencies are starting to appear on their radar screens. In addition, currencies are driven by the macro environment, which has shown high volatility in the past few years, and because currencies are valued relative to other currencies, therefore if one goes up then the other must go down. Thus depending on whether an investor has gone long or short, an investor can potentially pro! t regardless of market direction”.

ETF Securities rolls out 22 new currency ETCs

CHARLES ROBINSON

NIK BIENKOWSKI

LUCAS TURTON

06 Currency Investor | Autumn 2010

Macro Currency Group, announced the launch of the Principal High Alpha Currency Fund (the Fund), a Dublin-registered Qualifying Investor

Fund launched with £25mn of external seed capital. The Fund is a response to clients’ growing interests in the group’s higher alpha capabilities, with net in" ows into the high alpha funds totaling $185mn in 2010 alone. This brings total net in" ows across the wider currencies business to $650mn for the same period.

The Fund is a sub-fund of the Principal Global Opportunities Series and utilises the same fundamental discretionary investment process that the Group uses to manage its other active absolute return portfolios. It

has a target volatility of 25%, managed on a three year annualised basis, with an implied return target of 17.5%. The Fund complements the 15% target return fund launched by Macro Currency Group in February with a further 10% target return fund set to be added on to the range in Q1 2011.Commenting on the fund launch, Nick Lyster, European CEO of Principal Global Investors, said, “Macro Currency Group’s goal is to offer high performance, absolute return strategies that give investors the con! dence to increase their long term exposure to currencies. Simply using currencies as an overlay function to limit portfolio risk or for short term pro! teering fails to capture the true value add of the asset class.”

RICHARD HOUSE

Threadneedle has announced the launch of its Threadneedle (Lux) Absolute Emerging Market Macro Fund, for investors who want to tap into

opportunities in emerging market debt and currencies, whilst bene! ting from the increased " exibility of a UCITS III structure. The fund has been awarded an A rating by S&P. Lead manager on the fund will be Richard House, Head of Emerging Market Debt at Threadneedle. Mr House has 15 years experience in emerging markets investment and three years hedge fund experience.

Mr House said. “The new Threadneedle (Lux) Absolute Emerging Market Macro Fund allows us to exploit the many macro-based opportunities that exist across the Emerging Market universe, without the constraints of any index. Within the fund, we have the " exibility to express our highest conviction macro views via sovereign credit, rates and FX, both on an absolute and relative basis. Using processes and resources that we have successfully employed over the years in our Threadneedle Emerging Currencies Crescendo Hedge Fund, we aim to deliver absolute returns to a broader range of investors under UCITS III.”

Investec Asset Management announced that it has been appointed to sub-advise a newly launched emerging markets debt fund by Nykredit

Asset Management, a prominent ! nancial services organisation in Denmark.

The Fund will be open to both retail and institutional investors. It will be managed by Investec’s Emerging Market Debt Team using their proprietary investment process developed speci! cally for locally denominated emerging market debt and currencies. Claus Bilde, Head of Manager Selection at Nykredit Asset Management, commented, “We are pleased to appoint Investec Asset Management to manage this fund. Following a thorough due diligence process, our decision to choose Investec Asset Management endorses the quality of the team, the robust risk-adjusted returns delivered through differing time periods, and the Firm’s client-focused approach.”

NEWS

Threadneedle launches emerging market absolute return fund

Macro Currency Group announce new Fund

Investec Asset Management wins EMD mandate in Denmark

CLAUS BILDE

NICK LYSTER

®

We are one of the world's foremost currency risk managers, offering the benefi ts of a risk-based approach to currency management from our headquarters in London and offi ces in New York, Sydney and Tokyo. With nearly two decades of experience and about US$46 billion of exposures and assets under management, we are an established name in institutional currency management, providing:

Active Currency Hedging | Specialist Currency Alpha Strategies | Multi Strategy Programmes

Our balance of investment expertise and academic excellence is designed to maximize returns while controlling risk.

For more information, please contact:

Jonathan Lubran+44 207 163 [email protected]

www.bnymellonam.com

Arnaud Gérard, CFA+44 207 163 [email protected]

www.paretopartners.com

Uncertain times call for specialisedcurrency risk management.

This is a financial promotion and is not intended as investment advice. The information provided within is for use by professional investors and should not be relied upon by retail investors. This document may not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or not authorised. The value of investments and the income from them is not guaranteed and can fall as well as rise due to stock market and currency movements. When you sell your investment you may get back less than you originally invested. To help us continually improve our service and in the interest of security, we may monitor and/or record your telephone calls with us. Assets under management are as at 30 September 2010. This document is issued in the UK, mainland Europe (excluding Germany) by BNY Mellon Asset Management International Limited. BNY Mellon Asset Management International Limited, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorised and regulated by the Financial Services Authority. In Germany, this document is issued by WestLB Mellon Asset Management Kapitalanlagegesellschaft mbH, which is regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. WestLB Mellon Asset Management was formed as a 50:50 joint venture between The Bank of New York Mellon Corporation and WestLB AG. In Singapore, this document is issued by The Bank of New York Mellon, Singapore Branch for presentation to professional investors. The Bank of New York Mellon, Singapore Branch, One Temasek Avenue, #02-01 Millenia Tower, Singapore 039192. Regulated by the Monetary Authority of Singapore. In Dubai, United Arab Emirates, this document is issued by the Dubai branch of The Bank of New York Mellon, which is regulated by the Dubai Financial Services Authority. If this document is used or distributed in Hong Kong, it is issued by BNY Mellon Asset Management Hong Kong Limited, whose business address is Level 14, Three Pacific Place, 1 Queen’s Road East, Hong Kong. BNY Mellon Asset Management Hong Kong Limited is regulated by the Hong Kong Securities and Futures Commission and its registered office is at 6th floor, Alexandra House, 18 Chater Road, Central, Hong Kong. In Korea, this document is issued by BNY Mellon AM Korea Limited for presentation to professional investors. BNY Mellon AM Korea Limited, 21/F Seoul Finance Center, 84 Taepyungro 1-ga, Jung-gu, Seoul, Korea. Regulated by the Financial Supervisory Service. BNY Mellon Asset Management International Limited, Pareto Investment Management Limited and any other BNY Mellon entity mentioned are ultimately owned by The Bank of New York Mellon Corporation. In New York and Sydney Pareto operates through FSA Representatives, Pareto New York LLC and Pareto Australia Pty Ltd. CP5757-28-09-2010(3M)

08 Currency Investor | Autumn 2010

NEWS

Citi have announced that its Global Transaction Services unit has launched a global technology platform speci! cally designed for servicing

funds of hedge funds. The new service, which integrates into Citi’s Global Operating Platform for Hedge Fund Services, enables Citi to provide a comprehensive suite of fund of hedge fund solutions through a single, seamless front-to-back online service.

“For the bene! t of servicing fund of hedge fund managers around the world, we have pulled together the entire client experience under one seamlessly integrated, globally consistent platform,” said Neeraj Sahai, Global Head of Securities and Fund Services, Citi. “Managers have direct, on-line access to our custody services, our suite of middle-of! ce solutions and all standard administrative reports, resulting in greatly improved ef! ciency, accuracy, transparency and risk mitigation.”

Citi’s fund of hedge fund services product suite delivers the following types of customized tools for portfolio managers:

• analysis of liquidity terms of underlying hedge fund investments

• ability to track and analyze underlying fund performance

• “what-if” trade scenario analysis• pre and post trade compliance reporting against

investment guidelines• real-time dynamic NAV reporting• automated FX hedging functionality for share classes

denominated in non-base foreign currency

Db x-trackers has entered the currency

exchange traded fund market with the launch of two products. The db x-trackers Currency Returns ETF comes in a sterling and a US dollar-hedged version and takes long and short positions in the G10 currencies, which include the Australian, New Zealand and Canadian dollar, Swiss franc, euro and Norwegian krone.

Manooj Mistry, head of db x-trackers ETFs UK, comments: ‘The Currency Returns ETF is ideal for investors who are increasingly recognising the bene! ts of allocating assets to investment classes that show low or negative performance correlation with equity and bond markets, as well as investors looking for an additional way to achieve alpha in a low-growth environment.’ The ETFs are linked to the DB Currency Returns Index, a benchmark that db x launched in 2007 to take advantage of the long-term returns that it says can be found in the currency markets. Deutsche Bank historical analysis claims that that over the long term an investment in the DBCR will outperform an equivalent investment in global bonds or equities on a risk-adjusted basis.

Citi launch platform for Funds of Hedge Funds

Db x-trackers launches Currency ETFs

Nomura has launched the Nomura C10 Fund, a regulated currency investment product, which aims to provide investors with directional

exposure to Chinese economic growth.The Nomura C10 Fund is the latest development in Nomura’s UCITS compliant products suite. Its investment objective is to provide investors with direct exposure to the performance of Nomura’s C10 Currency Strategy.

“Investors seeking to participate in the China growth story have, up until now, had little choice but to suffer from the usually high volatility and the lack of liquidity and transparency associated with exposure to China. The Nomura C10 Fund is a unique opportunity to harness China’s economic growth in a liquid, ef! ciently risk managed and UCITS compliant investment,” said

Jean-Philippe Royer, head of the Fixed Income Fund Solutions Group at Nomura.

Nomura’s C10 Currency Strategy is designed to capture the return of currencies which are best positioned to bene! t from Chinese growth and Yuan appreciation based on their country’s exposure to China. Developed by Nomura’s FX Research and Structuring teams, the dynamic, rules-based strategy takes long positions in 10 liquid currencies with the highest trade exposure to China as measured by the ratio of exports to China versus Gross Domestic Product (GDP). The fund offers daily liquidity and is available in EUR, with USD and GBP-hedged share classes accessible to institutional and retail investors. It is currently approved for public distribution in Ireland and is being registered across all major European countries.

Nomura launches currency fund to harness Chinese growth

MANOOJ MISTRY

Autumn 2010 | Currency Investor 09

NEWS

Record plc, the specialist currency manager, has announced the

appointment of James Wood-Collins as Chief Executive Of! cer, taking on this position from Neil Record, who has been both Chairman and CEO since the IPO in 2007.

Mr. Record will remain as Chairman, in an executive position to which he will commit four days a week. He will continue to play an active role with clients, investment consultants and other external parties, as well as maintaining his involvement with Record’s products and product development. Mr Wood-Collins joined Record from J.P. Morgan Cazenove in 2008, and has led Record’s client team since December 2009.

Baring Asset Management has appointed Thanasis Petronikolos as a Director in the Fixed Income and Currency team, responsible for managing exposure

across the ! rm to Emerging Market Debt and Currencies. This includes managing the new Baring Emerging Markets Debt Local Currency Fund.

Thanasis is based in London and reports to Alan Wilde, Head of Fixed Income and Currency at Baring Asset Management. Thanasis has over 15 years’ investment management experience in emerging market ! xed income and currencies. He was previously a Fund Manager at RAB Capital, responsible for investment decisions for the emerging market debt and currencies component of the RAB Emerging Market Opportunities Fund. Prior to this he held roles managing emerging market debt at Avebury Asset Management and Rothschild Asset Management.

Record appoints new CEO

Barings appoints Currency Fund manager

The Depository Trust & Clearing Corporation (DTCC) announced its plans to introduce multi-currency settlement for European

investment fund transactions through its Fund/SERV suite of services. This service, which is subject to regulatory approval and will be available by early 2011, streamlines how offshore fund transactions are handled, giving the nearly 10,000 European investment funds the opportunity to expand their distribution networks across borders while signi! cantly reducing processing challenges.

The new service will be offered through a new DTCC subsidiary called DTCC Solutions Worldwide Ltd. and settlement will now be available in Euros and pound sterling in addition to U.S. dollars. The business unit overseeing the cross-border service will have of! ces in London, making it a centrally located facility for global funds processing. DTCC will also establish a best-practice users’ group to ensure that the new multi-currency platform continues to meet the needs of customers.

“Fund/SERV’s multi-currency platform enhances Fund/SERV’s

suite of offshore fund processing

capabilities,” said Annemarie Gilly, DTCC vice president and head of Global Mutual Funds. “Our ability to settle fund trades in Euros and pound sterling will ! ll a long-standing void in global funds processing as well as substantially reduce processing fees and handling costs for market participants.”

Fund/SERV to providemulti-currency settlement for global funds

ANNEMARIE GILLY

JAMES WOOD-COLLINS

THANASIS PETRONIKOLOS

10 Currency Investor | Autumn 2010

NEWS

The JSE has unveiled its Rand Index (Rain), a currency index that can be used by asset managers, economists, importers, and exporters as a tracking

and forecasting tool to determine the rand’s strength against a basket of currencies.

The Rain, which tracks the movement of the rand against the currencies of South Africa’s top ! ve major international trading partners - the euro, US dollar, Chinese yuan, UK pound, and Japanese yen - provides a public benchmarking tool, it said. The representative weight of each currency in the index will be calculated using audited import and export data of physical goods obtained from the SA Revenue Service, data which is only available two months in arrears.

“We believe the Index will be particularly useful to those users wanting to measure the competitiveness of South African goods in international import and export markets,” said JSE director, Allan Thomson. The RAIN will be calculated and distributed daily by the JSE at 15h00 and 17h00. A review of the inclusion of each of the ! ve currencies and changes in individual currency weightings will take place annually at an index review. The JSE will then communicate any changes to currencies that make up the index or their weighting to the market.

John Hancock Funds has announced its fourth new fund launch of the year,

the John Hancock Currency Strategies Fund (JCUAX). The new fund is now available for sale to retail investors through their ! nancial advisers.

The decision to develop and launch the new fund grew from lessons learned in the aftermath of the 2008 market turmoil, said John Hancock Funds President Keith F. Hartstein.The John Hancock Currency Strategies Fund seeks to generate positive returns over all market cycles by making diversi! ed investments in global currencies in order to take advantage of market anomalies. The Fund primarily uses short-term forward currency contracts on developed market currencies to achieve its goals.

“Once we identify an investment strategy that we believe will ! ll a need in the market, our unique sub-advisory business model affords us the luxury of seeking out best-in-class institutional asset managers to manage that strategy,” added Mr. Hartstein

The sub-adviser to the fund, investment management ! rm First Quadrant, manages approximately $6.3 billion in currency strategies and is the general partner of Af! liated Managers Group.

JSElaunches

CurrencyIndex

Hancock launches Currency Strategies fund

TD AMERITRADE Institutional has launched a new Uni! ed Managed Account Exchange (UMAX), which expands the types of investments

independent registered investment advisors (RIAs) can offer to clients and provides more " exibility in how the portfolios are managed. The UMAX platform revolutionizes uni! ed managed accounts (UMAs) by providing two distinct investment management solutions. An open architecture approach in which advisors can construct solutions from a large universe of products using their own research and product selection strategy, and a bundled option that includes robust product research and asset allocation guidance from leading third-party investment managers. “As RIAs continue to demand more " exibility and ef! ciencies to streamline the investing process, UMAs have become a go-to solution

allowing advisors to spend more time on business development and serving clients. However, advisors working with UMAs have been limited by rigidity and lack of investment options,” said Matt Judge, director of product management, TD AMERITRADE Institutional. “With its open architecture and comprehensive product access, UMAX aims to provide advisors with the added " exibility and investment choice to help them respond to today’s volatile markets.”

TD AMERITRADE Institutional launches UMAX

ALLAN THOMSON

KEITH F. HARTSTEIN

MATT JUDGE

Autumn 2010 | Currency Investor 11

Currencies - still themost liquid and tradable asset

market in the world The latest Triennial Survey of the Foreign Exchange and Derivatives Market, published by

the Bank for International Settlements this September, con! rms that volumes traded daily on the foreign exchange market are now past the $4 trillion mark. Three years after the onset of

the ! nancial crisis, the foreign exchange market is now above pre-crisis levels of trading. This is a testament to the market’s fast pace of recovery, as much as it is a testament to its resilience

during the crisis period. Indeed, the currency market continues to be the most liquid and tradable asset market in the world, with daily turnover estimated to be more than seven times

the daily turnover of global equities.1

LEADER

By Diana Ples and Bhavesh Trivedi at Record Currency Management

1. Estimate by Citi Group, FX, September 2010

12 Currency Investor | Autumn 2010

Currencies – still the most liquid and tradable asset market in the world

Whilst the foreign exchange market is now larger than ever, it has not fully returned to its pre-crisis patterns. This, we believe,

may be indicative of trends to come, with some of the changes here to stay. We have identi! ed the following main themes which we believe represent the most salient features of the FX market today:

1 High increases in spot transactions and subdued interest in other instruments

2 A concentration in the geographical distribution of trading with the UK strengthening its dominance

3 Changes in the market shares of the top traded currencies, the Australian Dollar overtaking the Swiss Franc in volume traded

4 The continued rise of emerging markets

Instruments Over 90% of the 20% increase in daily turnover, since the last Triennial Survey was published in 2007, is attributable to the growth in the turnover of conventional spot transactions and outright forwards. At the same time, we saw a subdued increase in the turnover of currency swaps and foreign exchange swaps, and an actual decline in the volumes of options traded. This may be symptomatic of a decreased demand for exotic structured products, as traders reverted to more traditional instruments following the ! nancial crisis.

To some extent, the 48% jump in turnover of spot transactions may also be due to the rise of algorithmic trading – where black boxes can now process thousands of trades per minute – and to the rise of online platform trading, which has enhanced the appeal of retail trading by adding functionality and accessibility.

We believe that the growth in spot and forwards could also be credited to the recovery of cross-border capital " ows and international trade. Thus, the BIS reports that foreign exchange activity has now become more global, with cross-border transactions representing 65% of total activity, up from 62% in April 2007.

Although we saw a slight decline in options turnover and little change in the volumes of swaps traded since April 2007, investors should rest assured that these instruments are still liquid and widely traded.

Geographical distributionof turnoverIn April 2010, banks in the UK increased their geographical dominance of the foreign exchange market, with Switzerland and Germany in particular losing out. As expected, the US stayed in second place in terms of trading activity, with its growth of daily volumes re" ecting growth in the market as a whole. Japan has regained its third place and Singapore has now overtaken Switzerland in fourth place. This, together with a 30% increase in volumes traded in Hong Kong, point to increasing market activity in Asia.

As the geographical distribution of trading changes, investors should consider where the deepest pools of liquidity are in order to ensure optimal execution of trades.

Share of the market volume traded in each instrumentChart 1: If we look at the share of the total market value traded in each instrument over time, we can see that spot

transactions and outright forwards have become more popular amongst market players.

