Foreign exchange funds fail to fly
Saturday, 1 September 2007
Steve Johnson
A headlong rush by pension funds into active currency management has resulted in losses for many investors.
And strategists are warning of further losses to come if the carry trade - the practise of borrowing in low-yielding currencies and buying higher-yielding ones -- was to unwind amid rising risk aversion sparked by the meltdown in the US subprime sector.
A series of dummy portfolios calculated by ABN Amro is set for an unprecedented third straight year of losses, its worst run since floating exchange rates were introduced in the early 1970s.
Real currency funds appear to be faring little better. "In the past two or three years, median returns are around about zero [before fees]," said Diane Miller, principal at Mercer Investment Consulting.
The Deutsche FXSelect Top Diversified Index, encompassing 70 currency funds, paints a gloomier picture, falling 4 per cent in 2005, 5.4 per cent in 2006 and 4.2 per cent so far this year.
The concerns come as the carry trade, the one successful strategy in currency markets in recent years, appears to be coming under pressure.
The Japanese yen, the lowest-yielding major currency, has risen 3.9 per cent against the US dollar since July 20, with its rise closely mirroring the iTraxx Europe Crossover Index, a barometer of risk appetite in credit markets. The New Zealand dollar, a perennial favourite of carry traders, has tumbled 10.5 per cent against the yen since July 24.
Deutsche Bank's Currency Returns Index, designed to show the returns available to currency managers, has fallen 3.3 per cent since peaking on July 25.
"We do think it's a pertinent time for investors to re-examine what they are doing on the carry side," said Collin Crown over, head of currency management at State Street Global Advisors, which has cut exposure of its $100bn of currency assets to the carry trade to zero.
"Currency funds are a minimum three to four times levered and I think we could see a lot of these funds under water in the future."
Bilal Hafeez, global head of FX strategy at Deutsche Bank, warned that trend-following funds, the second most popular FX strategy, would also suffer if the carry trade continued to unwind, given that they have built up broadly the same positions. The faltering returns strengthen the hand of those who believe that the sheer weight of return-seeking money entering the $2,000bn-a-day foreign exchange market is likely to arbitrage away those returns.
Although the currency market has a beta of zero, proponents argue it is possible for active traders as a whole to make money because so many participants are non-profit maximisers, such as central banks, asset managers passively hedging overseas exposures and the corporate sector. While this appears to have been true in the past, some believe the flood of new money, combined with more aggressive behaviour by previously non-profit seeking participants, is tipping this balance.
"As more return-driven money enters the industry it will arbitrage away some of the returns," said Mr Crown over, who cited the trend for corporate treasuries to be increasingly run as profit centres and for central banks to become more active in currency management.
"We tend to think that the currency markets are moving closer to the model of the equity and bond markets. It's closer to an efficient market in aggregate."
James Binny, director of FX analytics and risk advisory at ABN, said: "In the past few years traditional assets such as equities, credit and property have been mostly strong. With negative correlations [to these assets] currencies haven't really had the opportunity to make money.
"With traditional assets facing tougher times it is crucial currency managers do return to form and make money. A substantial part of the argument for including currency in portfolios is that it makes money when other assets are struggling." -- FT Syndication Service
A headlong rush by pension funds into active currency management has resulted in losses for many investors.
And strategists are warning of further losses to come if the carry trade - the practise of borrowing in low-yielding currencies and buying higher-yielding ones -- was to unwind amid rising risk aversion sparked by the meltdown in the US subprime sector.
A series of dummy portfolios calculated by ABN Amro is set for an unprecedented third straight year of losses, its worst run since floating exchange rates were introduced in the early 1970s.
Real currency funds appear to be faring little better. "In the past two or three years, median returns are around about zero [before fees]," said Diane Miller, principal at Mercer Investment Consulting.
The Deutsche FXSelect Top Diversified Index, encompassing 70 currency funds, paints a gloomier picture, falling 4 per cent in 2005, 5.4 per cent in 2006 and 4.2 per cent so far this year.
The concerns come as the carry trade, the one successful strategy in currency markets in recent years, appears to be coming under pressure.
The Japanese yen, the lowest-yielding major currency, has risen 3.9 per cent against the US dollar since July 20, with its rise closely mirroring the iTraxx Europe Crossover Index, a barometer of risk appetite in credit markets. The New Zealand dollar, a perennial favourite of carry traders, has tumbled 10.5 per cent against the yen since July 24.
Deutsche Bank's Currency Returns Index, designed to show the returns available to currency managers, has fallen 3.3 per cent since peaking on July 25.
"We do think it's a pertinent time for investors to re-examine what they are doing on the carry side," said Collin Crown over, head of currency management at State Street Global Advisors, which has cut exposure of its $100bn of currency assets to the carry trade to zero.
"Currency funds are a minimum three to four times levered and I think we could see a lot of these funds under water in the future."
Bilal Hafeez, global head of FX strategy at Deutsche Bank, warned that trend-following funds, the second most popular FX strategy, would also suffer if the carry trade continued to unwind, given that they have built up broadly the same positions. The faltering returns strengthen the hand of those who believe that the sheer weight of return-seeking money entering the $2,000bn-a-day foreign exchange market is likely to arbitrage away those returns.
Although the currency market has a beta of zero, proponents argue it is possible for active traders as a whole to make money because so many participants are non-profit maximisers, such as central banks, asset managers passively hedging overseas exposures and the corporate sector. While this appears to have been true in the past, some believe the flood of new money, combined with more aggressive behaviour by previously non-profit seeking participants, is tipping this balance.
"As more return-driven money enters the industry it will arbitrage away some of the returns," said Mr Crown over, who cited the trend for corporate treasuries to be increasingly run as profit centres and for central banks to become more active in currency management.
"We tend to think that the currency markets are moving closer to the model of the equity and bond markets. It's closer to an efficient market in aggregate."
James Binny, director of FX analytics and risk advisory at ABN, said: "In the past few years traditional assets such as equities, credit and property have been mostly strong. With negative correlations [to these assets] currencies haven't really had the opportunity to make money.
"With traditional assets facing tougher times it is crucial currency managers do return to form and make money. A substantial part of the argument for including currency in portfolios is that it makes money when other assets are struggling." -- FT Syndication Service