Standard Life Investments

Published Article

Pensions Week - Investment Snapshot


 

Currency

Pension funds like to invest in a broad number of assets in order to spread their risk and help maintain efficient portfolios. Of course, true diversification becomes harder to find in crisis environments where correlations increase dramatically as shorter term investors exhibit a preference for cash assets. Nevertheless currency returns have shown solid diversification benefits over time and suffer from low drawdown compared to equities. Yet use of direct currency exposure in pension funds is still limited.

The industry itself has not convinced institutional investors that currency is actually an asset class in its own right, despite conferences holding numerous panel debates on the topic. Nevertheless, in the past few years there has been an increase in the appointment of active currency mandates. The currency market is an excellent tool for asset allocation given you can express almost any market view you want with excellent liquidity and at incredibly low trading costs. Moreover, the specialist currency management industry is convinced that there are systematic returns to be generated and it continues to search for ways to distinguish alpha from beta in currency portfolios.

Typically beta is represented by a benchmark index for the given market (e.g. the S&P500 for US equities). At first sight the concept is not obviously applicable to currencies but in reality benchmarks are a set of investment or trading strategies. A benchmark for the performance of US stocks might include market capitalisation weights (Trend in currency terms) or earnings based rule (Fair Value). Bond Indices might also be coupon or duration based (Carry), whilst Developed and Emerging market characteristics could also be used to highlight general liquidity. As a result currency managers have tended to market their products against so-called naïve strategies which can act as a benchmarking tool.

In doing so we have discovered that these naïve styles rarely perform well at the same time. So a diversified approach to currency investment will perform better than with using one style only. Pension Funds would benefit from the appointment of currency managers with distinct styles or ensure that they mandate sufficient flexibility for discretionary fundamental managers to achieve diversified returns. Since the 1980’s both the naïve Trend style and the naïve Carry style has created healthy annualised returns, 6.1% and 8.6% respectively at a Sharpe Ratio of 0.5 yet a 50/50 basket of these benchmarks has returned 8% per annum with an enhanced Sharpe Ratio of 0.7.

The bottom line is that there are systematic and uncorrelated returns in the FX markets. The addition of a variety of currency mandates to a portfolio of bonds and equities could significantly enhance the quality of a pension fund’s risk-adjusted returns.