Autumn 2010 | Currency Investor 13

In addition to changes in G10, we also saw increased trading activity in some of the emerging market countries such as Turkey, Brazil, China, Malaysia and the Philippines. On the one hand, this re" ects increased investor interest in emerging markets. On the other hand, we believe that – in the case of Turkey and China at least – increased activity in April 20102 may be indicative of central bank interventions in the market. In April, the Turkish Central Bank increased the proportion of foreign currency reserves, which banks must deposit to cover loan risk, in a ! rst step to withdraw some of the liquidity it inserted into the market; whilst China continued to increase its foreign currency reserves.

Overall, therefore, London retains its dominance, but we expect the continued rise of emerging markets, and ! nancial centres in Asia in particular, to weaken this dominance over the years to come.

Changes for G10The currency composition of turnover, as expected, has not varied substantially from the composition reported three years ago. Whilst the Dollar has continued its slow decline in proportional daily turnover (a pattern that we have observed over the past decade), it remains the dominant currency in the market. There were noticeable increases in the volumes of Euro and Yen traded, and a big decrease in the daily turnover of the Pound Sterling. As the Yen is traditionally considered to be a safe haven currency, the Yen’s rise in market share is probably due to increased risk aversion following the ! nancial crisis.

The most prominent change was the Australian Dollar’s rise to the top ! ve most traded currencies, overtaking a declining Swiss Franc. The Canadian Dollar too showed a notable 23% rise in turnover.

LEADER

BHAVESH TRIVEDI

“We believe that volumes traded in the

Australian Dollar also re" ect the fact that Australia has

maintained relatively high interest rates,

making the currency a favourite amongst

carry players.”

2. The survey is constructed by collecting data about market activity during the month of April, every three years.

14 Currency Investor | Autumn 2010

Currencies – still the most liquid and tradable asset market in the world

The rise in the Australian and Canadian Dollar may re" ect recovering appetite for commodities. In particular, April 2010 saw the price of gold rise by just under 6%, which may have contributed to the appreciation of the Australian Dollar against the US Dollar, thus stimulating the increase in turnover.

We believe that volumes traded in the Australian Dollar also re" ect the fact that Australia has maintained relatively high interest rates, making the currency a favourite amongst carry players (i.e. investors who buy higher yielding currencies and sell lower yielding ones with the aim of capturing the interest rate difference).

It is also possible that a portion of the Australian Dollar’s rise in turnover is due to increased merger and acquisition speculation in April 2010, as market players were speculating about the takeover of a couple of US companies by Australian businesses. Thus, any speculation and ensuing pre-emptive hedging might have had a one-off effect on hedging volumes.

As well as changes amongst the ! ve most traded currencies, we saw a drop in the market share of Scandinavian currencies. Whilst this decrease in market share was not re" ected in a decrease in turnover for the Swedish Krona, Norwegian Krone volumes have actually decreased since 2007.

To some extent, this may be to do with the fact that these currencies have come much closer to “fair valuation” levels against the Euro since the credit crisis, becoming a less appealing opportunity for fundamental players. Furthermore, we have seen a decrease in hedging by Scandinavian exporters as order " ows have been hit since the credit crisis.

One of the upshots of the decline in the market share of Scandinavian currencies is that banks could become less keen on these currencies and this could have an impact on liquidity. For investors, this will highlight the importance of having diversi! ed counterparties, as the execution capabilities of banks and managers vary even within the G10 universe.

As emerging markets and other countries continue to diversify away from the US Dollar, we expect the gradual proportional decline in US Dollar traded volumes to continue over the coming years. Indeed, this is already re" ected in the currency composition of country reserves, as published by the IMF.

The rise of Emerging MarketsWhilst the market share of G10 currencies as a group stayed similar to 2007 levels, we saw a slight, but steady increase in the market share of the 23 emerging market currencies in the survey. The most signi! cant increases were for the Turkish Lira and the Korean Won, followed by the Russian Rouble, Brazilian Real, India Rupee and Malaysian Ringgit.

The Korean Won’s 30% increase in market share has now put it above the Norwegian Krone and Singapore Dollar, becoming the most actively traded emerging market currency. This may be associated with FTSE’s promotion of South Korea to developed market status in September 2009. Whilst South Korea is now considered to be a developed market from the point of view of equity investors, its currency, we believe, still shows characteristics of an emerging market. In particular, it is only tradable offshore via non-deliverable products, creating a disparity between onshore and offshore rates.

The Turkish Lira has shown staggering progress, nearly quadrupling its market share since April 2007. This is re" ective of the Turkish Lira’s upwards path over the last decade. As one of the highest yielding emerging market currencies, we would not be surprised if the increased market activity in the Turkish Lira is due to carry players.

We believe that the increase in the market share of key emerging market currencies serves to strengthen the view that emerging markets are becoming increasingly more appealing and accessible to investors world-wide. Subdued growth and collapsing interest rates in the developed world as a result of the ! nancial crisis are increasing the appetite for investments into emerging markets in the search for enhanced returns. Indeed, the latest estimate from the Institute of International Finance is that over $800bn will " ow into emerging markets over the course of the year, a 40% increase from last year.

We at Record also think that investors can pro! t from the high rates of growth in emerging markets by allocating a portion of their risk budget to emerging market currencies. There are good long term reasons for holding emerging market currencies. As emerging market countries become richer, their currencies are expected to become stronger, converging in value with those of developed countries. We have already

seen this effect taking place in some emerging market economies; the path of the Korean Won – which is now the most traded emerging market currency – serves as a good example. We believe investors can generate high returns by exploiting this upwards trend in emerging market currencies.

Furthermore, we think that emerging market currencies are a better engine for bene! ting from emerging markets growth than other asset classes.

Firstly, our research shows that for equities as well as bonds a signi! cant part of the returns is attributable to the currency component – as investors bene! t from currency appreciation against their base currency. For equity returns, for instance, we estimate the currency return to be between a third and a half of the total unhedged return (depending on the starting point of the analysis and an investor’s base currency).

Secondly, the currency market is signi! cantly more liquid than both the stock and bond market, which means that investors will be able to trade emerging market currencies easily, at low costs and without having an impact on their market value.

Thirdly, an emerging markets currency portfolio would be signi! cantly less volatile than an equity portfolio, hence investors could bene! t from growth in emerging markets without incurring as high levels of risk. Indeed, as the more recent period has shown, emerging market currencies are not signi! cantly more volatile than developed market currencies.

Whilst G10 currencies still dominate the market, the continued growth in the market share of emerging market countries highlights increased investor

interest in emerging market assets. We believe that emerging markets are going to become a much more prominent feature of the investment world over the next few years and that there are considerable long-term bene! ts to holding emerging market currencies. In particular, as the events of the past weeks have unfolded, we have seen emerging markets come under increased pressure to allow their currencies to appreciate to match the pace of economic growth. This, we believe, is only a natural consequence of their stronger fundamentals and, in

many cases, historic undervaluation.

ConclusionConditions in the foreign exchange market have varied a lot over the last three years; from the liquidity crisis following the banking crisis to higher levels of trading now than ever before, the currency world has had a rough ride. Nevertheless, the rebound in turnover seems to indicate recovery.

The size, accessibility and liquidity of the foreign exchange market increases the appeal of currency for investors looking to diversify their portfolios and to reduce their reliance on more traditional asset classes. Nonetheless, even within developed market currencies, differences in liquidity between instruments, trading locations and even G10 currencies mean that investors should ask their banks and managers tough questions about transaction execution.

With the slow recovery of developed economies, we encourage investors to explore emerging market currencies. This re" ects increased interest in emerging markets as an investment opportunity and allows investors to bene! t from the fast pace of growth in these economies.

DIANA PLES

“We believe that the increase in the market share of key emerging market currencies serves to strengthen the

view that emerging markets are becoming

increasingly more appealing and

accessible to investors world-wide.”

Autumn 2010 | Currency Investor 15

LEADER

16 Currency Investor | Autumn 2010

The New Normal - de! ning Alpha in

Currency Management

Since the 1990s, institutional investors have been allocating resources less toward traditional assets like equities and bonds, and more towards alternative investments

like hedge funds, real estate, private equity, currencies and commodities. This strategy was partly the result of a conventional belief that diversi! cation is the key for successful investing and that the returns on alternative assets will have little or no correlation with returns on traditional investments. Unfortunately, during the ! nancial crisis, investors

discovered that correlations vary and that average correlations could be misleading.

By Dr. Momtchil Pojarliev, CFA, Director and Senior Portfolio Manager, Hathersage Capital Management LLC

CURRENCY MANAGEMENT

Autumn 2010 | Currency Investor 17

In turbulent markets, all asset returns generally become more volatile and more

highly correlated. For example, the correlation of hedge funds to global equities is 4% when global equities produce returns greater than one standard deviation above their mean return, but it rises to 80% when equities generate returns more than one standard deviation below their mean (see Fig 1). Thus, diversi! cation tends to fail exactly when it is most needed, i.e. in falling markets.

Do currency managers provide “real” diversi! cation to investors with large equity exposure? Talking about currencies to institutional investors reminds me of one of the most famous baseball comedy acts, a humorous exchange between Bud Abbott and Lou Costello: “Who’s on ! rst, What’s on second, I Don’t Know is on third…” The confusion arises from the peculiar names of the ball players. But what explains the confusion about currency investing?

One of the most confusing things about currency investing is that every currency mandate is unique. The easiest way to differentiate between currency investment mandates is to look at the expected excess return, or the Alpha Continuum1. Let’s take as an example a USD based investor, who wants to allocate USD100 million to global equities, but does not want exposure to foreign currencies. In this case, a currency mandate could be to simply hedge the foreign currency exposure (sell the local currencies versus the US Dollar). The expected excess return of such a mandate is zero; the objective is only to remove currency risk. This is passive currency management.

In contrast, let’s assume an institutional investor, who has an USD98 million allocation to global equities and has used the remaining 2% of its assets to a cash margin account to invest in a currency alpha mandate with USD20mn notional exposure. The objective of such a mandate could be to generate a 15% return with volatility of 20%. In this case, the expected alpha is obviously quite large. Currency overlay is another typical example of a currency management mandate and it falls somewhere between the two previous examples on the Alpha Continuum. The prime objective of a currency overlay is to limit the risk from adverse movements in exchange-rates, i.e. hedge, as

well as to pro! t from tactical foreign-exchange views.

Institutional investors should ! nd the right point along the Alpha Continuum, depending upon their speci! c needs. When the primary concern is to eliminate currency risk embedded in foreign investments, a passive currency management product is most appropriate. When the primary concern is to increase the return on their portfolio, a currency alpha mandate could be more suitable. However, one of the challenges for institutional investors after allocating assets to currency managers is to ! nd an appropriate benchmark to gauge the performance of these managers. While evaluating passive mandates is a simple exercise, gauging the performance of alpha mandates is more challenging. Without an appropriate benchmark, the investor cannot know if he should be pleased or disappointed with the results achieved by his managers, or put differently, if these managers have demonstrated true skill or not. The lack of a well-established benchmark may be one of the reasons why allocations to currency strategies are still relatively low compared to other asset classes.

Is the benchmark zero or something different?Traditionally, the benchmark for an unfunded currency manager (someone who is trading only on credit lines while core assets are invested elsewhere) has been zero, while the benchmark for cash funded mandates has been the risk-free rate. Such benchmarks imply that all the returns generated by currency managers are alpha returns and beta returns are assumed to be zero. However, ! nancial market theory2 tells us that the return of any portfolio

CURRENCY MANAGEMENT

1. Anson (2008) introduced the term Beta Continuum and shows that beta is not a point estimate, but rather there is a range of risk premium capture that can be described as beta. The term Alpha Continuum should highlight that alpha might not be just a simple point estimate, but should re" ect the objectives of the speci! c mandate.

2. Waring and Siegel (2006) show that the returns of any portfolio can be broken down into market (beta) components and an alpha component. Currency fund returns offer another example of this principle.

Figure 1: When MSCI World Index Monthly returns <= -1STD

18 Currency Investor | Autumn 2010

should have a beta and an alpha component. The beta component captures the systematic relationship between returns and the special factors driving returns. For currencies, the beta might stem from exposures to risk factors or trading styles similar to how the arbitrage pricing model relates returns on equities to factors representing large vs. small cap ! rms, value versus growth ! rms, etc...

In order to recognize currencies as an asset class, there should be factors that correlate with or explain patterns of currency fund manager returns. Building

on earlier hedge fund research, and several well-known currency trading strategies, Pojarliev and Levich3 (PL, 2008a) propose four potential factors that could explain currency returns generated by professional managers. These four factors are transparent, easily replicated trading strategies within the currency domain:

• Carry – Borrowing a low interest rate currency and investing in a higher interest rate currency.

• Trend following – Borrowing in a depreciating currency and investing in an appreciating currency.

• Value – Borrowing in an overvalued currency and investing in an undervalued currency.

• Volatility – Re" ecting the impact of currency volatility on trading returns.

Pojarliev and Levich use a 4-factor regression model as a technique to gauge the performance of currency managers. The model estimates what portion of currency trading pro! ts is due to exposure to these speci! c trading style or risk factors (or beta), and what portion is due to skill, or alpha. PL (2008a) and PL (2008b)4 use different proxies for the risk factors, but the results are strikingly similar. Depending on the time period, periodicity, and model speci! cation, four risk factors explain 50-75% in the variability of currency fund (index) returns. A signi! cant part of currency returns comes from exposure to a small set of factors that proxy the returns from well-known and easily implemented trading styles. What is sometimes labelled as “alpha” is really more beta.

Why should institutional investors be concerned about how much of the currency return is alpha and how much is beta? First, proper return attribution could lead to some re-pricing for “active” currency products. Investors should not pay alpha fees for exposure to currency style betas that could be earned more cheaply. Second, currency beta might be less suited when the goal

The New Normal - de! ning Alpha in Currency Management

“Institutional investors should ! nd the right

point along the Alpha Continuum,

depending upon their speci! c needs.”

DR. MOMTCHIL POJARLIEV, CFA

Figure 23. See “Do Professional Currency Managers Beat the Benchmark?” Financial Analysts

Journal, vol. 64, No. 5, pp: 18-30, Sep/Oct 2008]4. See “Trades of the Living Dead: Style Differences, Style Persistence and Performance of

Currency Fund Managers, Journal of International Money and Finance, forthcoming

is to diversify global equity exposure. For example, the correlation of carry beta to global equities is -9.3% when global equities produce returns greater than one standard deviation above their mean, but it rises to 28.5% when equities generate returns more than one standard deviation below their means5. Thus, carry beta diversi! es when it is not needed, i.e. in rising markets and it provides no diversi! cation when it is most needed, i.e. in falling markets. Even though the recession caused by the ! nancial crisis of! cially ended in June 2009, the global economic outlook is still uncertain. PIMCO calls this the “New Normal6,” a world in which growth prospects may be lower and long-held assumptions about portfolio allocations are being challenged. For example, many institutional investors still assume that asset returns on their investment portfolios will average 8% over the long-term future. With the investment grade bond market yielding only 2.5% and nominal GDP growth of 2 to 3% this assumption is increasingly coming under pressure and alternative sources of return are needed more than ever.

The New NormalWhat does the New Normal means for institutional investors? First, future returns from traditional asset 5. These correlations are based on monthly return of the MSCI World Index (in local currencies) and the FTSE Currency Forward Rate Bias Index

(Bloomberg Ticker FRB5USDE) from January 1980 until September 2010. Correlations computed using different proxies for currency beta exhibits similar pattern. 6. El-Erian, Mohamed A. (2009). “A New Normal,” Secular Outlook, PIMCO, May 20097. Bernanke (2010).

classes are likely to be lower, while currency alpha mandates offer an alternative source of return, which can be added on top of any investment portfolio. Second, future volatility is likely to be higher; the outlook is “unusually uncertain7“, while currency alpha mandates offer uncorrelated return, which will lower the volatility of the portfolio. Third, diversi! cation might work less than expected and should be complemented with tail hedging. For example, Figure 2 shows the performance of different asset classes in periods of market stress and highlights that diversi! cation often fails when it is most needed. Investors should consider managers with investment processes designed to bene! t from periods of market dislocation.

Many questions remain open. First, how does one choose the right managers? Second, is past performance any indication for future performance (are alphas persistent)? Third, are investment styles (beta exposure) persistent? Fourth, do currency managers provide true diversi! cation to institutional investors with large equity exposure? We will address these questions in future issues. The dialogue between managers and investors does not have to resemble the humorous exchange between Bud Abbott and Lou Costello.

30 SE

CON

D FO

CUS

NAME: FREDERIC BETTANJOB: MANAGING PARTNER

AT SWING CAPITAL1. Holidays - Sun or Snow?Sun - I live in Canada, we have enough snow.2. Stick to the Trend or catch the correction?Catching the correction has become harder than before. When I grow up I think I want to be a Trend follower.

3. Personal investments - Fine Art or Gold?Please God make me invest in another ! eld next time. Art, whatever.4. Food - Meat or Vegetable?MEAT.5. Systematic or Discretionary?Next time. As systematic as can be. Call me for my paycheck.6. Motor Racing or Lawn Tennis?Kite sur! ng in Tahiti.7. Trading preference - Dollar or Yen?Try trading CAD in European or Asian hours. Good luck!!!8. Lifestyle - Town or Country?Town, Town, Town.9. Majors or Emerging Markets?

Even Euro trades like an emerging market when you need to get out of a position.10. Dom Perignon or Krug?Dom Perignon or Krug - just give me lots of it please.11. Mozart or Rolling Stone?Rolling Stone.12. Volatility - Risk or Opportunity?It use to be a bigger opportunity.13. Early bird or Night owl?Early bird.14. Research approach - Technical or Fundamental?Technical.15. FX - Asset class or Commodity?Virtual Asset: Now you see it - Now you don’t!

Autumn 2010 | Currency Investor 19

20 Currency Investor | Autumn 2010

Timing: - just how important is it for

achieving currency alpha?

When looking at the currency market right now and its evolution, you can say its fundamentally based upon four obvious

styles - the carry model, the trend model, the relative value model incorporating things like purchasing power parity (PPP) and volatility,” says Jay Moore, managing director, State Street Global Markets. When discussing the topic of timing and alpha generation, you therefore ! rst have to examine what is beta and alpha, with some consultants proposing that the true carry trade should be seen as de! ning beta.

