Currency Overlay - An Investment Management Issue


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  • Good afternoon and welcome to this second in a series of JPMorgan Fleming webcasts focused on topical investment management issues. Today I’ll present information on why currency overlay management is an investment strategy that you can’t afford to ignore. As we proceed, you’ll be able to log any questions which arise via the questions box on the internet site. Write them in while you think of them and I’ll answer questions at the end. We will also appreciate your completing the short feedback form at the end. This will help us improve for future webcasts. Currency volatility has recently come to the fore in investors concerns about international investing as the dollar’s slide has further detracted from returns. Currency overlay is a strategy that can help control that risk as well as enhance returns. The uncorrelated source of potential extra return is an appealing feature of this often neglected strategy.
  • I said that currency risk management is often neglected. That results because it is often an inherited risk that comes along with international investments, be they stocks or bonds. Currencies are an afterthought, but they can have a tremendous impact on risk and return. In the short term they can have a sizable impact, positive or negative, frequently dwarfing the returns from the underlying investments. For instance, in the past year the dollar has fallen about 11% against Sterling, and the dollar represents the major allocation in international portfolios. However, in the long term currencies tend to produce very little extra return and offer only unrewarded risk. Investors should address this risk first by setting a benchmark allocation to currency risk, just as they have decided upon a benchmark allocation to other investments. Then, again in parallel with their approach to other investment classes, they should determine whether active management offers the potential to add value. Let’s look at some examples and evidence.
  • We’ve prepared a graphic to illustrate the point that a good stock pick can be a bad investment if a currency moves the wrong way.
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  • The most important decision to make then is the benchmark decision. It controls the currency risk that the investment portfolio is facing. The next decision is to decide whether active currency overlay management can add value.
  • The choice of a higher hedge ratio will dial back the risk. In this conceptual chart we’re showing that fully hedged returns are somewhat lower than unhedged returns. This is based on a long term assumption that there is no long run return to currencies and that there are transactions cost to be considered when hedging. These are quite small, however, less than 5 basis points in the bid-offer spread.
  • The goal of active currency management is to take timely deviations from the benchmark in order to enhance returns. Mandates can control just how large those deviations are, controlling the risk of outcomes. If there are inefficiencies and there is volatility offering opportunity for increasing returns, the next question that arises is “What is the evidence indicating that managers can add value?” The answer is quite favorable.
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  • May I have your questions now, and remind you once again to complete the evaluation form.
  • Currency Overlay - An Investment Management Issue

    1. 1. Currency Overlay - An Investment Management Issue Brian Strange, Vice President and Client Portfolio Manager 020 7742 3716 JPMorgan Fleming Asset Management [email_address]
    2. 2. <ul><li>Currencies are an inherited exposure </li></ul><ul><li>Currencies can have sizable impact in the short term </li></ul><ul><li>Currencies can have high risk and low return in the long term </li></ul><ul><li>Risk can be managed by a strategic hedge ratio </li></ul><ul><li>Managers have added value through active management </li></ul>Why currency matters Total investment return Asset return in local currency terms Currency return = + TMcP: 26/10/99
    3. 3. Every investment has a currency component <ul><li>Even a good stock pick can be a bad investment if the currency decision is wrong </li></ul>Stock price of US asset USD vs GBP GBP value of asset
    4. 4. Currencies have high risk and low return Average of trailing 1 year periods 1988-2003 Unhedged Hedged Equities outside the UK for GBP based investor Source: JPMorgan Fleming Asset Management, MSCI <ul><li>Unhedged international stocks are riskier than hedged ones </li></ul><ul><li>Why take the risk if you don’t get paid for it? </li></ul><ul><li>Incorporate some hedging in the investment policy </li></ul><ul><li>Use the risk saved in currencies and invest it where there is a return for bearing risk </li></ul>50% Hedged
    5. 5. Investments in international markets can be higher when more hedging is done GBP investor allocating into MSCI World ex-UK Source: JPMorgan Fleming Asset Management, MSCI Typical allocation to overseas equities
    6. 6. Stock returns and currency returns are separate Source: JPMorgan Fleming Asset Management, MSCI There are times for more hedging and times for less hedging - an active strategy can enhance returns while lowering risk
