Consider the plight of the long-suffering currency fund investor, which has seen currency hedge funds deliver disappointing returns for the past two or three years.
According to Hedge Fund Research (HFR), in 2011 currency managers in aggregate delivered -3.79%, and although they have consistently delivered positive returns since then, they have been modest: 3.04% in 2012, 0.31% in 2013 and 1.7% year to date.
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| Clearly something has changed in terms of not only currency behaviour but in terms of performance as well Tim Schuler |
Investors tracking the S&P 500, meanwhile, earned around 13% in 2012, a little under 30% in 2013 and 11.96% year-to-date.
The picture is slightly better for macro funds, which invest in currencies alongside other asset classes. The strategy endured a tough 2013, posting a negative return of -3.88%. But in 2010 they delivered 4.15%; in 2011, -0.33%; in 2012, 5.2%; and YTD, 2.39%.
Neither has managed a repeat of the pre-crisis heyday, when macro funds managed to post returns of 6.79% in 2005, 8.15% in 2006 and 11.11% in 2007, according to HFR. (Its data for currency managers specifically does not go back beyond 2010.)
“Clearly something has changed in terms of not only currency behaviour but in terms of performance as well,” says Tim Schuler, investment strategist at Permal, the fund of hedge funds (FoHF) manager with around $22 billion in assets under management.
The markets have taken their casualties, with high-profile currency funds such as QFS Asset Management and FX Concepts closing down in recent years. Others have faced large redemptions. So is the game up for currency hedge funds?
“We see fewer hedge funds trading FX exclusively than we once did,” says Sam Diedrich, a portfolio manager at Pacific Alternative Asset Management Company (PAAMC), the FoHF.
Although its huge trading volume means FX is the largest asset class in the world, some large hedge funds see limited opportunities for core FX plays, since there are as few as 20 currencies that are liquid enough to easily trade – a small number of instruments compared to stocks and bonds.
Many managers have responded by expanding their investment horizons.
“Today, many hedge fund managers trading currencies like discretionary macro managers also look at rates and bonds, and on average allocate around 30% to 50% of their risk bucket to currencies,” says Diedrich.
| I am cautiously optimistic about the outlook for currency managers Sam Diedrich |
For the allocations still devoted to pure-play FX, trends that have made currency plays profitable in the past no longer apply. Everyone agrees the problems stem from the global financial crisis and the subsequent policy initiatives of the central banks.
“The uniformity in bias towards monetary accommodation post-2008 left little room for significant currency volatility or the potential for large-scale trending behaviour as each CB sought to weaken its own currency at the expense of others in an attempt to reflate their own sovereign through a ‘beggar thy neighbour’ approach,” says Permal's Schuler.
Switzerland’s euro peg, implemented in 2001, was a case in point, limiting CHF strength and thereby avoiding the deflation its continued rise would have fostered.
Before 2007, investors in the US and elsewhere ploughed money into emerging-markets (EM) equities which supported EM currencies and made carry trades very profitable. A reversal of EM sentiment undermined FX managers’ returns between 2009 and 2012, while in 2013 systematic managers were hit by yen and dollar strength.
PAAMC's Diedrich says: “Prior to Abenomics, the yen would consistently receive a flight-to-safety bid during times of stress. Following the secular depreciation of the yen in 2013, systematic models trading on this historic relationship experienced heavy losses.”
James Wood-Collins, CEO of Record Currency Management, one of the big currency managers still standing, says: “We’ve always tried to design our models to be as simple as possible, and to reflect cleanly the underlying behaviour – whether that’s carry, trend following, value, or one of the others.”
“These behaviours aren’t all rewarded in all environments, but rather than constantly re-engineer our models to chase performance, we favour diversification across strategies, coupled with thoughtful updating if and when we’re satisfied underlying fundamentals have indeed changed, or we come up with a better solution.”
| Hedge Fund Strategy Performance | |||||
| Strategy | YTD | 2013 | 2012 | 2011 | 2010 |
| Currency Funds | 1.70% | 0.31% | 3.04% | -3.79% | 2.83% |
| Macro/CTA | 3.17% | -1.79% | -1.00% | -4.88% | -1.73% |
| Equity long/ short | 1.08% | 11.14% | 4.81% | -19.08% | 8.92% |
| Event Driven | -3.61% | 13.87% | 5.96% | -4.90% | 1.98% |
| Source: Hedge Fund Research | |||||
Better times ahead?
Wood-Collins adds: “In the last 12 to 18 months, we have seen increased demand for hedging mandates due to growing concern about base currency strengthening, in particular from US dollar and pound sterling-based investors.”
However, optimists hope the increasingly divergent central-bank policy expected in 2015 will improve performance among currency managers trading FX as an asset class in its own right.
Diedrich says: “We are at an inflection point for opportunities in FX. If we see rates rising in the US and perhaps the UK while other central banks continue to add stimulus, that divergence should generate more volatility. We have already seen increased opportunities in yen, roubles, real and euros since the summer and that increased volatility should continue into next year.
"But it will take time for investor sentiment about FX funds to turn around and it will probably take a year of stronger performance until you see a significant number of new fund launches in this space.”
Schuler says: “A larger portion of macro managers' risk buckets have shifted back to currencies due to this phenomenon, as the disparate behaviours have allowed some trending elements to emerge, while implied volatilities have moved off their artificially low levels.
“If these divergences in policy persist, one should expect increased FX exposures to capture a greater portion of managers’ VaR exposure going forward.”
Interestingly, the outlook looks to be brightening across a number of FX strategies. The more conventional monetary picture “is supportive of some currency strategies such as carry and forward rate bias”, says Record's Wood-Collins.
“Trend following has been challenging more recently, but as divergence grows there should be more opportunities here too,” he adds. “But this strategy tends to struggle at inflection points, so it may be a bumpy ride for a while yet.”
Investors are likely to remain particularly cautious with this strategy.
“CTAs [systematic trend-following funds] have delivered quite good performance this year, but they are still a bit of a four-letter word among many allocators after five preceding years of underperformance,” says Diedrich.
Greater opportunities
Currency value strategies are less sensitive to the overall risk environment, but here too there may be greater opportunities.
“Banks have less risk-appetite now,” explains Diedrich. “Hedge funds are able to exploit dislocations caused by hedging activity within interest-rate curves and between bond and futures prices.”
There should be increasing opportunities for EM strategies as the dollar strengthens, adds Diedrich. “EMs that are more sensitive to funding risk will see flows reverse as the US rates rise, which will encourage those countries to raise rates.”
It is likely to be a long road back for FX funds before investors can fully get over the disappointments of recent years.
“We aren't betting the house on any one strategy, but we are certainly allocating to liquid-currency strategies like macro, CTAs and relative-value strategies at the margins,” says Diedrich. “I am cautiously optimistic about the outlook for currency managers.”
Wood-Collins says investors might conclude it is better to spread the risk within FX, rather than backing one particular FX strategy, adding: “We will see increased interest in a managed, diversified approach to currency investing.
"Each strategy has its own risks, but diversifying the approach is a straightforward and reliable tool for risk management.”