According to Moore, “Investors perceive the carry trade or trend trade as ‘naïve’ strategies, which they should be able to get through index funds or exchange traded products and are increasingly identifying these as sources of beta rather than alpha. The challenge for currency managers is to exploit these styles and data sets in unique ways in order

to differentiate and outperform those simple naïve strategies.” Does this then turn them into alpha generators?

“I think there’s no doubt that people are looking for alpha in these styles but with a form that is properly uncorrelated, that does diversify a portfolio and does not get caught in the downside that affects other investment strategies that we’ve seen over the last couple of years,” says Chris Brandon, managing director, Rhicon Currency Management, Singapore. And he accepts that with the right way of moving between styles and risk management, along with the innovative use of operational systems, alpha elements can be returned.

Alpha is generally seen as adding value, increased performance, over a benchmark or de! nable element. For others it is identi! ed as the managers skill.

Within the equities world there has been some discussion over whether market timing is a viable investment strategy or simply a form of gambling based on chance. The argument goes that prices might exhibit the ‘random walk’, a mathematical concept of a trajectory

made up of random steps, but that sooner or later the ef! cient-market hypothesis will kick in and things will rebalance. Of course whether this is correct or not, it still means there are opportunities for those who spot the opening. It also raises the question yet again of whether currency markets have innate inef! ciencies that bene! t the shrewd trader, not

a view that everyone accepts. Then there is the issue of alpha versus beta. That hoary old question of what is alpha comes to the surface again, especially when judging whether

particular styles in" uenced by timing behaviour are providing true alpha or a form of beta.

CURRENCY MANAGEMENT

By Gerry O’Kane

Autumn 2010 | Currency Investor 21

Need for experience“Experience of the manager is critical to performance and in my view, things that I’d be concerned about if I was an investor and a question I’d ask, is, does the manager invest in his own strategy. Do they truly believe in themselves? For me that would be a necessary condition for me to invest,” observes Brandon.

“Of course it is necessary to have experience along with a deep understanding of the market and how

currencies interact with underlying assets. These are key factors if you are trying to predict the behaviour and timing of the market, making for a better fund manager” agrees Mark Farrington, Head of Macro Currency Group.

Taking stocks, if one built a portfolio based on the FTSE 100 Index but had elements of divergence, leaving out certain companies, adding in others and increasing or decreasing percentage values relative to the Index and it outperformed the FTSE, have I created alpha?

CURRENCY MANAGEMENT

22 Currency Investor | Autumn 2010

What if I have taken a view that in a certain market environment large cap or value shares are in a position to outperform the Index, is performance merely re" ecting the beta of value shares or large cap shares, rather than providing alpha?

To an extent the level of the debate can become akin to navel-gazing. How far down the road do you go arguing that styles and systems are replicable and consequently should be seen as beta returns. As has been pointed out elsewhere, a comparison of widely used carry indices from different sources will not show identical returns.

Risk aversion modelsOne development from the fall-out of the carry trade downturn in 2007, has been the development of risk aversion models. “Many houses with quantitative models are trying to identify periods where risk aversion is very high or where volatility is very high, consequently highlighting where the carry trade is likely to do worse,” explains Matthew Roberts, a senior consultant at Towers Watson.

“At that point they would switch styles or reverse their carry positions. It’s an interesting development but also poses an interesting question, which is if all the managers develop risk aversion indicators how valuable is that, will it then re" ect beta?”

He accepts this can become a little philosophical, a case of when is an ‘it’ an ‘it’?

According to Thomas Suter, CEO of Swiss-based Quaesta Capital all of the common strategies can provide returns but not if followed exclusively and rigidly. “Most styles depend too much on the underlying market environment. Take the example of the carry strategy – it did very well until summer 2007. For about two years after, following the exact same strategy, the investment

manager just lost you money. Does this now mean that the strategy is wrong? No, it doesn’t really, just means that it’s the wrong strategy for the certain environment,” he says.

“On the other side, break out/momentum ‘long gamma’ type strategies did badly until summer 2007 and then had a great period throughout 2008, because suddenly big market activity took place. What does this all tell us? Market timing is crucial!” he adds. “It’s knowing which strategy does well in a certain environment and then, on the back of this, over- or under-weighting certain styles dependent on the market view for the near future.”

Market neutralWhile he accepts that market timing is crucial, Suter raises an additional point: “There are also strategies whose performance generation is market neutral or market independent. For certain clients it might be better to encompass those types of strategies – in particular when you choose just one strategy for your portfolio this should allow you to get a more stable portfolio risk/return pro! le.”

It’s a view with which Moore agrees. “The carry-style manager needs to demonstrate that they have the ability to exploit those risks on the downside and manage portfolios in a diversi! ed way and sustain alpha in the long run, when beta strategies might be out of favour.”

Timing: - just how important is it for achieving currency alpha?

JAY MOORE

“Investors perceive the carry trade or

trend trade as ‘naïve’ strategies, which

they should be able to get through index funds or exchange

traded products and are increasingly

identifying these as sources of beta rather

than alpha.”

Autumn 2010 | Currency Investor 23

has gone into quantitative and systematic models to eliminate market timing. In most cases these models have not proven to be that successful,” points out Mark Farrington.

He feels one investment style in particular exploits market timing better than any other and is the style adopted by the Macro Currency Group: “I’d say that fundamental discretionary investing relies on timing more than other styles.”

A classic example of carry trades providing returns based on timing would have been the Mexican Peso crisis in 1994. To ! nance the de! cit a debt instrument was launched at a ! xed interest rate pegged to the dollar. By the end of 1994 the country did not have enough dollars to pay out and subsequently devalued the peso, but for managers who could see the writing on the wall an early exit or the carry trade or a move to another strategy would have brought pro! t.

Of course should you go with the argument that these models do indeed represent beta returns, rather than alpha, then the argument may still be made that market timing provides beta too.

“In both recognising alpha and the importance of timing, you need to understand why the strategy is doing well and when it’s under-performing, is that what you expected?” advises Brandon. And while returns may increase is this simply a factor of increasing the risk exposure? “The questions you must ask are what are the differing patterns in the daily returns and can you identify any style drift?”

Market timing“In general, all styles use market timing to a differing degree and lots of work

CURRENCY MANAGEMENT

“...things that I’dbe concerned aboutif I was an investorand a question I’d

ask, is, does themanager invest in

his own strategy. Dothey truly believe in

themselves?”

CHRIS BRANDON

24 Currency Investor | Autumn 2010

Timing: - just how important is it for achieving currency alpha?

Farrington identi! es several factors that the industry generally views as being market timing-speci! c issues: “There are people who look to take advantage of excess positions and will therefore take a contrarian view, believing the position will be washed out. It’s frequently cited and used as a metric in the industry as being a market-timing issue. I don’t agree – to me it’s simply taking a view opposite to the market.”

And it’s only repeatable attribute is being contrary. Others he is more positive about, and argues that these sorts factors are what separates fundamental and discretionary styles from those based on quants and metrics.

“As a ! rst mover in a market, watching large merger and acquisition " ows across borders can generate one-off currency movements which can be exploited”, says Farrington. “The problem is that M & A " ows

are a lumpy way to get return and often such opportunities may not be there.”

He also points to other fundamentals: “We look at everything, no part is excluded. Changes in economic policies, monthly key economic data releases, changes in economic outlook are all examples of fundamentals that will change valuations and you have to be prepared for them.”

Other market timing events can include supply shocks, political events and structural developments, for example emerging market growth versus global growth. “All these things can be analysed allowing you to take a position prior to an announcement to the market. That way you are a step ahead and can capture decent movements in currencies before your competitors.” explains Farrington.

External forcesJay Moore agrees that these external forces make currencies unique as as an investment opportunity, providing you got the timing correct. “This reality is accentuated by how little of this market is actually driven by alpha seeking positions,” he says.

He points out that by timing movements in international equity markets in the short- to medium-term, alpha can be gained, helped by market inef! ciencies. “If Japanese equity markets are beginning to climb, there will be a lot of Japanese yen orders as foreign players buy shares, this in turn might also be in" uenced by the Central Banks. Central Banks will try to manage currencies based on their priorities, while markets bring other factors to play.”

And there are other examples of where the fundamentals might exist to suggest a certain investment approach, but getting the timing right is far more critical. “With a value strategy that has a strong element of PPP, the research we’ve done has recorded that currencies can extend the cycles of over-valuation or under-valuation relative to their purchasing power parity far longer than most investors are likely to stay the length,” observes Moore. “It’s been labelled as a very long-term strategy, however if the entry points are timed to follow large mis-valuations and the strategy is applied across a broad portfolio of currencies, such a strategy can perform quite well in the short term as well.”

MARK FARRINGTON

“I’d say that fundamental discretionary

investing relies on timing more than

other styles.”

Autumn 2010 | Currency Investor 25

Producing alpha in this case is all down to market timing.

ConclusionMark Farrington also points out that while having solid research in order to identify these market timing events is important, it is also crucial to have strong support systems in place. “It’s critical to be proactive in both style and systems – a lot of energy is wasted by managers on minimising costs rather than actual indentifying these market-timing issues. To take advantage of market-timing issues and produce decent returns a manager cannot afford to cut any corners. It should be no surprise that poor execution or poor timing of execution can destroy any skill of the manager.”

Of course the concept of timing is usually based on the presumption of the skill of managers to

outfox their rivals. But, as Farrington pointed out, quantitative and technical have tried to model the timing signals.

According to Adam Olive, a co-manager of HSBC’s GIF Global Currency Fund, a high-frequency trading strategy can produce alpha too. “The thing about currencies, is that the number of assets are

comparatively small, so to generate a good risk-adjusted return in a low turnover strategy,you have to predict where those assets are going incredibly accurately. A better way to generate a high Sharpe ratio is to “bet” very frequently but with less accuracy. You can also cut your positions very quickly, should you need to, if you have this ability to trade at higher frequencies.”

It is easy to argue that in order to gain alpha, timing the market is crucial. Even when using what might be considered beta

strategies, the secret of their out-performance and of a manager’s out-performance, is to use these strategies in differing amounts over selected time periods. The fact is the optimal mix of strategies, including fundamental styles, will change through time.

CURRENCY MANAGEMENT

MATTHEW ROBERTS

“Many houses with quantitative models are trying to identify periods where risk aversion

is very high or where volatility is very

high, consequently highlighting where the carry trade is

likely to do worse,”

THOMAS SUTER

“It’s knowing which strategy does

well in a certain environment and

then, on the back of this, over- or under-weighting certain

styles dependent on the market view for the near future.”

26 Currency Investor | Autumn 2010

Alternative approaches to Currency Management

Signi! cance of Currency RiskThe growing pressure on investors to match their liabilities is forcing them to assess how hard their risk budgets are working. By decomposing risk, it is possible to compare the expected returns of each risk exposure. An immediate consequence of considering the risk allocation, as opposed to the traditional asset allocation, is the sudden prominence of currency translation risk. It would not be unusual to see a 20% allocation to foreign assets, which results in a 20% exposure to the movements of foreign currencies. This unrewarded risk can have a major impact at the total portfolio level. Without mentioning the credit crisis ‘episode’, the dollar’s strength during 2005 resulted in a 15.8% currency translation loss on an MSCI EAFE portfolio.

International investors hold two types of currency risk: currency translation risk and

currency alpha risk. Confusion between these different types of risk can result in signi! cant currency losses. Currency translation risk is

a by-product of foreign investment. Investors gain from the diversi! cation bene! ts of holding foreign assets, but they take on the currency risk

without any expectation of adding value to the portfolio. Yet exchange rate movements generate losses and gains that can have a signi! cant impact at the total portfolio level. This type of currency

risk is unrewarded: developed market currencies have no expected return. On the other hand,

currency alpha risk results from positions taken by the managers of currency absolute return or global macro mandates. These managers are paid to increase the amount of currency

risk in a portfolio. The activity naturally forms part of the “alternative investments” category.

However, this activity does not assist in any way the management of the currency translation

risk. In this article Arnaud Gérard CFA, Head of EMEA Business Development, Pareto Investment Management Ltd, addresses the normal method

of controlling currency translation risk and highlights the challenges and weakness of

de! ning a ! xed benchmark and suggests an alternative solution.

CURRENCY MANAGEMENT

Translation Risk

Alpha Risk

Autumn 2010 | Currency Investor 27

This would have caused a 3.2% loss at the total portfolio level, easily wiping out all alpha generated by active managers in the entire portfolio. In contrast, the 19.0% currency translation gain in 2003 would have created a positive impact of 3.8% on the total portfolio.

These observations highlight the importance of implementing a well-de! ned currency hedging policy at the total portfolio level. As the proportion of foreign investment rises, currency translation risk consumes an ever larger proportion of the total risk budget.

Note that we evaluate risk in terms of the cumulative loss that can be sustained over a period. This is very different from simply measuring the standard deviation of returns as the de! nition of risk. It is quite common, for example, for currency movements to generate a 5% loss over the course of a year without having a noticeable impact on the volatility of portfolio returns.

A fund’s currency hedging policy has a far greater impact on investment returns than the alpha generated by risk-taking managers.

CURRENCY MANAGEMENT

“As the proportion of foreign investment

rises, currency translation risk

consumes an ever larger proportion of

the total risk budget.”

ARNAUD GERARD

28 Currency Investor | Autumn 2010

The Passive Route & Selecting a BenchmarkMany factors go into the determination of a currency hedging policy, but the subject of this paper is a comparison of methods of implementation. So let us assume that a decision has been taken to adopt a strategic hedge on foreign currency exposure, acknowledging the fact that, whatever the strategic stance, it cannot be more than 50% right in the long term: a fully hedged position is only correct when the base currency rises, whereas an unhedged position

only gains when the base currency is weak, while a partially hedged position is partially right all the time.The simplest approach is to apply a passive (static) hedge. This has the advantage that it is relatively straightforward to implement. However, although it reduces currency losses, it equally reduces the opportunity to make currency gains, so there is no expected return from this activity. There is also a cost of implementation and in managing the cash-" ows generated.

Simple mean variance work is often used to help in deciding what might be the optimum static hedge

outcome once given a set of ‘realistic’ /or expected mean, variance and correlation characteristics.

In the ! rst example, we selected two simple equity like global portfolios with long term characteristics for the unhedged portfolio [mean +10%, volatility +12%], for the fully hedged portfolio [mean +2%, volatility +9%] and the correlation between the two is -0.2. A 58% hedge ratio is being recommended to optimise the mix.

By recognising, some uncertainty (lack of long term stability) in the volatility and the covariance of our initial two portfolios, the results of the optimisation work will typically get a broader outcome as shown left.Already, this simplistic analysis no longer provides the unique answer of a 58% hedge ratio, but a range from 45% to 95%.

The recent market turbulence highlighted the true reality (or stability) of market/assets characteristics. By letting all our variables " oat (mean, volatility, covariance), the optimisation results provide a binary recommendation based on 100 random iterations – one should either hedge 0% or 100%! The reality of this scenario is well illustrated in the bellow chart of the MSCI World ex EMU index.With the MSCI index, one can observe that short term and long term correlation of market and currency were relatively stable around -0.6. This feature dramatically broke down in 2008 onwards.

The with-hindsight optimal hedge ratio resulting from the above statistics

Alternative approaches to Currency Management

All Variable Known

Variance & CoVariance Unknown

All Variables UnKnown

Autumn 2010 | Currency Investor 29

results in the following chart which shows an overwhelming preference for either 0% or 100% hedge position in order to maximise the information ratio of the portfolio.

These results undermine the classic mean-variance optimisation process. The principal drawback of the traditional approach is that by assuming that currency translation risk can be managed with a passive hedge, it fails to address the problem that in any particular year the strategic policy hedge can be precisely the wrong place to be. Being passively fully hedged in 2003, would have cost the total portfolio 3.8%, while an unhedged position in 2005 would have caused a total portfolio loss of 3.2%.

Active Route to Mitigate Benchmark RegretA pragmatic solution to this benchmark “regret” is to adopt an active approach which aims to alter the hedges as the environment changes. The analysis above has shown that selecting the middle ground will guarantee regret and never represents the optimum situation. There is no perfect benchmark that satis! es all constraints all of the time. As a result the static benchmark selected can only be reached by compromising (regulatory framework, cash " ows sensitivity, return sensitivity, international exposure size, market outlook etc).

In practice, an active approach will respect the recommendation that results in the selection of the strategic/static benchmark, but will lean towards reducing the negative cash " ows (by decreasing hedges during a weak base currency environment), while protecting against a strong base currency by increasing the hedges. By varying the hedge in this way there is the opportunity to add value over time, as well as to improve the risk management of the portfolio, and its impact on the funding status and the liabilities of its sponsoring company.

ConclusionIncreasing acceptance of the concept of risk budgeting, the broader acknowledgement of liability driven investment, and new accounting rules have all prompted new thinking about the way to implement currency management. Foreign currency translation

risk is important for investors whose liabilities are denominated primarily in base currency. As the earlier examples demonstrated, an incorrect currency hedging policy can result in signi! cant losses at the total fund level.

This means that the two types of currency risk need to be addressed at two different levels in the hierarchy of risk budgeting decisions. Currency translation risk must be addressed strategically at the total fund level, whereas the allocation to currency alpha risk is part of a lower level decision in the alternative investment’s risk budget. Therefore it is necessary to separate the two decisions, and to allocate the necessary governance to each.Having adopted a strategic stance, a currency hedging policy must also address the question of how that stance is implemented: passively or actively. Active hedging is a superior alternative to the passive approach, because it allows a skilful active manager to control currency translation losses by adjusting the portfolio’s currency hedges towards the ideal stance in any currency environment.

CURRENCY MANAGEMENT

Source: Datastream, from 31 December 1972 to 31 August 2010. MSCI world ex EMU index unhedged in Euro, MSCI world ex EMU index hedged in Euro.

Source: Datastream, from 31 December 1972 to 31 August 2010. MSCI world ex EMU index unhedged in Euro, MSCI world ex EMU index hedged in Euro.

30 Currency Investor | Autumn 2010

Currency Fund Operations -Why not let an administrator take the strain?

The past 18 – 24 months has been a dramatic transformation of the global ! nancial landscape. A dramatic destruction of asset

values as well as investor con! dence.

The period leading up to the Bernie Madoff affair and then subsequently, has seen a paradigm shift within the international asset management industry. The hedge fund community experienced a massive upheaval as liquidity and credit dried up almost overnight, counter-party risk increased exponentially with the increasing number of large bank failures and investors naturally " ocked to traditional safe havens such as cash and gold.