    7. 7. Investors should establish a strategic currency benchmark as a priority ... a benchmark is a long-term strategy used to measure performance “ Big picture” decisions are too complex to take daily: <ul><ul><li>“ Automatic pilot” designed to achieve long-term goals (e.g. liabilities) </li></ul></ul><ul><ul><li>deviation from benchmark to benefit from market opportunities </li></ul></ul>= Goals Benchmark portfolio + Active management Views + Overall strategy
    8. 8. Strategic currency benchmark helps investors focus on long-term goals Return Risk Fully hedged Partially hedged Unhedged TMcP: 26/10/99
    9. 9. Value can be added through active management <ul><li>Currency markets are inefficient </li></ul><ul><li>Currency markets trend </li></ul><ul><li>Currency markets are volatile </li></ul><ul><li>Currency markets are driven by fundamentals </li></ul>... inefficiencies and volatility can be exploited
    10. 10. Active currency management seeks to add value, control risk around a strategic benchmark Return Risk Fully hedged Partially hedged Unhedged Goal ... combine strategic with active to achieve objectives Strategic hedge ratio Strategic and active management
    11. 11. Hedges are adjusted relative to benchmark based on market outlook TMcP: 26/10/99 time hedge ratio Neutral on currencies: at benchmark 50% Hedged 100% Hedged 0% Hedged Currencies falling: hedge more Currencies rising: hedge less Period 1 Period 2 Period 3 benchmark
    12. 12. Currency overlay management mechanics JPMF Client Custodian Counterparty 4 - Deal foreign exchange contracts 1 - Agree on guidelines & benchmark 3 - Report exposures 8 - Settle trade 5 - Settlement details & performance 7 - Cash Flow Instructions 6 - Verification 2 - Credit risk & dealing lines 5 - Settlement details & performance Appendix
    13. 13. “ Capturing Alpha through Active Currency Management” Frank Russell update - published May 2000 <ul><li>18 Managers provided data </li></ul><ul><ul><li>earliest data from end 1988 through June of 1999 </li></ul></ul><ul><ul><li>14 provided returns covering at least the five years prior to June 1999 </li></ul></ul><ul><li>Covered about $ 85 Bn of currency overlay mandates </li></ul><ul><li>241 accounts </li></ul><ul><ul><li>75 discontinued </li></ul></ul><ul><ul><li>65% USD based, 13% AUD based, 22% other base currencies </li></ul></ul><ul><li>10,041 account months </li></ul><ul><li>Same methodology as Strange in Pensions & Investments 1998 </li></ul>
    14. 14. Performance and tracking error of complete time period Source: Frank Russell, “Capturing Alpha through Active Currency Management”, May 2000
    15. 15. Alpha from currency overlay is uncorrelated to traditional assets Source: JPMorgan Fleming Asset Management Rolling 12 month correlations Low correlations demonstrate diversification benefits for client portfolios
    16. 16. JPMorgan Fleming: Specialist currency solutions TMcP: 26/10/99 <ul><li>World class currency team </li></ul><ul><li>Outstanding breadth and depth of product offering </li></ul><ul><li>$50 billion in assets under management </li></ul><ul><li>Disciplined, transparent, diversified investment process </li></ul><ul><li>Long-term continuous track record </li></ul><ul><li>Cutting edge technology and risk management systems </li></ul>Pure currency alpha risk return Passive overlay Active overlay Emerging Market overlay Managed Currency Fund
    17. 17. JPMorgan Fleming currency overlay investment process TMcP: 26/10/99 STRATEGY IMPLEMENTATION TRADING <ul><li>Disciplined and consistent because we use quantitative models </li></ul><ul><li>Diversified because we look at many factors </li></ul><ul><li>Comprehensible because we focus on fundamental reasons why currencies are bought/sold </li></ul><ul><li>Comprehensive because we include the input of a strategy team </li></ul><ul><li>Risk-controlled because we allocate our decisions evenly among model driven and human decisions </li></ul>Quantitative Qualitative CIPC Implementation Trading <ul><li>Currency Investment Policy Committee (CIPC) </li></ul><ul><li>Ownership and accountability </li></ul><ul><li>Risk budgeting </li></ul><ul><li>Risk management </li></ul><ul><li>Client guideline compliance </li></ul><ul><li>FX forwards </li></ul><ul><li>Straight through processing (STP) </li></ul>Quantitative  80% Valuation Return on capital Currency specific drivers Technicals Qualitative  20% Major policy events Short-term sentiment
    18. 18. Currency overlay offers the potential to raise returns and lower risk <ul><li>Why currency management? </li></ul><ul><li>Explicitly addresses an unrewarded risk </li></ul><ul><li>Active risk should be budgeted to investments offering persistent alpha opportunities </li></ul><ul><li>Low correlation with other asset classes and alpha strategies </li></ul><ul><li>Why JPMorgan Fleming? </li></ul><ul><li>Institutional depth and experience: first mandate in 1989 still a client </li></ul><ul><li>Long-term partnership with clients: average relationship 7 years </li></ul><ul><li>Diversified, disciplined, research-driven investment process </li></ul><ul><li>Cutting edge technology and risk management systems </li></ul>