As the world has moved on from Mr. Madoff, there has been a momentous residue left from his imprint. The two common themes that ran through the Madoff affair and indeed the vast majority of all poster child hedge fund failures over the past twenty years, has been the lack of safe custody and segregation of assets from the investment manager and other counter-parties on behalf of the fund along with the independent veri! cation and validation of the assets within the investment vehicle.

Moves toward BestPracticeThe hedge fund industry has been progressing, or perhaps maturing is a better description, over the past

number of years from an investor base principally consisting of high net-worth individuals and private banks to one of institutional investors. With this maturation comes an enforced transformation in terms of operational infrastructure and the application of ‘Best Practice’ in the controls and processes of any product or service offering, if a currency asset manager hopes to raise assets in the post Madoff world!

This requires improvements in infrastructure for middle- and back-of! ce operations, enhanced reporting to stakeholders and independent veri! cation of portfolio values. Consequently, the appointment of an independent third party administrator can go a long way to re-assuring investors and easing some of the increased ! duciary pressures that are now placed on managers.

With an administrator taking care of these key duties, it leaves the currency manager with a lot more time to dedicate to the ! duciary duties it has to the fund and, most importantly, trading performance. Of course the key is ! nding an administrator that can do this work up to the new institutional standards expected and, as importantly, one that has the same ideology in terms of growing with the

In today’s environment two key words are at the forefront of considerations for investors – liquidity and transparency. Currency shouts those key words, being both transparent

and liquid investment, highly desirable attributes in a post-2008 world. After experiencing signi! cant losses, liquidations, freezing of assets and exit restrictions, investors have become far more risk aware and are requiring greater transparency

and accountability in the managers that look after their investments and the investment products in which they are housed, including, as John McCann Managing Director of Trinity Fund Administration Limited outlines in

this article, the process of fund administration.

FUND OPERATIONS

Autumn 2010 | Currency Investor 31

currency manager and consistently

innovating with technology.

In this regard, at Trinity we predict that in order to attract

the institutional allocation, it will eventually become standard

practice and a prerequisite for portfolio managers to release

unambiguous information to investors, such as large positions and exposures in

their portfolio or by providing them with documents such as compliance manuals,

valuation policies and risk management procedures. Investment businesses will have

to evolve continuously in order to maintain their competitive edge over other less transparent ! rms

and one of the best places to look for this edge is to evaluate what your administrator can do for you as the currency manager.

New operational paradigm

The new operational paradigm ensures that administration services are no longer centered simply on back-of! ce functions dealing with

accounting, valuation and share

registration. Fund administration can now be de! ned as everything after the trade, and increasingly, prior to the execution of the trade. Therefore, the currency manager can turn to their administrator to take over a whole array of services over and above the traditional core services associated with fund administrators such as risk management, reporting, performance attribution, position monitoring, pre-trade compliance and investment analytics.

Within my own company, we have seen the writing on the wall and have embraced the requirements of the new paradigm, ! nding it necessary to increase signi! cantly our investment into our IT capability and continuing to make comprehensive improvements to our proprietary in-house system by adding new modules for price-check reporting, revaluations and investment restriction monitoring. This is something already becoming a trend within the more progressive fund administrators.

Even within areas such as our web applications we’ve taken over hosting of our public web presence to allow further expansion of the functionality on offer to our external clients with real-time reporting. This allows any of our managers to go online in their time to see the latest transactions, NAVs, fund prices and other pertinent transactional information at the click of a mouse, with information updated four times daily, to provide data on a same-day and intra-day basis. And this too is becoming an increasingly demanded solution from investment houses across the business.

Credit exposure issuesAdditionally, many currency managers implement their strategies using FX forward contracts or other such over the-counter instruments that often require only a contractual agreement between client and counter-party (typically in the form of an ISDA Agreement). This bilateral credit exposure is a point of regular discussion, particularly since the ! nancial crisis in which counter-party credit moved to the forefront of investor concerns. Moreover, this credit is often agreed-upon without cash collateral, allowing for more ef! cient cash-managed portfolios. However, it should be recalled that potential deferred losses from FX positions can create signi! cant liquidity issues at settlement, when portfolio managers may be forced to sell underlying assets to the detriment of the portfolio. While regulators may impose incremental oversight on the industry to address these concerns, it’s up to market participants to provide their clients with process transparency that allows more continuous management of these issues. In this

FUND OPERATIONS

32 Currency Investor | Autumn 2010

regard an industry experienced and technologically ef! cient third party administrator can assist the currency manager immensely in this regard.

Regulatory overhaulAs if the complete transformation of one’s historical business model was not enough of a challenge for a currency fund manager to come to market and hope to attract signi! cant institutional assets, there has also been a complete international sea-change in terms of the rules of the game in the form of global regulatory overhaul.

The nations of the G–20 and the prominent international regulators have been furiously busy over the past 18 months scrambling to implement rule changes motivated to prevent a repeat of the conditions that led to near global ! nancial meltdown and to achieve that over-used phrase “Never again!”

As such, despite their communal pledge early on in the crisis to ! nd a collective universal approach to improved regulation for investor protection and reduce systemic risk, regulatory and political groups have recently reverted to national or regional tendencies to impose disparate ideological approaches to achieving this lofty goal.

Over the past few months the world has seen a slew of major legislative announcements in terms of new rules to play the same game. As a direct result of these there will be a colossal impact on all stakeholders within the asset management industry. Administrators expect permanent and signi! cant change as a result of these major pieces of legislation being ! nalised within the USA, Europe and further a! eld. Namely such ground shifting rule changers such as the Dodd-Frank bill, the Transparency Bill, the FATCA Tax Reporting, the AIFMD (Alternative Investment Fund Managers Directive), and global accounting and ! nancial reporting revised guidelines, will raise the bar immensely.

The AIFMD for one, in recent days looks like it will be somewhat watered down from previous

more draconian versions, to a more realistic piece of legislation than what was originally proposed. However, its most recent form will still have a transformational impact on asset management operations in terms of monitoring of risk and reporting duties for the currency manager. No attribute will be more important than transparency, and this means providing clients with insight into the importance of the various implementation decisions (contract tenor, rebalancing frequencies, trading ! lters, proxy currencies and so on). This is where a good fund administrator can add serious value for an investment manager, providing guidance on these decisions and also be able to measure their effectiveness through performance reporting tools.

Currency Fund Operations – Why not let an administrator take the strain?

“Fund administration can now be de! ned as everything after the trade, and

increasingly, prior to the execution of the

trade.”

JOHN MCCANN

Autumn 2010 | Currency Investor 33

personnel and view the technology in operation. This ‘kicking the tyres’ exercise can be the key factor in revealing if the administrator can really partner with the manger in growing the fund and take care of all the key duties we have mentioned above in an ever rapidly changing world.

Another key factor should include whether the administrator has experience in dealing with

currency funds and whether they have the systems that can cope with the different

scenarios of multi-currency management and pricing, including handling OTC

products.

ConclusionThe international asset management industry has been radically transformed as has the global ! nancial environment in the past 18 months post

Mr. Madoff. Some of the change will be good,

some will be not so good, but there is no doubt that it

will be onerous, costly and all-intrusive in a new world order in

which transparency and liquidity are the buzz words for investors and

regulators alike.

The one sure thing is that change is constant and in order to compete in this

new world order, currency managers will need to keep up with it’s wide ranging nature in terms of the demand for best of breed operational infrastructure and compliance burden, in order to attract assets of an ever increasing institutional nature.

One of the best decisions currency managers can make to assist

them complete is by selecting a properly quali! ed, internationally

knowledgeable, technologically capable and service-oriented third-party fund

administrator, to assist them. As an independent third-party manager, we believe

that helps in facilitating " exibility when handling the changing needs of a more regulated and demanding world.

As with the changes that were necessary to adapt to the new operational and reporting requirements, administrators equally need to adapt to the new regulatory requirements in order to support the increased demand placed upon our clients. This is a prime example of where over the past few years the traditional role of the administrator has changed beyond recognition from the days of simple accounting and NAV production. Fund administration companies are becoming very much involved in providing corporate secretarial and corporate governance services of a bespoke and industry variety, such as listing obligations and EUSD compliance. It is becoming more critical to provide support to fund boards and asset managers in terms of the multitude of international reporting obligations with respect to operational cross border compliance. This includes a wide array of local and international legislative requirements that may directly or indirectly impact the product and the business of the asset manager.

Selecting anadministratorPrior to 2008, the fund administrator selection process was straightforward and largely handled by managers, a check-the-box type of exercise that revolved around fund administrators’ brands and fees. The problem with relying too heavily on brand awareness is that a brand’s quality was often correlated with size. But size and brand do not ensure that an administrator deploys the most reliable technology, SAS 70 certi! ed processes, domain expertise and scalability, not only in terms of size but the funds ability to adapt its operation to changing technology, regulations and market conditions.

When choosing an administrator, the manager should perform a thorough due diligence process and, where possible, visit the of! ce and meet the staff and key

FUND OPERATIONS

34 Currency Investor | Autumn 2010

Regulatory Roundup

United StatesThe CFTC’s new rules governing retail forex trading went into effect on October 18, 2010. These new rules are signi! cant because they are amongst the ! rst to be promulgated pursuant to the Dodd-Frank Act. While the majority of these rules are aimed at entities that serve as counterparties to retail forex transactions, a number of provisions concern CPOs operating in the forex industry. Such relevant changes include the following:

• Rule 4.7: Allows for CPOs to gain exemption from certain requirements with respect to offerings to quali! ed eligible persons. For a quali! ed eligible person the minimum security deposit for the transaction must be included in the calculation of the portfolio agreement.

• Rule 4.13: In order for a CPO to claim an exemption from registration under this provision, the aggregate initial margin,

In the wake of the recent ! nancial crisis, the United States and the European Union are instituting major regulatory changes which will impact currency traders and fund managers. In the U.S., the

Commodities Futures Trading Commission (“CFTC”) recently promulgated new rules regarding over-the-counter retail foreign currency trading (“forex”). Also, in October, the CFTC proposed another set of rules codifying more transparent registration requirements for certain Commodity Pool Operators (“CPOs”). On the other side of the Atlantic, the European Union is working on

the Alternative Investment Fund Managers Directive. In November the European Parliament will vote on this Directive, which proposes changes in the regulation of private equity and hedge

funds. Since currency funds are classi! ed as hedge funds in Germany, this piece of legislation is of signi! cant interest for currency fund managers operating in Germany.

FUND OPERATIONS

By Felix Shipkevich, The Shipkevich Law Firm, PLLC

Autumn 2010 | Currency Investor 35

premiums, and required minimum security deposit for retail forex cannot be larger than 5% of the liquidation value of the pool’s portfolio.

• Rules 4.24 and 4.34: CPOs must provide customers a risk disclosure statement which states that under the Bankruptcy Code forex transactions may not be given the same preferential treatment as commodity customer claims.

• Rule 5.3: People who operate or solicit funds or property for a pooled investment vehicle including forex pools must register as CPOs. Associated persons of such CPOs must also register as associated persons.

• Rule 5.9: The minimum leverage for retail forex transactions is 2% of the notional value for major currencies pairs and 5% the notional value for minor currency pairs. If the amount deposited does not meet this requirement, the counterparty must liquidate the customer’s position. The CFTC originally proposed setting the minimum leverage at 10%; however, they decided to lower the requirement in the ! nal rules after receiving a lot of negative comments suggesting that such a high leverage requirement would force industry to move offshore.

• Rule 5.13: Counterparties must furnish to each customer a monthly statement (this can be submitted electronically with the CPOs’ consent).

• Ruless 5.15 and 5.16: CPOs, principals, and those who solicit for them, cannot represent that the CFTC or federal government has sponsored, recommended or approved them in any way.

The new CFTC rules are aimed at preventing fraud in retail foreign currency trading. Currency fund managers should note that the CFTC has recently brought a number of enforcement actions against CPOs and fund managers. For example, in July the CFTC brought an action against a registered CPO for making false statements to customers and in required CFTC regulatory ! lings. Other recent actions center around ponzi schemes, defrauding customers, and failing to register as a CPO.

“Currency fund managers should note that the CFTC has recently brought a

number of enforcement actions against CPOs and fund managers.”

Additionally, on September 8, 2010, the CFTC proposed to change the regulatory structure pertaining to certain CPOs whose units of participation are listed and traded on a national securities exchange. The proposed changes would relieve these CPOs from certain disclosure, reporting

FUND OPERATIONS

36 Currency Investor | Autumn 2010

and record-keeping requirements. Such CPOs would still need to provide the same disclosure information, make the same periodic reports, and keep the same books and records they are already maintaining. However, they would be relieved from:

(1) Obtaining a signed acknowledgment of receipt of the disclosure document if the disclosure is already available on the CPO’s website

(2) Delivering monthly account statements if the required information is available on the CPO’s website and

(3) Keeping all required books and records at the CPO’s main business address. Such relief is based on substituted compliance with corresponding federal securities law. Previously the commission had issued such relief on a case-by-case basis. Additionally, the changes would require certain independent directors or trustees of actively managed commodity pools to register.

The new CFTC forex rules which went into affect on October 18, 2010 and the proposed CFTC rules related to CPOs are microcosms of the shift the ! nancial markets are experiencing leading to more stringent speci! c regulation. In the wake of the ! nancial crisis the government will likely continue to take a hands-on approach to regulation, an approach that is likely going to permeate through many ! nancial centers around the world.

GermanyAnother important upcoming regulatory change concerning currency fund managers is the Directive on Alternative Investment Fund Managers (AIMFD) which was proposed in 2009. Since 2009, member states of the European Union (“EU”) have been negotiating the controversial provisions, and in mid-October, 2010, a common text was adopted. The main obstacle to adopting this text has been debates regarding how to treat hedge funds domiciled outside of the EU. On November 11th the European Parliament will be voting on the ! nal text, and if it passes, member states will have two years to incorporate the rules into their national laws. The Directive is aimed at providing regulation of private equity and hedge funds, as there is currently

no EU supervision of these sectors. Subsequently, the Directive will create a pan-European watchdog with greater oversight powers. Through this watchdog, the directive aims to establish a harmonized framework for monitoring and supervising the risks that alternative investment fund managers pose to their investors, counterparties, other market participants, and the stability of the entire ! nancial system. Another one of the law’s main goals is to promote transparency by extending the range of information private equity advisers and hedge funds must distribute. As a result such companies will have to indicate what ! nancial products and markets they are investing in. They will also have a duty to disclose to investors and regulators their investment strategy and the amount of leverage they are using to implement it. Additionally, private equity and hedge funds will be banned from short-selling. These requirements are aimed at safeguarding investors’

Regulatory Roundup

Autumn 2010 | Currency Investor 37

• There is no minimum leverage requirement. The Ministry of Finance, however, can restrict leverage in short-selling transactions through an executive order intended to prevent abuse and protect capital market integrity.

• Relative lack of restrictions in Germany for retail investors in hedge funds. There is no minimum requirement to invest in hedge funds in Germany.

The main way in which the EU directive will change the regulation of hedge funds in Germany is with regards to transparency

and disclosure requirements. German law does not currently require fund managers to disclose leverage

and investment strategies to clients, and

prefers to leave it up the investors to make individual

arrangement with fund managers. Additionally, the EU

“passport” regime will allow investors to bypass the current private placement regime in Germany. Instead, investors can gain access to the entire EU market, rather than complying with each individual countries requirements. Although the German regulators favor a higher standard for the passport regime, this will be a favorable development for currency fund managers outside the EU looking to enter the German market. Also, additional costs will be incurred as fund managers will need to comply with the German regulators and the pan-European watchdog.

While many have speculated that the ! nancial crisis is ending, an inevitable result is more stringent government intervention in the ! nancial markets. The failure of the global ! nancial system was likely perceived by the government as a failure on self-regulation. In the U.S. the Dodd-Frank Act will greatly impact the ! nancial sector and continue the trend to increased government regulation which will likely trickle to European ! nancial sectors.

money and preventing fraudulent investment schemes. Other speci! c requirements include that each fund has an independent valuator, a minimum capital requirement of 125,000 Euros, and unspeci! ed leverage requirements to be promulgated in the ! nal directive.

The main compromise in the common text is the marketing of non-EU funds within the EU. Such funds will be given a “passport” enabling it to be marketed throughout the EU, rather than having to gain permission in each individual country. The requirements for receiving this passport are the that the country in which the fund is domiciled must (1) have high enough standards for anti-money laundering (2) grant reciprocal access to the marketing of EU funds in its territory (3) have agreements with EU member states where marketing covers the exchange of information relating to taxation and monitoring, and (4) recognize and enforces judgments in the EU on AIMFD issues.

The AIFMD has raised concern among currency fund managers operating in Germany, because such funds are categorized as hedge funds under German law. They are concerned with how the AIMFD will change the regulation of hedge funds in Germany. Currently, major requirements for hedge funds in Germany include the following:

• Hedge funds must obtain a written license from the national regulator.

• Hedge funds can only market and distribute through a private placement. Therefore, they must follow the rules applicable to prospectuses, which includes containing a list of the fund rules and a warning about the total possible loss. This rule applies to foreign funds as well.

• Hedge funds are subject to minimum capital requirements, but advisers are not. Such capital requirements are expected to provide a safety-net against existing obligations when asset values decline sharply.

FUND OPERATIONS

Felix Shipkevich can be reached at [email protected] or on +1 212-252-3003

38 Currency Investor | Autumn 2010

Thanos Papasavvas: “We are guardians of a 30 year track record”

Thanos, how long have you been working in the currency management business and what do you particularly like about the industry?

I have been involved in currency markets for 18 years. In fact, about a week after starting my ! rst job as an economist for the UK government the ERM crisis took place in September 1992 which sent the pound 15% lower in two weeks and 25% lower by the end of that year. That experience gave me an early indication of the type of movements expected in this asset class but also the opportunities which they can generate.

Why currency management? It is the one asset class which is impacted directly by everything taking place around the world, 24 hours a day, whether it is economic developments overnight from New Zealand, political turmoil in the Middle East, threats of ‘currency wars’ at the G20 level or interventions by central banks. It gives us the opportunity to add value to our investors’ portfolios by taking advantage of economic and political developments around the world alongside a thorough understanding of market positioning and expectations.

What do you see as the main value proposition of making an allocation to active currency management to a portfolio and why does the case for doing this remain so strong?

In the UK we are seeing pension funds invest an average of 5% of their asset allocation strategy

to active currency management. The UK has been ahead of the curve so far, but certain parts of Europe and the US are catching up. Why invest in currencies? Most importantly because currency investing can be pro! table. This is partly due to the inef! ciency of the asset class as a large number of market participants do not try to maximise their returns when trading currencies, but also because currencies may trade away from their fair value for prolonged periods of time.

If we take a step back to the ! xed exchange rates world of the 1950s and 1960s, currency investing was neither necessary nor worthwhile. This changed over the last 15 to 20 years and has developed greatly by way of cross-border portfolio exposure management and as a stand-alone way of managing assets.

In addition, currency investing has historically provided welcome portfolio diversi! cation with returns providing a low correlation to equities and bonds. Furthermore, currency markets are exceptionally liquid; in fact, the foreign exchange market was the only market which stayed open for business throughout the recent ! nancial crisis. Its transparency and liquidity were so prevalent that equity and credit managers would use currencies as a proxy for hedging some of their more illiquid positions.

Investec Asset Management believes that applying a multi-strategy approach to currency management creates superior risk-adjusted returns. Why is that?

Currency Investor speaks with Thanos Papasavvas, Head of Currency Management at Investec Asset Management.

CI INTERVIEW

CI IN

TERV

IEW

Autumn 2010 | Currency Investor 39

Studies highlight many different ways to generate returns across both major and emerging market currencies such as valuations, trends, interest rate differentials, fundamental analysis etc. Some currency strategies can be easily quanti! ed but others are better applied on a qualitative basis. We believe that applying a multi-strategy approach to currency management creates superior risk-adjusted returns.

How is the Investec currency management team organised and what are your main day-to-day responsibilities within the ! rm?

The team is broken down to the three key components of our process: quantitative, qualitative and emerging markets. We believe in a multi-strategy approach and the team represent their key specialisations with separate risk/return targets, drawdown limits and risk management. I maintain the overall responsibility for the program and ensure that our process operates ef! ciently and optimally.

In what ways has Investec tried to differentiate itself from other leading currency management ! rms?

We differentiate ourselves in both process and products.

From a process point of view we believe that there are three key differentiating features between currency managers: the quantitative / qualitative split, the behavioural / fundamental split and the breadth of the currency universe. We believe in a blended quantitative / qualitative approach which ensures that quantitative models capture the strategic drivers of currencies and do the ‘heavy lifting’, whilst qualitative analysis and judgement from managers with long experience over a number of economic cycles complements the process. We also believe in analysing both fundamental and behavioural drivers as the former tend to drive currencies in periods of uncertainty whilst the latter impact market positioning, momentum and technicals. Finally, we have a very long heritage and deep understanding of emerging market currencies which helps us invest in a very broad universe of over 50 currencies.

CI INTERVIEW

THANOS PAPASAVVAS

40 Currency Investor | Autumn 2010

More importantly we do not invest in a naive pro-beta approach to emerging market currencies, but instead in a relative value approach taking an active view on emerging market beta.

Our offering of currency management solutions is diverse, ranging from conservative un-geared to highly geared absolute return solutions, multi-currency benchmarked solutions and emerging market only solutions.

Your heritage in currency management has developed over the last thirty years – could you tell us about the evolution of the currency management investment capability?

We do have one of the longest standing active currency capabilities in the industry, which dates back thirty years and was the ! rst to introduce the concept of a

multi-currency benchmark in addition to the more familiar single-currency based strategies. Since then, we have expanded our capabilities, tailoring these to ! t the varying needs of clients looking for currency management solutions. Maintaining continuity in our investment process and team, our strategies incorporate all three of our quantitative, qualitative and emerging market drivers and include our specialist emerging markets currency expertise.

Most recently, having been pioneers of a multi-currency benchmark, we this month have broadened this benchmark to include core exposure to 24 of the most liquid emerging market currencies. Although we have long included an active allocation to these markets in our process, we now feel it is time to formally include them in our underlying benchmark given the opportunities available for investors looking to take advantage of improved fundamentals in the broader EM currency universe.

What methodology do you use to oversee the currency management process and allocation of the risk budget?

We have a process committee which meets quarterly and oversees the currency management process. The committee reviews the performance, risk utilisation and process dynamics of the three sub-processes as well as their risk management disciplines. Our long term aim for the risk allocation across the three diversi! ed drivers of performance is to be equally divided.

As well as ensuring diversi! cation and low correlation across our process, it is equally important for us to maintain a low correlation with other asset classes and market ‘betas’ in the industry. Our analysis monitors a number of market correlations be it the S&P 500, Deutsche Bank’s DBCR Index or JP Morgan’s ELMI index. We think that it is important for investors to distinguish between genuine “alpha” based currency capabilities rather than a ‘beta’ process charging ‘alpha’ fees.

Having identi! ed market inef! ciencies and investment opportunities to generate currency signals how do you go about constructing a portfolio?

Our currency portfolios are constructed using our currency management process. Our managed currency and currency alpha solutions are constructed by combining all three of our diversi! ed drivers: quantitative, qualitative and emerging market analysis. Our emerging markets solution is constructed using only our emerging markets driver.

Thanos Papasavvas: “We are guardians of a 30 year track record”

Autumn 2010 | Currency Investor 41

Our risk monitoring tools calculate daily predicted tracking error, market beta and value at risk (VAR) for the selected strategies. The VAR ! gures are reviewed by an independent risk team, and compared to pre-set limits to serve as review and risk reduction triggers.

Moreover, the market risk team generates a weekly risk-budgeting report reviewing the predicted risk utilization level per sub-process. Positions are also monitored daily by the portfolio management team, with stop-loss levels in the market.

We also analyse tax, legal and administrative issues in great detail. In cooperation with our legal and administration departments, we aim to determine the best way to access the local markets (e.g. forward market/NDF, treasury bills, commercial paper, through credit-linked notes).

In addition to all the risk analysis we believe that pragmatism and good portfolio management are essential to successful investing, especially in emerging markets. We will always have long and short positions in a core portfolio and will aim to keep the portfolio well diversi! ed at all times.

Our process blends quantitative and qualitative inputs which in turn are supported by state of the art external and internal systems for risk management and implementation. The currency team meets weekly to discuss strategy and convenes daily at 4pm to review all positions and risk following the London closing prices.

In terms of converting positions to portfolios, we de! ne investment risk as projected volatility relative to our clients’ benchmarks. A portfolio should exhibit suf! cient tracking error to achieve its performance targets, but without exposing the portfolio to unnecessary volatility. For each client we tailor a risk budget based on their performance objective, risk appetite and mandate restrictions that looks to take full advantage of the permitted investment opportunity set and diversi! cation potential.

What external and internal risk management systems does your team employ?

Risk management is an integral part of our process. In our view risk management is not only about limiting drawdowns when performance is negative, but preventing signi! cant losses by applying a well diversi! ed process. Our preference for a multi-strategy approach with diversi! ed drivers of performance, not reliant on one particular style such as carry, should ensure that our portfolios are well balanced. This in itself, however, is necessary but not suf! cient in limiting drawdowns.

We therefore apply risk management to each underlying process as well as to the overall program in order to ensure capital preservation amidst more uncertain or turbulent times. We have speci! c drawdown triggers which reduce risk as the pro! t and loss of each strategy starts to deteriorate below a prede! ned level.

We have an independent market risk team that works closely with portfolio managers in a pro-active fashion to monitor levels of risk, including provision of the daily and weekly risk reports. Working in close physical proximity at our London of! ce helps to facilitate regular discussion.

CI INTERVIEW

42 Currency Investor | Autumn 2010

Thanos Papasavvas: “We are guardians of a 30 year track record”

Preliminary results from the BIS triennial report indicate that daily traded FX volume increased from USD 3.3 trillion in 2007 to USD 4 trillion in April 2010 with a signi! cant increase of client " ow in Asia and more demands for emerging market currencies. Were you surprised at this data and in what ways do think it might help to further expand the currency investment opportunity set?

The survey shows that not only have foreign exchange volumes continued to increase, but the mix of currencies traded is becoming more diversi! ed. For example, the percentage share of the US dollar has continued its gradual fall ! rst apparent in the April 2001 survey, while the euro and the Japanese yen have gained relative share. Australian and Canadian dollars both increased market share, while the British pound lost ground and the Swiss franc declined marginally. The market share of 23 emerging market currencies increased, with the biggest gains for the Turkish lira and the Korean won, followed by the Brazilian real and Singapore dollar. In general, the survey also re" ected an increasingly global marketplace, with cross-border transactions increasing as a proportion of total transactions for the ! fth consecutive survey.

Do you have any pointers for new investors looking to choose a manager and get exposure to currency funds?

First we would suggest that investors with no specialist understanding of currency management, or no internal research team, partner with an independent investment consultant for the selection process. Key selection criteria might include some of the following:

• Ensure diversi! cation within a currency allocation, either through the appointment of multi-strategy managers or a selection of different styles of currency managers.

• Ensure that managers have a clear succinct philosophy and transparent, repeatable process.

• Ensure that managers have had a long continuous live track record.

• Ensure that there is a dedicated currency team with low turnover of staff and long experience spanning a number of economic cycles.

• Ensure that risk management is an integral part of the philosophy and process, not a reactive afterthought following a period of underperformance.

• Last but not least ensure that the company is committed to currency management as an asset class and invests both time and resources to maintain the team’s competitive advantage.

Do you think we are entering a period when currency manager returns will start to increase and become more stable?

Currency managers with a diverse process have in general delivered positive and uncorrelated returns throughout the recent market turmoil of the past three years. The exception has been carry strategies which were adversely impacted by the rising volatility and changing market environment of 2008. For this reason we have always been of the view that investors should select managers with diversi! ed processes within their program or mix together different styles of currency managers in order to diversify their allocation.

Over the next few years what factors and issues do you think will most in" uence currency manager performance and may present challenges for the industry as a whole?

We believe that volatility will remain elevated and hence systematic single strategy processes will most likely underperform. Volatility should remain high partly due to the economic uncertainty of the current monetary/! scal policy mix applied by policy-makers around the world, but also due to the geopolitical friction between countries’ currency tolerances. We believe that governments will be

Autumn 2010 | Currency Investor 43

unable to reach a multilateral consensus and will revert to unilateral approaches creating friction and opportunities not too dissimilar to the recent rhetoric in the news on ‘currency wars’. In this type of market environment we believe that quantitative tools, which do the ‘heavy lifting’ within a process, should be complemented with qualitative judgement and analysis from managers with long experience who have navigated similar market conditions in the past.

What are your latest views on currency markets?

We are seeing a new phenomenon emerging: the willingness of markets to reward pro-active ! scal tightening with lower risk premiums and stronger currencies. This was most evident in the UK where the coalition government’s June ‘austerity’ budget and the more recent Comprehensive Spending Review have been welcomed by the market and rating agencies, despite cuts in near-term growth forecasts. As far as the US dollar is concerned, we believe it will continue to weaken for a number of reasons. Unlike the euro zone and the UK, we believe the US (and Japan) are behind the curve of ! scal adjustments. Not only has the US not started to address their large and expanding ! scal imbalances, but there are signs of a possible rift between policy makers. The prospect of gridlock in Congress will only make it more dif! cult for the Administration to push forward a coherent ! scal agenda and eventually, a buyers’ strike by the so-called ‘bond vigilantes’ could leave the US dollar vulnerable in the medium term.

As far as the recent ‘Currency wars’ headlines is concerned, it has been a great catch-phrase for the media, but there is nothing new from what has been happening already in currency markets. The Brazilian, Israeli and Korean authorities, amongst others, have been intervening for quite some time to stop their currency from appreciating, with the only new participant being the Bank of Japan which stepped in to the markets in September. We believe that policy rift at the G20 level will remain with a multilateral consensus unlikely. The most likely outcome in our view is a ‘benign neglect’ on the US dollar not too dissimilar from the period after the previous US recession in 2001.

Investec Asset Management has achieved a remarkable track record over the last 30 years in managing both developed and emerging currencies. Looking to the future, what steps will you and your team be taking to maintain that achievement and protect your competitive advantages?

The three key factors which will help us maintain our competitive advantage are the same three reasons

why I joined Investec Asset Management in the ! rst place four years ago. First, the quality of the individuals and the passion of the team; second, the long heritage in currency management combined with a clear process and philosophy; ! nally, the clear direction and support of the organisation. Given the strength of our team, our clear philosophy and process, and a supporting organisation, I believe we have all we need for the future.

The views expressed are those of Thanos Papasavvas and do not necessarily represent the views of Investec Asset Management. The information contained in this interview should not be construed as investment advice nor as an invitation to make an investment. Whilst all reasonable care has been taken to ensure that the information contained in this interview is accurate, no representation or warranty is made in relation to its accuracy or completeness.

CI INTERVIEW

44 Currency Investor | Autumn 2010

From strategies to style buckets: searching for weakness in the

investment processBy Gerry O’Kane

INVESTOR PERSPECTIVES

Whatever varying opinion you might get from investment managers, the one thing they will agree upon is that investment strategies have weaknesses. What they won’t agree on is which style has what weakness because that might undermine their own business, but you

can be sure everyone can highlight " aws. What has become more apparent is that investors in the currency sector, or those seeking to dip a toe into it, are desperate to understand

the strategies available in the marketplace and their relative strengths and weaknesses. In spite of the carry trade hiccup of a couple of years ago, applying currency strategies to both portfolio risk mitigation and gaining a diversi! ed positive return has taken on a new lustre.

Autumn 2010 | Currency Investor 45

Since the changes brought about by the Credit Crunch, with respect to both the structure of portfolios (especially in the US) and expected

returns, institutions are having to pay greater attention to currencies. “There may be remaining doubts about currencies as an asset class in some quarters,” says Ulf J. Lindahl, Chief Investment Of! cer at A. G. Bisset & Co., “but their relative performance has done well. Pensions typically have about 40 per cent of their portfolios in overseas assets and about half of that US dollar-denominated. Even a two per cent swing in the value of the dollar with equity return expectations standing at up to eight per cent means that you can lose 25 per cent of your expected portfolio returns.”

“Investment objectives are an important determinant of how an investor participates in currency trading

– it can be an attractive, independent source of investment alpha, which often has a low correlation with other investment returns, or it can be used to manage the currency exposure that results from investing globally in other asset classes,” says Mike Harris, Director of Trading at Campbell & Company.

Identifying the aimsIt is also important for clients to identify what their aims ought to be. “They should split their desires,” advises Lindahl, “They need to look at their currency risk because a declining currency over three years can have a considerable impact on a portfolio. Your objective ought to be to hedge against currency declines and remove the risk with a repeated shorter

term investment cycle.” “However,” he warns, “You have to be aware that this sort

of cyclical currency overlay is unlikely to provide added value when the currencies go up.”

But as with ever-lasting debate of what exactly constitutes beta and alpha, the

description and labelling of strategies can vary between managers although more often on the

minutiae rather than the generalities.

You have investors seeking to pursue an active approach in either hedging the currency risk in their property, commodity, ! xed income or equity holdings. They might have the same objectives using a passive approach.

Then you have those seeking alpha, doing better than simply re" ecting market movements, whether seeking absolute returns or not. Primarily the approach requires active management.

Strategy formatsAccording to Matt Roberts, senior investment consultant specialising in currencies with Towers Watson, whatever the format of overlay or hedge fund the strategies generally fall into four formats, and the one that encompasses all of them.

“You’ve got managers focused on the carry trade, managers interested in value type signals and those interested in the momentum signals and ! nally those interested in volatility trading,” lists Roberts. Then there are those using quantitative, discretionary, fundamental, technical discretionary and so the combination of lists continues.

INVESTOR PERSPECTIVES

46 Currency Investor | Autumn 2010

“Typically managers promote themselves with a list of characteristics, like systematic or discretionary, however often these characteristics do not help a lot at all. And more commonly it’ll be a more speci! c strategy declaration like carry, fundamental, break-out or momentum, mean-reverting and volatility,” says Thomas Suter, CEO of Swiss-based Quaesta Capital. “Some de! nitions help us a bit more, but they still aren’t giving highly transparent information for the investor such that he would know in which environment he would earn or lose money, for example,” he adds.

Indeed, identifying the weaknesses of these strategies or styles goes beyond their individual characteristics but also encompasses how risk factors should be considered and how contemporary currency products might make certain styles redundant.

Roberts, for example, points out that many UK institutional clients had opted only for the passive currency hedging route, typically as a risk management method. According to him: “We haven’t

felt positively inclined towards and number of strategies that are available within the active currency arena [in hedging]. One of the reasons are the high fees charged by many of these managers.”

He argues hedge fund type fees of two per cent of asset value and 20 per cent on out-performance are high when many of the styles offer little more that a crude combination of the basic carry, value, volatility or momentum styles. As he and other managers point out this comes back to the argument of alpha and beta and de! nitions.

The argument goes that if you are replicating a pure carry strategy - long high-yielding currencies through funding by the low-yielding currencies, should this

not be de! ned as beta? And if it is, why are you paying a premium for it?

Of course even that discussion is not straight-forward as Dori Levanoni, a partner at First Quadrant and the global macro strategies manager explains: “Let’s look at carry trade, it’s a well-de! ned theory, but if you take 10 managers saying

From strategies to style buckets: searching for weakness in the investment process

MIKE HARRIS,CAMPBELL & C OMPANY

“Investment objectives are an important

determinant of how an investor participates in

currency trading ...”

MATTHEW ROBERTS

“You’ve got managers focused on the carry trade,

managers interested in value type signals and those interested in the momentum signals and ! nally those interested in volatility trading,”

Autumn 2010 | Currency Investor 47

they do carry, the correlation of their performance would be less than 100 per cent and in some cases less than 25 per cent and that’s the problem with beta; a divergence of opinion leads to a divergence in performance.”

On top of that, according to others, some of the more basic styles might easily be replicated through cheaper products such as exchange traded notes.

Mix and matchThe reality is that very few institutions or boutique investment houses would boast that they based their process on a single strategy, most talk of a mix-and-match activity, what’s best for the market environment. And there’s little doubt that the set of style buckets, using these multiple strategies is what’s expected. “Like most other markets, currencies are impacted by both broad macro-economic factors and by narrower market-speci! c factors,” says Mike Harris. “Consequently no single investment style can be successful in all market conditions. For this

Questions you should ask your

currency managerGeneral questions:• What kind of experience should we

anticipate as currency investors? • What are realistic risk/return expectations? • What are realistic time horizons within

which we should expect to realise our goals?• What can go wrong, and how will we

recognise it?• How real the presented track record?• What are the the draw-down/behavioural

risks of a style?• Classic due diligence questions – operational

set-up, back up on portfolio management team, risk management, operational frame work, external partners, prime broker, execution banks… etc.

• If I’m told the strategy is ‘unique’, what makes it so or am I paying over-the-odds for an enhanced commoditised service?

Questions on styles:• Momentum: what time horizons do your

strategies use? • Value: what do you do when the “animal

spirits” are out and the markets ignore the fundamentals?

• Carry: does your strategy trade “long only” carry, or can it also trade “short” carry? If so, what sort of information does it use to oscillate between long and short?

• Volatility: do you use volatility as a stand-alone trading strategy, or as a risk-management overlay on positions accumulated by other styles?

INVESTOR PERSPECTIVES

THOMAS SUTER

“Typically managers promote themselves with a

list of characteristics, like systematic

or discretionary, however often

these those characteristics do not

help a lot at all.”

48 Currency Investor | Autumn 2010

From strategies to style buckets: searching for weakness in the investment process

reason it is important to invest either with a manager that trades multiple styles, or with several different managers who employ different investment styles.”

From Lindahl’s point of view, while managers might move between styles, trend following or the momentum strategy is probably one of the most common investment styles, certainly among currency trading advisers. While it might be called trend investment there are elements of fundamental research. “It’s important that when the managers see a change in the economic winds, you can suitably trim your sails. The trends will continue to unfold but might be based of different fundamental conditions: in the 80s, for example, issues of money supply and in" ation were key factors,” outlines Lindahl.

But whatever the managers call their styles or how they mix-and-match them, clients must understand the underlying weaknesses of each methodology

that goes into the manager’s ‘bucket’. “Managers are often guilty of using these phrases but are poor at explaining them and are imprecise in how the process works,” says Levanoni.

While the carry trade became the doyen of the currency sales pitch in the mid-2000s, its fall from grace caused a stutter in the use of currencies either as an asset class or in risk mitigation. “The carry strategy did very well until summer 2007, but afterwards for about two years the exact same strategy just lost money. Does this now mean that the strategy is bad and not working? No, it doesn’t really, it just means that it’s the wrong strategy for a certain environment,” argues Suter.

“Unfortunately, like most of these things, what tends to happen is that people down-weight certain strategies when they’ve done poorly, like the carry, rather than before they have done poorly and without a lot of foresight,” observes Adam Olive, a co-manager of HSBC’s GIF Global Currency Fund. “One of the carry trades biggest risk is you can have very sudden and abrupt draw-downs.”

“If a manager is just making the decision to go long that high yielding currency and short the funding currency based on the yield differentials, then if everybody is doing that, the higher the long currency goes and it gets very expensive based on fair value. When the correction comes you are obviously positioned the wrong way when everybody tries to unwind the trade,” he warns.

Then the market realise the fundamental value of the currency, perhaps based on

purchasing power parity (PPP), has skewed the currency away from fair value.

And when it has downturns, it has serious downturns. The RBS FXY index (carry) shows that in the ! rst three months of 1980 the strategy returned 4.56%, 8.04% and 16.38% but in April you would have lost a whopping 20.75%. Similarly in 2008 August, September, October and November, the carry strategy would have lost you 10.62%, 10.26%, 15.88% and 3.99% respectively.

But it’s not just holding a carry trade at the wrong time and incurring losses. It has other implications to a portfolio.ADAM OLIVE

“what tends to happen is that people down-weight certain

strategies when they’ve done poorly, like the carry, rather

than before they have done poorly

and without a lot of foresight,”

Autumn 2010 | Currency Investor 49

“In reality the carry trade acts like you’re buying risky assets and selling safe assets increasing your exposure to risk, so when risk rises it can hit your portfolio. So many of these currency strategies act similarly to other asset classes which are much simpler or cheaper to buy,” observes Levanoni. He also argues that if you do examine the returns of carry indices to the MSCI World Index or FTSE there is a fairly strong correlation between the two numbers. “It varies over time but it is not zero,” he says.

It’s a viewpoint with which Matt Roberts at Towers Watson agrees. “If you take an historical analysis and look back at the carry trade, it has left tail properties and the distribution of returns of the carry trade has a skewed pro! le. So you get large negative events, but you don’t get to very large positive events... When equities have a very bad time, so can the carry trade,

although not always. That would be one reason why it could not be a seen as a diversi! ed return source.”Often the position is leveraged and in 2007 institutions had to ! nd the cash to pay off their positions, often having to sell equities which had also plummeted. It acted as a ‘double-whammy’, since institutions would also lose whatever upside the equities might have made in the coming market recovery. “So what you have, especially with the

passive hedge done in this way is not the just the immediate costs but losses on future gains translating into cash-" ow risk,” summarises Lindahl.

Momentum trading has similar disadvantages.”If you have just been buying Aussie dollar because it is going up, it shows no awareness of where fair value is and as it becomes expensive relative to

fair value and when there’s a correction it will take a while before the momentum signal changes sign

INVESTOR PERSPECTIVES

ULF J. LINDAHL

“There may be remaining doubts

about currencies as an asset class in some

quarters, but their relative performance

has done well.”

50 Currency Investor | Autumn 2010

From strategies to style buckets: searching for weakness in the investment process

and you get out of the trade,” warns Olive. Abrupt changes in the perceived risk premia can have a similar effect.

Impact of Greek crisisThe Greek crisis had implications on both the momentum and carry trading, and, to an extent volatility. As the perception of risk on the Euro increased as more and more bad news " ooded out of Athens and you were playing it against the Swiss franc, for example, you got large exchange rate moves.

“And that’s what happened in those currencies, triggered by the Greek problem. It was the perception of risk in the Euro currency - it isn’t so much there

would be chaos in the Euro region if Greece did default, since it only represents about two and a half per cent of the Euro’s GDP, it’s the perception,” explains Olive.

On top of this is another weakness the client has to resolve. “With something like momentum you can highlight that your analysis is purely price-based with an intuition to move in and out of trends, but that can mean that the investor does not truly understand why a product has made or lost money,” says Roberts.

Volatility trading has taken on a higher pro! le in recent months, bene! ting from a perceived unstable global economy, with uncertain corporate earnings, GDP growth and high jobless rates. According to Suter, good volatility strategies can have many bene! ts. “Long/short volatility strategies may be capable of performing in every market environment, however, their weakness is the missing transparency and knowing whether the underlying strategy should have performed well or badly in the last few weeks, there’s a dif! culty in predicting performance ! gures of those programs,” Thomas Suter points out. “Some investors may look at it and just say, I just want to have this investment over the long run that provides me with good uncorrelated positive returns.”

But there is another issue with volatility strategies. Because of their nature they must use derivative products traded over-the-counter (OTC), like options rather than forwards or futures.

Increased riskThese OTC products create increased operational and settlement risk. “Something like an option can have very large changes in price because of the leverage and people shouldn’t trade instruments if they are

not capable of measuring the risk in them and managing it. So obviously somebody who’s

doing volatility trading will need a much better risk management system than

somebody who was just trading spot or forwards,” agrees

Olive.

On top of that is counter-party risk and making sure your prime broker or under-lying counter-party

Autumn 2010 | Currency Investor 51

INVESTOR PERSPECTIVES

doesn’t go the way of Lehman Brothers. This is usually done through master netting agreements under the auspices of ISDA, multiple prime brokers and holding collateral and cash in separate accounts, often with a custodian. “Nearly everybody has ISDA netting agreements and anybody who isn’t, is incompetent,” warns Olive.

They are often also leveraged. “This can create capital ef! ciency, less assets put in to generate the same overall return, but the problems that we have found in the high more highly leveraged products are more about behaviour in nature,” says Roberts “First of all, if you invest in a high volatility product then it really requires you to react in a rational way, i.e. a logical way. If a highly leveraged product experiences draw down, but you believe that it has good fundamental qualities, you should probably increase your allocation. But at such high levels of volatility, what

you tend to see that when you get these draw-downs is that the product comes under pressure - you don’t get rational behaviour.”

And this behavioural factor extends to the value strategy, often based on more fundamental economic analysis. “Valuation factors like PPP can take a long time to come right, the same with any value strategy. It doesn’t mean it doesn’t work over time, but it can take a long time to come right over time, and consequently is open to behavioural issues, and clients might not stay the course to ultimately realise the bene! ts of that strategy,” explains Roberts.

This style also has other drawbacks. “Value may not work when a powerful external force, like Central Bank intervention, is propelling markets,” observes Mike Harris.

ConclusionThe reality is that all single strategies are open to criticism and houses have increasingly moved to multiple styles, moving from one to the other depending on the environment.

Over at Campbell & Company the trading bucket includes momentum (trend), value, carry, volatility and mean reversion. “We use quantitative models to trade all of these styles,” explains Mike Harris, Director of Trading at Campbell. One style Campbell does not trade is arbitrage . “For us, arbitraging small price differences between different ECNs or market makers would negatively impact the pool of liquidity we depend on to trade all the other styles.”

However the quantitative approach whether based on multiple styles or high frequency trading has its own drawbacks. They are only as good as the underlying model and understanding that is as much an issue in understanding the investment process, as it is with institutions swilling around in their style buckets.

One way to assess styles, according to Dori Levanoni, is to use consultants but he warns few of the smaller ones might have the necessary skill-set to understand all the methodologies in the market. “You have to ask, will the style avoid the elevator down? Look at whether it has a high frequency of positive returns coupled with a small frequency of large negative losses. Does it have a positive mean?”

DORI LEVANONI

“You have to ask, will the style avoid the elevator down?”

52 Currency Investor | Autumn 2010

‘Currency wars’ and emerging in" ation risksVI

EWPO

INT

INVESTOR PERSPECTIVES

Autumn 2010 | Currency Investor 53

The world is in the middle of what Brazilian ! nance minister Guido Mantega has called an ‘international currency war.’ And on this view of the world investors might rightly feel that they are in the trenches! The US Fed seems poised to commit to injecting up to USD 1 trillion in additional QE, ensuring ! nancial markets remain saturated with liquidity. For their part, central banks in China, Brazil, Taiwan, South Korea and elsewhere are intervening to curb appreciation of their currencies as the wall of cash " oods into emerging markets.

Loose monetary policyWithout doubt, the starting point is very loose monetary policy in the developed world. It re" ects the weakness of the recovery in industrialised countries where ! nancial sectors are damaged and where there is a massive overhang of indebtedness in the government and household sectors. Policy rates and market rates are very low and growth in the developed world is anaemic. It means that when investors search either for yield or for growth they are drawn to emerging markets where the fundamental outlook is stronger and where in" ation rather than de" ation concerns are driving up interest rates, generating an attractive interest differential.

Brazil epitomises this story. The economy is growing at a very healthy pace, debt ratios have been falling not rising, interest rates give a very decent pick up for G3-based investors (the Selic policy rate is 10.75%, more than 10 percentage points above Fed funds) and earnings growth has been very supportive of equities. But the in" ows into Brazil and other emerging markets have created a problem - unwelcome upward pressure on currencies.

Governments and central banks in the emerging world have responded with currency intervention. But there is no free lunch. The intervention itself only shifts the pressure it does not remove it. If the intervention is fully ‘sterilised’ through open market operations it will create a loss for the public sector via a ‘negative carry’ on the resulting position. If it is not sterilised, the likelihood is that it will generate in" ationary pressures.

Don’t forget asset price in" ationFor investors, it’s not just about getting exposure to higher yielding currencies. Stronger emerging markets fundamentals have also drawn investment into debt and real estate markets. And the attraction of higher levels of economic growth and expectations of corporate earnings growth have additionally created in" ows into equities, although the equity " ows have been selective.

Brazil received close to USD13bn in net foreign equity in" ows in the year to end August and India has also been a big recipient whereas Russia, by contrast, has not seen " ows of this magnitude. In China’s case it is the real estate market not equities that has been the favoured asset class.

In certain markets, valuations have already become stretched and there is a risk that bubbles build. This is one of the reasons why monetary policy needs to be tightened in a number of emerging economies. And over the longer term, there also needs to be development and reform of domestic ! nancial and asset markets to improve the ability to absorb these in" ows productively.

Will in" ation mean westill end up with realappreciation?In common with other emerging markets, recently China, the central bank in Brazil has been raising rates to combat in" ation pressures. There are three key sources of in" ationary pressures in many emerging markets. Firstly, food price in" ation has been a problem in a number of markets, for example in India. This re" ects local and global supply disruptions. It is particularly problematic because food is a dominant component of CPI baskets in many emerging markets - in some cases it is more than 60% of the basket.

Philip Poole, global head of macro and investment strategy at HSBC Global Asset Management, looks at the implications for investors as appreciation pressures

continue to build up with many Emerging Market currencies.

INVESTOR PERSPECTIVES

54 Currency Investor | Autumn 2010

As already mentioned, unsterilised currency intervention is a second contributory factor. And thirdly, it should not be forgotten that markets like India and China did not see a decline in output during the global recession. In fact, in these two cases, there was only a slight moderation in growth.

With growth having re-accelerated, it has created concerns about tightening capacity utilisation and labour markets in a number of emerging economies and this runs the risk of turning a supply side in" ation shock into an on-going in" ation process.

Buy some in" ation protection in emerging marketsFor this reason, in my view, monetary policy needs to be tightened in many emerging markets. The problem, of course, is that by raising rates when the Fed and other developed world central banks are on hold only increases the interest differential and the carry on these emerging currencies.

One way to square this circle is to increase reserve requirements for banks to prevent base money growth translating into broad money growth and China and Turkey, for example, did this recently.

Another is to try to restrict portfolio in" ows and I believe we are likely to see more controls introduced on inward capital " ows. Brazil recently shored up its defences, pushing up the so-called ‘IOF’ tax on such in" ows from 4 to 6 percent, the second increase in a month.

Policy makers in other emerging countries could well follow suit. But with so much cash sloshing around the global ! nancial system in search of yield and return, to have a chance of being successful controls on inward capital " ows need to be highly punitive and even then may not work. Indeed, upward pressure on high yielding currencies is likely to intensify.

But there is no escaping the fact that in" ation could also be the end result for emerging markets of the combination of a frantic search for yield coming

from the developed countries met by currency intervention in the emerging world. In such an event, despite currency intervention to prevent nominal appreciation, the risk is that there is real appreciation through the backdoor – via an adverse in" ation differential with most of the developed world – such that currency intervention would ultimately prove to be self-defeating.

For now it looks like liquidity will continue to " ow from developed to emerging economies. While this suggests on-going upside momentum for emerging markets asset prices it also creates the risk of asset price bubbles and in" ation.

So as well as remaining exposed to carry currencies, investors in emerging markets should consider getting some in" ation protection via in" ation-linked securities.

‘Currency wars’ and emerging in" ation risks

“as well as remaining exposed to carry

currencies, investors in emerging markets

should consider getting some

in" ation protection via in" ation-linked

securities.”

PHILIP POOLE

55 Currency Investor | Autumn 2010

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56 Currency Investor | Autumn 2010

Currency investment in Asia –a market that can’t be ignored

The global economic growth now seems set to slow again and we put a 25%

risk for a double dip scenario on the global front. Obviously such a potential outcome also constitutes a risk to a still export dependent Asia. Still, a range of

factors may mitigate the negative impact a cooling of global demand would have. We believe there are a range of positive

factors that will continue to attract capital in" ows and help not only to strengthen

regional currencies but also help Asia to further develop and increase the depth

and liquidity of its capital markets.

REGIONAL REPORT

By Seppo Leskinen, Head of Asset Management, Asia - Paci! c and Magnus Prim, Chief Strategist, Asia at SEB

Autumn 2010 | Currency Investor 57

Economic outperformance For developing Asia as a whole we are now forecasting growth over 8% for 2010. India and China remains the locomotives for this impressive performance (although they in terms of growth rates will be outshined by Singapore this year). Even such impressive growth rates actually include expectations of a slowdown in H2 (in other words ! rst half growth was in many cases exceptional).

The main risk remains that another contraction in the industrialized world materializes but as highlighted below the region has room to counteract the negative impact from such a development through both ! scal and monetary policy stimulus.

Lower debt levelsWhile the developed world struggles with soaring debt levels approaching and likely to surpass 100% of GDP, the rise in debt in emerging markets has been very modest, standing at around 40% of GDP despite signi! cant ! scal stimulus. This not only means there is little need to cut back on spending, thus weighing on growth, it also gives the countries in the region plenty of ! scal room to provide further stimulus should it again be necessary.

Higher interest ratesThe strong bounce back in growth has made central banks in the region begin to normalise interest rates much earlier than the majority of central banks in the developed world, and from a higher starting point. This not only means that there is plenty of room for monetary policy stimulus to be resumed should it again be necessary but it also means we presently are seeing a pronounced widening of interest rates spreads that is likely to give a further boost to already strong capital in" ows due to an increasingly attractive carry.

REGIONAL REPORT

Contribution to global growth 3yr ma

58 Currency Investor | Autumn 2010

Current account surpluses and capital in" ows Virtually all countries in Asia are running current account surpluses. This is partly due to strong exports and excess savings but to an increasing degree also due to rising capital in" ows. In particular, this is evident in the bond market where local currency bond market has grown by an annual 18.8% as of end June with USD 4.8trn now in outstanding papers. Contributing to this welcome deepening of the local bond markets is increasing foreign demand. According to the most recent data foreigners now hold 27.4% of Indonesian government debt (popular carry position with foreign investors), 18.1% of Malaysia and 7.4% of sovereign debt in S. Korea.

Further, there is also increasing demand within the region with China starting to make an impact. For example, China now account for about 10%

of total foreign holdings in Korean Treasury bonds (one of the most liquid in Asia). All this development is creating a virtuous cycle where increased interest to invest in Asian markets begets more interest to invest. Overall, the effect tends to be strong capital in" ows and appreciation pressure on the regional currencies.

Interventions still constitute a riskStrong foreign capital in" ows are not always a good thing, especially if they consist of

“hot money” that can severely increase the risk of big out" ows on back of unforeseen events, but also because of the appreciation pressure they contribute to when things are going well. Despite its strong fundamentals and promising emerging shift in economic drivers, the region remains export driven to a large extent.

This means there is a real concern on part of authorities to lose competitive advantages

if their respective currency appreciates too much. Thus, a policy of intervention

has been adopted. This behaviour has brought up regional FX

reserves to record levels and is running the risk of creating a “beggar thy neighbour” behaviour, a risk that has been further underlined following Japan’s recent interventions. This is however not our core scenario.

While regional central banks don’t report

exactly how much they intervene, it is a well known fact that most prefer to attempt

to “smooth out”

Currency investment in Asia – a market that can’t be ignored

Source: OECD, SEB

Autumn 2010 | Currency Investor 59

currency movements, or slow down the pace of appreciation in the case of Asia, rather than turning an established trend.

Strong interest set to remain – Our favouritesWhile there still are certain risks associated with exposure to the Asian region it remains a compelling case and we foresee a continued increase in capital in" ows ahead, a development that will lead to further

REGIONAL REPORT

Foreign Holdings of LCY Government Bonds (% of Total)

“While there still are certain risks associated with exposure to the Asian region it

remains a compelling case and we foresee

a continued increase in capital in" ows

ahead..”

SEPPO LESKINEN

60 Currency Investor | Autumn 2010

appreciation of regional currencies. In a historical perspective currencies are by no means on any levels that can be considered extreme or out of line with fundamentals yet. None is yet back at pre Asian crisis levels. In all, while there is, in this environment, no lack of attractive regional currencies to go long we still maintain some favourites we believe have the potential to out-perform.

Short USD/IDR: This trade has been our favourite for some time. Not only is there a signi! cant carry associated with any long IDR position but also fundamentals continue to improve in the country with Asia’s third largest population.

Short USD/PHP: This is one of the currencies in the region that has recovered the least in terms of the value seen before the Asian crisis. As such it is

lagging its regional peers. Arguably fundamentals are not quite as solid as in other peer countries but the downside risk to taking on a long position is also likely limited due to the big support provided from

signi! cant remittances (well over 10% of GDP).

Short USD/KRW: One of the more liquid positions you can hold in Asia and while the room for strengthening may be somewhat less than in some other countries in the region, this particular fact is compensated by the certainty we have on the direction.

Currency WarsThe summer of 2010 will be remembered for many reasons by currency managers and our team was no exception.

The month of May was dominated by the European Debt crises and the inertia of the European politicians to deal with the issues in a timely fashion caused the markets to question the very existence of the single currency itself. The impact on the currency markets was immense, with one US bank estimating that global currency volatility during the month was the highest since Bretton Woods.

Our SEB Multi Manager currency fund entered the month poorly positioned for the shock, with legacy positions generally being long Emerging Markets, Commodity Currencies, and ‘Carry’ against a short USD. This seems to have been experience that was shared widely among currency managers.

The summer months June, July and August continued with high volatility, with weakening data out of the US leading to a market dominated by the Risk On / Risk Off paradigm. This period saw many asset classes becoming highly correlated, and active currency trading was further hindered by a succession of negative news events for both the EUR and then the USD. These lead to numerous sudden and rapid reversals in the direction of many currency pairs.

The direction-less volatility witnessed during these months meant the managers in our portfolio performed poorly during the summer. Since we have always favoured managers who take a more relative value approach, and utilise active risk control, these conditions were highly unsuitable.

Currency investment in Asia – a market that can’t be ignored

“My own experience is that the EM

strategies in general tend to perform better

than the strategies focussing on majors.”

MAGNUS PRIM

Autumn 2010 | Currency Investor 61

levels to exhibit periods of high correlation to a particular factor, and equally we would also expect periods of strong negative correlation in the future. Finally in September we saw continued tepid data out of the US, and an acknowledgement from the Federal Reserve that further monetary stimulus may be necessary to protect jobs and growth. This spurred investors to sell US Dollars, with the US Dollar Index falling by nearly 5% on the month. Bene! ciaries included both the Australian Dollar and South African Rand (both of which gained over 6%, supported by the ongoing strength in commodities), and the Euro, which gained nearly 7%, despite ongoing concerns over Ireland’s spiralling de! cit.

In Asia, Japan intervened in the currency markets for the ! rst time in 6 years, causing the Yen to weaken 3% in a day – although it later regained the losses to end the month " at. Asian emerging markets had a strong month, posting gains of around 3%, aided by a steady appreciation of some 1.5% in the Chinese Yuan.

The events over the summer have caused dislocation in many ! nancial markets, not least in FX, where many currencies have been driven away from any measure of fundamental fair value. Furthermore, central banks around the world are increasingly focused on exchange rates as a component of monetary policy, and their actions are likely to create opportunities for currency managers to exploit. The military terminology has been launched and central bankers are talking about “currency wars”.

The summer market surprised us with a temporary increase of correlation to the equity market. Historically, SEB MMCF has exhibited a low correlation to the MSCI world, with the correlation since inception at around 0.2, and the rolling 12m normally ranging from -0.2 to +0.2. However, over the past 6 months, this has leapt to around 0.75.

Although this is a concern, we believe this to be a case of episodic correlation caused by the market shock caused in May. It would not be unusual for something that is normally correlated at low

REGIONAL REPORT

62 Currency Investor | Autumn 2010

As a result of the change in the market conditions we experienced very strong positive performance in the month of September as many of our managers were well positioned for the weakness in the US Dollar. The biggest contributions came from our carry strategy (mainly from long positions in South African Rand, Hungarian Forint, and Turkish Lira), and our Emerging Market strategies (which bene! ted from strong investor " ows into most Developing countries during the month).

Perspectives on Asian Currency ManagersWhen talking about Asian currency managers we include managers who are both based in Asia – Paci! c and those whose strategy has major element of Asian currencies.

Small numbersOur ! rst slight surprise is that the number of absolute return currency strategies in Asia is actually quite low. When we look at our currency manager data base that has nearly 300 managers We are surprised that the number of Asian managers doesn’t go much beyond 10% of those who we track. The number will not grow much even if we include those larger names that operate from multiple sites and a small number of Australian names.

The low representation of Asian strategies can not be explained by the macro economical situation in Asia. The capital " ows clearly show that the Asian currency denominated investments are growing – see the capital " ows from European domiciled funds (see Fig 1). It looks like the other asset classes than currency has been focussing on the Asian growth story more than our currency managers. However talking to local Asian investors and asset managers they do feel the pain from the strength of their own currency against the revenues from their international portfolios.

Asian managers among top performersThe Barclay Hedge Alternative Investment Database (see Fig 2) shows a ranking of top 10 currency

Currency investment in Asia – a market that can’t be ignored

Figure 2: Top 10 Currency Traders managing greater than $100M. Source: BarclayHedge

Figure 1: 2006-2009 Europe domiciled funds investing in Emerging Asia

managers based on compounded annual return. These managers are almost all involves in Asian currencies although Cambridge Asian Markets strategy is the only pure one.

Our experience is that the EM managers in general tend to perform better than the strategies focussing on majors. Our own Asian specialist managers have clearly been the top performers since inception nearly 3 years ago.

The currency investment business going forward in AsiaThe future looks very positive for the Asian currency business. There is increasing demand for both absolute return and overlay strategies among Asian investors:

• The economies are growing and getting more open and exposed

• The portfolio allocation towards Asian managers is increasing and today 80 % of Asian Hedge funds allocation are coming outside Asia .

• The Asian currency risk and exposure is “exported” to the western portfolio investors. The various benchmarks have ever larger portion of Asian exposure due to relative strength of their economies.

• There is still room for further strength in many Asian currencies and some commentators expect further 30% strengthening on Asian currencies and we are personally surprised when we ! nd out that DLR / IDR today is about the same level as it was 8 – 10 years ago!

• The Renminbi market is opening up and we all read about both ICAP and Reuters been ready to offer execution in that market.

• The regulatory framework for setting up a currency fund is extremely light here in Singapore and we are sure the similar policy will apply to Hong Kong too because we can’t see these two centres stop competing with one another.

The future is bright and we will leave you with the thought of the “Asian middle class revolution” that is predicted by a research report submitted by the Asian Development Bank. Their research shows that Asia’s middle class who spends today some $ 4.3 trillion will in 20 years time be spending $ 32 trillion i.e. 43% of global consumption.

REGIONAL REPORT

Autumn 2010 | Currency Investor 63

64 Currency Investor | Autumn 2010

INVESTMENT PRODUCTS

Autumn 2010 | Currency Investor 65

Listed currency vehicles – helping investors to make

the right choices

The absolute number of listed currency investment vehicles available, along with the total size of assets managed, has grown

signi! cantly over recent years. This has occurred amid a global ! nancial crisis and subsequent crash in the value of many ! nancial assets. The ! nancial crisis which began in 2008 may have acted as a catalyst

in increasing demand for currency exposure: many investors came to the harsh realization that their portfolios were not adequately diversi! ed to protect against downside risks. Indeed, ! nding uncorrelated asset classes has proven increasingly dif! cult: most asset classes moved up in tandem approaching the credit crisis; most asset classes moved down

Low correlations to traditional asset classes, inherent market inef! ciencies and potential pro! t opportunities, relatively low volatility and high levels of liquidity may explain the

increase in investor demand for currency exposure.1 Global currency market turnover has risen substantially, from $3.3 trillion in average daily turnover in April 2007 to $4.0 trillion in 2010. This increase has been largely driven by increased trading activity in a category of

investors including hedge funds, pension funds, mutual funds and insurance companies, where turnover rose by 42% during this same time period.2

By Axel Merk

INVESTMENT PRODUCTS

1 For a detailed description of the unique attributes displayed by the currency asset class, please see our White Papers titled “Portfolio Bene! ts of The Currency Asset Class” and “The Currency Asset Class: A New Era of Investment Opportunity”

2 Bank For International Settlements (BIS) Triennial Central Bank Survey, April 2010

66 Currency Investor | Autumn 2010

together as the credit crisis took hold; and most asset classes continue to move in lock-step today. In an environment with increased correlations across many asset classes, portfolio diversi! cation is of the utmost importance. The currency asset class may help meet this objective. There are three types of listed currency investment vehicles commonly available to investors: currency mutual funds, currency exchange traded funds (ETFs) and currency exchange traded notes (ETNs).

As a result of the increased investment demand, many new currency mutual funds, currency ETFs and currency ETNs have been launched over the past few years. Investors now have greater options available for currency investing, a trend that is likely to continue as the currency asset class becomes an evermore established component of investors portfolios. Currency mutual funds, ETFs and ETNs all share similarities, and each vehicle also displays unique characteristics and distinct risk and return pro! les. Investors should be cognizant of these differences when considering a currency investment.

Growth of Listed CurrencyInvestment VehiclesAggregate assets under management for listed currency investment vehicles grew at an annualized pace exceeding 80% between December 2004 and June 20101. As of December 31, 2004, total assets managed in listed currency investment vehicles totaled $244 million; in contrast, aggregate assets managed as of June 30, 2010 stood at $6.5 billion.As of December 31, 2004, only one currency mutual fund was available for investment. The ! rst currency ETF was launched in 2005 and the ! rst ETN was launched in 2007. Since then, we have witnessed rapid growth in the number of currency investment

vehicles available: as of June 30, 2010, there were a combined total of 43 listed currency investment vehicles (14 currency mutual funds; 19 currency ETFs; 10 currency ETNs).

Currency Mutual Funds Mutual funds are open-end funds, regulated primarily under the Investment Company

Listed currency vehicles – helping investors to make the right choices

Listed Currency Vehicle Assets Under Management

Number of Listed Currency Vehicles

Autumn 2010 | Currency Investor 67

Act of 1940.2 A mutual fund is a type of investment company, legally known as an open-end company. The speci! c objectives of any currency mutual fund will differ from one fund to another, and will be outlined in its prospectus. However, its investment approach can generally be classi! ed as one of two types: directional or non-directional. Directional approaches generally take a speci! ed position in a managed basket of currencies relative to one currency, typically either long or short vs. the U.S. dollar. In contrast, a non-directional strategy has no pre-determined view on any one currency; non-directional strategies may take long or short positions in a variety of currencies.

Currency mutual funds typically invest in wide baskets of currencies and typically don’t track a prede! ned index. Therefore the portfolio rebalancing and management of currency exposures tends to be driven by the portfolio manager of the mutual fund, who invests according to the investment objectives outlined in the prospectus. Speci! c holdings are required to be reported semi-annually, though many report more frequently.

Investors typically do not purchase mutual fund shares in the secondary market. Rather, shares are purchased from the fund itself (usually via a broker). The price investors pay for a share is the approximate NAV per share. The NAV for a mutual fund is typically calculated at the close of the trading day, therefore the price an investor pays for a share will be determined at the close of the trading day in which the investor places their order. As such, a mutual fund generally does not trade at a premium or discount to its NAV, nor does it typically trade continuously throughout the trading day.

Currency ETFs and ETNsThe objective of most ETFs or ETNs, currency or not, is to reliably track an underlying index, less any expense ratio. This is not the case for actively managed ETFs; presently, there are no actively managed currency ETFs. Generally speaking, a currency ETF or ETN will have a de! ned index before it is launched. This index, its structure and rebalancing, if any, will be outlined in the prospectus. An ETF is an open-ended investment company or unit investment trust that is registered under the

Investment Company Act of 1940. An ETF allows investors to buy and sell shares that represent a fractional ownership of a portfolio of securities. This portfolio of securities typically tracks, as closely as possible, an underlying index, such that the investment return produced re" ects, as closely as possible, the investment return that would be produced by investing directly in the underlying index.

As opposed to an ETF, an ETN is not a fund, nor registered under the Investment Company Act of 1940. Rather, an ETN is a debt instrument. This is an often overlooked, yet critical aspect of an ETN. Notably, there is counterparty risk with ETNs; investors should understand that while the objective of an ETN is to provide returns that track some de! nable benchmark or index, ultimately the ! nancial health of the issuer may have a marked effect on whether coupons, or even the principle of an ETN, will actually be paid. Essentially, an ETN is another way that a ! nancial organization can access debt ! nancing. For these organizations, an ETN is treated the same way as any other issued debt instrument: it is a liability for the issuer. From an investor’s standpoint, buying an ETN is essentially the same as purchasing a bond of that ! nancial

INVESTMENT PRODUCTS

1 Data source: Bloomberg, Morningstar. Calculation based on total assets under management as of 12/31/04 and 06/30/10.2 The full text of the Investment Company Act of 1940 can be found on the SEC’s website. Please see: http://www.sec.gov/about/laws/ica40.pdf

“Investors now have greater options

available for currency investing, a trend

that is likely to continue as the currency asset

class becomes an evermore established

component of investors portfolios.”

AXEL MERK

68 Currency Investor | Autumn 2010

Listed currency vehicles – helping investors to make the right choices

organization; an ETN could be considered a special case " oating rate note, with the coupons, if any, and principle typically linked to an underlying index or benchmark, less any fees. As such, investors may want to consider assessing the ! nancial health of any ETN issuer before investing.

A key similarity between currency ETFs and ETNs is that both are typically designed to track a de! ned index or benchmark. Generally speaking, the simpler the index, the easier it is for any ETF or ETN manager to track it. In this respect, many currency ETFs and ETNs tend to take a simple directional approach to currency investing. A simpler index also makes it easier to communicate to investors the objective of the investment vehicle, and may give investors a greater level of clarity surrounding what they should expect in terms of a risk-return pro! le. For currencies, the simplest index is often to track the value of one currency, as measured in U.S. dollars. As such, many single currency ETFs and ETNs have been launched in recent years – from the Australian dollar to the euro to the Japanese yen. As of June 30, 2010, 22 of the 29 listed currency ETFs and ETNs were aimed at tracking a single currency. In addition, leveraged currency ETFs and ETNs have also been launched. The aim of a leveraged ETF or ETN is to replicate some multiple of the underlying index, such as 200% (2x). As of June 30, 2010 there were two leveraged ETNs, both aimed at replicating 200% of the performance of the euro.

Both ETFs and ETNs are listed on an exchange and can be bought and sold throughout the trading day. This allows investors to take advantage of very short movements in price; indeed, some investors may

trade an ETF or ETN multiple times a day. There may, at times, be a mismatch between supply and demand for the securities, which may cause the price of each vehicle to deviate from the net asset value (NAV) of the underlying portfolio of securities (in the case of an ETF) or the asset value underlying the debt obligation (in the case of an ETN). In fact, some investors trade on this unique attribute alone; devising trading rules based upon whether an ETF or ETN is trading at a premium or discount.

Which Investment Vehicle?There are numerous factors that may ultimately impact a currency investment decision. Investors may want to consider the following issues when assessing the various listed currency investment vehicles.

Investment ComparisonGenerally speaking, currency investment vehicles can be classi! ed as either static baskets or managed baskets, and directional or non-directional in investment approach. Static baskets refer to set positions in a de! ned basket of currencies, or a basket which is predetermined by some set formula (in many cases the “basket” is a single currency), whereas a managed basket vehicle refers to an actively managed basket of currencies, oftentimes having no predetermined allocation. Typically, currency ETFs and ETNs tend to be static baskets, with many vehicles following a directional investment approach. On the other hand, mutual funds tend to follow a managed basket investment approach, and may be both directional and non-directional. These dynamics are visually depicted in the chart below:

Investment StyleIn many ways, the decision of whether to invest in a currency ETF or ETN, or a currency mutual fund, parallels the decision of whether to invest in an individual equity or an equity mutual fund. In general, when investing in an ETF or ETN, one must ! rst understand the underlying index, and then formulate an opinion on that index. In many instances the underlying index is a single currency, so investors must ask themselves whether or not they believe that

Autumn 2010 | Currency Investor 69

particular currency will appreciate or depreciate, and over what timeframe. This is similar to how an investor might assess the future price direction of an individual stock. It logically follows that many currency ETFs and ETNs are better suited for short-term, tactical investors who have very strong convictions on one currency or another, or a small basket of currencies, over a speci! ed time frame. Oftentimes the holding period may be quite small, sometimes intra-day, so the ability to trade ETFs and ETNs multiple times a day may be advantageous for such investors.

On the other hand, because mutual funds typically invest in an actively managed basket of currencies, often take long and short positions, and don’t typically track a pre-determined index, mutual funds may not lend themselves as well to short-term, high-turnover investors.

Rather, the mutual fund’s portfolio managers typically rebalance and update portfolio allocations based on specialized investment processes and perceived implications of market dynamics. Moreover, because currency mutual funds are generally priced only once per day, they don’t lend themselves to very short term trading strategies (day trading currency mutual funds, for example, is not possible). As such, mutual funds may be more suited to an investor who is seeking the diversi! cation aspects of the currency asset class over the medium to long-term, and who personally does not wish to speculate on the short-term price movements of speci! c currencies.

Another consideration is the " exibility the different vehicles have with respect to trading currencies. Currencies can be traded 24 hours every business day, yet ETFs and ETNs can typically only rebalance during U.S. trading hours. Currency mutual funds are often able to trade while the U.S. markets are closed. This can be bene! cial should signi! cant news " ow occur overnight, and with regards to some of the less liquid currencies available, which may exhibit higher levels of

liquidity at times when the U.S. markets are closed (for example, select Asian currencies are often more liquid during Asian trading hours).

VolatilityBecause the value of currency ETFs and ETNs are typically tied to a one-way directional view on one currency, or a small basket of currencies, whereas mutual funds typically invest in a larger basket of currencies, the return series generated by ETFs and ETNs have historically often been more volatile than those exhibited by currency mutual funds. Importantly, currency mutual funds have the ability to adjust currency allocations in such a way that minimizes expected volatility of returns. In fact, many currency mutual funds speci! cally employ such a strategy in the overall allocation process.

The chart above depicts annualized volatility of returns for unleveraged currency mutual funds and ETFs/ETNs for calendar years 2008, 2009 and for year to date 2010 (through June 30, 2010). For comparison purposes, we have also included the annualized volatility exhibited by the S&P 500 index. Note that leveraged vehicles have been excluded from the below comparison

It is also possible that a currency ETF does not track its underlying index, commonly referred to as “tracking error”. This can be caused when the manager is unable to invest in securities such that the NAV of the fund does not reliably track the underlying index. Currency mutual funds, because they generally do not track a pre-de! ned index, are not subject to “tracking error” in this respect.

INVESTMENT PRODUCTS

Annualized Volatility of Returns

70 Currency Investor | Autumn 2010

Listed currency vehicles – helping investors to make the right choices

Expenses As outlined above, currency ETFs and ETNs tend to follow simpler, more easily communicated investment approaches relative to mutual funds. As such, currency ETFs and ETNs tend to have lower fee structures. As of June 30, 2010, many currency ETF and ETN expense ratios were approximately 0.5%, whereas the average fee charged by currency mutual funds was approximately 1.5%. Some currency mutual funds have front-end and/or back-end sales loads in addition to a management fee, although no-load funds are also available. These additional fees and higher expense ratios are generally representative

of the active management approach employed by many mutual funds, which often requires a higher level of process specialization and resources.

Leveraged funds tend to have higher expense ratios, as the use of leverage typically generates interest expenses, which tends to be re" ected in the overall expense ratio. Investors should be cognizant of the fee structure charged by any currency investment vehicle before investing. The chart (left) outlines the

average and range of expense ratios for the various listed currency investment vehicles:

Summary In conclusion, when considering a listed currency investment, investors may want to ! rst consider the type of investment style they wish to pursue. An investor’s style has a large bearing on which type of listed currency vehicle they may ultimately choose, given the attributes unique to each vehicle outlined above. Generally speaking, when an investor takes a more tactical, short-term approach to investing,

with a higher level of turnover and short expected holding period, and is willing to accept a higher level of volatility, they may wish to consider ETFs or ETNs.

On the other hand, investors seeking the portfolio diversi! cation bene! ts of the currency asset class over the medium and long-term, with a longer anticipated holding period may wish to consider currency mutual funds.

If investors have the time and expertise to pick speci! c currencies, currency ETFs or ETNs may be the better option; if investors wish to access the bene! ts of the currency asset class, but haven’t the time to pick speci! c currencies, then currency mutual funds may be more feasible.

Average Annual Expense Ratio

ETF Securities – World’s largest Exchange Traded Currency platform

• Europe’s first ETCs providing exposure to the Chinese Renminbi or Indian Rupee on the London Stock Exchange (“LSE”): ETFS Short CNY Long USD (SCNY)*, S Short CNY Long USD (SCNY)*, ETFS Long CNY Short USD (LCNY)*, ETFS Short INR Long USD (SINR)*, ETFS Long INR Short USD (LINR)*

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72 Currency Investor | Autumn 2010

Achieving realistically sustainable returns with FX Managed Accounts

In the past two decades, Managed FX has emerged as the stellar class of alternative managed investments (see Fig 1.).

As seen from Fig. 2, the size of the estimated current Managed FX industry (under $20B) is less than 1,000th of the Mutual Fund industry ($26T), less than 100th of the Hedge Fund industry ($2.2T) and less than a 10th of the CTA industry ($200B). Due to recent overwhelming interest in Retail FX, the Managed FX sector is poised to grow dramatically in the next few decades.

There are numerous advantages in utilizing the Managed FX structure (see Table 1 on the last page of this article).

Managed FX Work" owFig. 3 overleaf shows a typical Managed FX work" ow.

PAMM accountsPAMM (Percentage Allocation Management Module) is a trading account that consists of multiple investor accounts which form one whole trading structure,

where the trading is carried out by the advisor. The principle of PAMM functioning is sharing the pro! ts and losses in proportion.

Portfolio allocationThere are many schools of thought on this concept, but a 10%-20% range is the most accepted. Managed FX allocations seem to increase in times of worldwide ! nancial hardship, as stock markets don’t generate suf! cient returns or create losses for investors. Investors should start with a small portion of their portfolio (10%-15%) and increase their allocations once they get comfortable with the process (assuming good performance).

Achieving sustainable success with Managed FX requires investors to go through a comprehensive process by questioning their advisor of choice. In this article Timothy J. Maxwell, Principal at QP Capital LLC ([email protected]), outlines a practical guide to the investigative process.

INVESTMENT PRODUCTS

Fig 1. Asset Class Evolution. Source: QP Capital LLC © 2010

Fig 2. Relative Industry Size. Source: QP Capital LLC © 2010

Autumn 2010 | Currency Investor 73

INVESTMENT PRODUCTS

74 Currency Investor | Autumn 2010

RegulationsStarting from October 18, 2010, the CFTC (Commodity Futures Trading Commission) requires all FX managers in the US to register with the NFA (National Futures Association) as a CTA (Commodity Trading Advisor). FX managers must now comply with the same strict set of guidelines as the CTA have been doing for many years.

Funds safetyIn today’s world of outright fraud by many hedge fund “managers”, funds safety (part of operational risk) is a major concern. When dealing with a Managed FX advisor, there are three inherent areas of concern:

a) FX Broker Security – A reputable broker with a good pedigree is a must. Preferably, it should be regulated by local authorities and well capitalized. This should be researched by the advisor. The advisor should also constantly monitor the broker for any red " ags, as seemingly even the most reputable brokers are prone to serious fraud (e.g. Refco).

b) Custodian Stability – Generally the bank where the funds are physically held. This research should be performed by both the advisor and broker. This aspect should also be constantly monitored, as even the largest ! nancial institutions could fall in times of extreme crisis (e.g. Lehman Brothers).

c) Advisor Competency - This due diligence should be performed by the client. The most crucial potential issues are volatility of returns and depth and length of program’s drawdowns. Investors should keep an eye on program performance and consider reducing their allocations in case of high volatility of returns or drawdowns outside their comfort zone. Most investors seem to be comfortable with short drawdowns under 15%.

Trading methodologyBoth technical and fundamental approaches, as well as a combination of two, work equally well in Managed FX. Various trading principles, style and methods could be successful, as long as they produce steady and smooth returns, while managing risk over a long period of time.

Long-term trading offers reduced turnover expense (spreads/interest), while short-term offers greater " exibility and control. Trading in ultra-short timeframe (scalping) does not produce good results due to liquidity, spreads and slippage issues. A lot of system developers create scalping bots (automated programs) that produce great results on paper. However, in a real environment with a sizeable fund, these systems are useless.

Proper automation of Managed FX trading is a good idea. It eliminates trader’s emotions and errors and allows for activity 24 hours a day without human intervention. The advisor should utilize the latest technologies (e.g. redundant power and internet feed, co-location, etc.) in order to keep an automated program running smoothly.

Performance and reportingThere are many important aspects of performance, such as history length, ROR, maximum drawdown, positive/negative months ratio, amount of pairs traded (more is better), various risk-reward ratios. The Sharpe ratio is a good indicator of consistency of returns. Investors want to see Sharpe of .75 and higher over a signi! cant period of time (one year or more).

Sharpe over 1.00 over a year or longer is exceptional. Managed FX performance is typically benchmarked against major market indices (e.g. S&P 500), as well as managed futures (CTA) indices (e.g. NewEdge) as

Achieving realistically sustainable returns with FX Managed Accounts

Fig 3. Managed FX Work" ow. Source: QP Capital LLC © 2010

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76 Currency Investor | Autumn 2010

Achieving realistically sustainable returns with FX Managed Accounts

the closest alternative investment class. This allows the investor to determine how well the advisor is performing against the overall market and its group of peers.

Investors can always log into their brokerage account and check their P/L, closed/open trades and other basic information. Some advisors, however, provide their clients with additional performance reports with features like trade stats, equity charts, drawdown analysis, won/lost pip breakdowns, pair analysis, risk-reward ratios, etc. This could be very bene! cial in gauging performance.

DrawdownsThere are three important aspects regarding a program’s drawdowns (largest peak-to-valley drops in equity):

a) Frequency of signi! cant drawdowns (per annum)

b) Average time to recover (in days)c) Size of the largest drawdown (monthly basis)

Drawdown frequency and time to recover largely depends on the program’s frequency of trading and style. There is no speci! c metric, but generally the program should not experience frequent drawdowns over 10% and should recover from drawdowns quickly.

The largest acceptable drawdown depends on the programs’ ROR (Rate Of Return) and investor’s pro! le. Most investors are comfortable with drawdowns under 15% on closed trades, assuming good returns. The majority of investors also accept an occasional drop slightly over 15%. Drawdowns upwards of 30% should only be acceptable in extraordinary circumstances.

Currency Pairs & CrossesPopular currencies perfectly suitable for Managed FX are: USD (US Dollar), CAD (Canadian Dollar), EUR (Euro), GBP (British Pound), CHF (Swiss Franc), JPY (Japanese Yen), AUD (Australian Dollar) and NZD (New Zealand Dollar). Most FX brokers offer dozens of pairs (e.g. USD/CAD) and crosses (e.g. CAD/JPY), based on these currencies. These pairs and crosses offer great liquidity with good spreads and ! t almost any trading style.

Other currencies, called “exotics” (e.g. RUB – Russian Rubble), are typically acceptable only to speci! c programs due to their lower liquidity and more importantly wider spreads. Some exceptions to that rule might be HKK (Hong Kong Dollar), SGD (Singapore Dollar) and DKK (Danish Kroner), as they offer good spreads and liquidity when paired with US Dollar.

Spreads and InterestSpreads are a crucial part of the Managed

FX business. Most non-ECN (Electronic Communication Network) FX brokers

earn their revenues exclusively via the difference in spreads they offer to

the advisor and Interbank spreads. Working with tight spreads is even TIMOTHY J. MAXWELL

“Managed FX performance is typically

benchmarked against major

market indices (e.g. S&P 500), as well

as managed futures (CTA) indices”

Autumn 2010 | Currency Investor 77

more crucial to advisors with high-volume of trading (short-term). ECN FX brokers charge commissions instead and do not pad the interbank rates. In that case the advisor should try to negotiate the best possible commission rates with its broker. Every trading night, during a rollover, the portfolio would either gain or lose interest on every open position. While an important aspect, the interest typically does not play a large role in Managed FX, unless the program holds positions for a long time with minimal leverage, but constant negative interest. In that case the interest could add up quickly.

Program minimum and capacityMinimum starting balances vary greatly from one advisor to another. For most advisors it ranges between $10K and $1M Investors should always inquire about a program’s theoretical capacity and current AUM (Assets Under Management). For any successful program there must be plenty room to grow, as new investors, contributions and pro! ts keep rolling in.

Broker selectionInvestors should also do due diligence on the advisor’s broker. Here are some key aspects of a good FX broker in order of greatest signi! cance:

a) Solid Reputation – must be in business for a long time and have a good reputation and positive client reviews

b) Tight Spreads – either ! xed or variable, the spreads must be tight for all major pairs and crosses

c) Good Customer Service – any issues must be resolved quickly to keep downtime low

d) Powerful Trading Software – to allow for quick execution, minimize slippage and downtime

e) Flexible Manager/Client Software – must be easy to use for clients to allocate, contribute and withdraw funds

f) Low Minimum Trading Size – some FX brokers require the advisor to trade full-size currency lots (100,000 units). Some offer mini-lots (10,000 units). Few offer no minimum at all.

It is often bene! cial to deal with mini-lots or no minimum, as the advisor can trade precisely the amount necessary, which could smooth out the equity curve and improve compounding.

Introducing BrokersThere is another potential revenue stream for the advisor that could be completely hidden to the investor. This revenue comes from so-called “rebates” or “kick-backs” that the advisor might collect from the portion of the spread from the broker. This is accomplished by utilizing a third party called “Introducing Broker” or IB. An IB introduces the clients to the broker and collects a portion of the spreads for its efforts. That revenue is then split between the IB and the advisor. In some cases, the advisor is also the IB, and it realizes all of that additional revenue.

This practice should only be acceptable to investors if rebates come directly from the broker spreads, and not “padded” on top of it. If an advisor “pads” every trade with as little as half of pip, with suf! cient volume of trading, it becomes equal to the advisor charging its clients a 5%, 10% or even 20% management fee, which is highly unethical. This also diminishes the performance, but guarantees a higher income for the advisor. Investors should always inquire if the advisor utilizes any such practices. Recent regulations made IB – broker relationship more structured better protecting investors.

Trading own accountMost Managed FX advisors have their own funds allocated to their program. This is due to all the bene! ts Managed FX has to offer, plus the full control over the trading. This adds additional bene! ts to the investors, as the advisor generally works extra hard, as his or her net worth is directly affected.

Leverage and Notional FundsManaged FX offers a signi! cant potential leverage to the advisor. Some FX brokers used to offer leverage up to 400:1 or higher, but with the recent Dodd-Frank Act, the maximum leverage available to the

INVESTMENT PRODUCTS

78 Currency Investor | Autumn 2010

Achieving realistically sustainable returns with FX Managed Accounts

US FX brokers is now limited to 50:1. In practice, 50:1 leverage is suf! cient for any style of trading. The sweet spot for the majority of trading programs is 3X-10X. Anything above 20X only works on short-term strategies, and should be used only for speci! c programs. Some advisors offer “Notional Funds” option. An account is notionally funded when the advisor trades the client’s account, as if the funding amount was higher than the actual funds on deposit for that client. This frees up capital for the client, but that capital should always be available upon advisor’s request. It’s up to the client whether or not to use this feature.

Contributions and withdrawalsMost Managed FX advisors allow for client’s contributions and withdrawals at any given time and with minimal notice. To add/delete funds from the program, the advisor would run a process called “Re-Proportion”, that adjusts current balances and positions accordingly, using broker’s PAMM software. Contributions often require a minimum proportionate to the initial minimum (e.g. $100K initial minimum, $25K minimum addition). When withdrawing, clients are often required to keep at least their initial balance to stay in the program. Ideally, clients should not withdraw any funds for a long period, so pro! ts get reinvested for maximum gains.

FeesThe fee structure for Managed FX is identical to ones

for hedge funds and CTAs. There are two types of fees: incentive and management. The incentive fee is based on percentage of performance pro! ts and typically ranges between 20% and 25%. The incentive fee is typically charged monthly or quarterly. The management fee is ! xed and charged monthly, quarterly or annually and typically ranges between 1% and 2% of client’s allocation per annum. Some advisors charge 30%, 35% or even 50% incentive fee and/or 3+% management fee. This should only be acceptable when the advisor’s performance is truly extraordinary. The sweet spot in today’s world is 20-25% incentive fee with 0-1% management fee for an advisor with solid performance.

Account openingWith most advisors it only takes a few days to open an account. This typically consists of the following steps:

1) Opening and funding an FX brokerage account2) Executing client agreement and LPOA

(Limited Power Of Attorney) with the advisor3) Following an invitation hyperlink to be added

to the advisor’s portfolio of accounts

ConclusionBy following guidelines which this article has tried to outline and conducting proper due diligence, investors stand a good chance of achieving long-term success with Managed FX.

Table 1. Asset Class Features

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80 Currency Investor | Autumn 2010

October 2010 - The Parker Blacktree Currency Index (PBCI)

The CMI is a comprehensive multi-manager based index comprised of three sub-indices:

• Macro Discretionary • Model-Driven • Diversi! ed.

Using its proprietary FX Style Select™ style mapping, PGS has selected “best of breed” currency managers and programs to represent each of the sub-indices. Each sub-index may include one or more managers, depending upon the number and quality of managers mapped.

The ISI is a diversi! ed index of rules-based investment strategies comprised of three sub-indices:

• Macro Pressures • Risk Perception • Market Dynamics.

Each sub-index measures the performance of a distinct set of currency market drivers that Blacktree has identi! ed as being critical factors in capturing returns from currency markets.

The PBCI is comprised of two sub-indices: the Currency Managers Index (CMI) and the Investment Strategies Index (ISI). The CMI Index measures the alpha generated by active currency managers. The ISI Index is a portfolio of

thematic rules-based trading strategies that decompose the market into tradable themes. The CMI comprises 65% of the PBCI, the ISI 35%, to create diversi! ed exposure across the range of investment opportunities.

PERFORMANCE SNAPSHOTS

Although the CMI sub index was down for the month, the Model Driven managers performed the best once again. The ISI sub index‘s model groups generated largely " at performance.

As Chart 3 suggests, the most pro! table currencies were the eastern European and emerging markets, which showed more price appreciation versus G-10 currencies.

As the table above indicates, two of the three top managers in the CMI were Model-Driven programs. The performance was noteworthy given the choppy performance of the G-10 currencies versus the broader universe of currency markets. Although the previous month also saw superior performance by Model Driven managers, this month’s outperformers in contrast has models focused more on either fundamental inputs or EM currencies.

Top Performers OCT Return Return (YTD) Type

Manager 1 6.67% 6.80% Model Driven(Multi Week Breakout)

Manager 2 2.78% 9.46% Model Driven(Multi Week Quant/Value)

Manager 3 2.20% 15.57% Diversifi ed(Multi Week Blended

Strategy)

Chart 1: PBCI Return Breakdown (October 2010)

The distribution of individual managers’ performance within the CMI (Chart 2), shows that the majority of the programs were negative, but with two exceptions, most of these programs incurred moderate losses.

Chart 2: Manager Return Distribution (October 2010)

Chart 3: PBCI Currency Returns Breakdown (October 2010)

Best FX Post Trade Service, FX Week 2009. No.2 Global FX House, Euromoney 2005-2010. © UBS 2010. All rights reserved. 04364 06/10 CurrInv

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