Why Sovereign Wealth Funds Should Look at Currency Alpha
Steady globalization, government interventions and increased investment into rapidly developing economies are key factors influencing emerging market currencies. Sovereign funds and large Canadian pensions, such as the Canada Pension Plan Investment Board (CPPIB) and Ontario Teachers’ Pension Plan (OTPP), continue to invest capital into markets such as India, Brazil and China. Sizable portfolios of listed securities have accumulated for wealth fund investors in non G-7 economies, thus exposing them to currency risk. Public institutional investors continue to weigh the benefits of currency management and alpha opportunities versus the cost. According to SWFI Compass, an RFP and opportunity tracker, there continues to be compelling demand in 2016 for allocation to emerging market external fund managers. Asset owners demand international exposure to emerging market debt and equities; however, they may be unaware of the issues regarding these securities when it comes to currencies. Liquidity constraints are one of many concerns when it comes to these currencies. However, not all asset owners embrace currency hedging. For the most part CPPIB does not hedge foreign currency holdings to the Canadian dollar. CPPIB has a number of reasons including the perceived costs of hedging in developing countries and its view that the Canadian dollar is powerfully linked to the price of oil. On the other hand, the world’s largest sovereign wealth fund, Norway’s Government Pension Fund Global (GPFG) has taken a different approach than CPPIB. In April 2015, the Norwegian wealth fund started to systematically hedge its stocks against currency risk. The fund greatly considers currency risk when they invest in select equity markets.
Global sovereign wealth funds and institutional managers are, by investment mandate, susceptible to volatility and fluctuations in the currency markets, which can be reduced via FX hedging and fund investments.
Stages of Currency Hedging and Investing
There are different levels of engagement when it comes to currency activities. Proper currency management has provided investors in the past with the ability to potentially enhance portfolio returns and expand diversification. Pensions, endowments and SWFs can view the progression of currency programs as starting at never hedging currencies, using currency overlay, enhanced currency overlay, all the way to having a currency alpha program.
Amid the torrent skepticism of another product, currency alpha had provided an opportunity set for asset owners seeking diversification and risk mitigation in a world of increased volatility. Through academic studies and research, currency alpha strategies have historically offered low correlation with other traditional investments. The foreign exchange market is massive and liquid, where the majority of participants are not profit-seeking, such as central banks and corporations. However, as mentioned earlier, emerging market currency markets are less efficient and could be more impacted by fund flows. Large wealth funds to small U.S. pensions have embraced or are starting to analyze the importance of these programs. For example, the Iowa Public Employees’ Retirement System in mid-2015 initiated plans to allocate to liquid absolute return strategies such as currency alpha.
“Foreign currency trading and investing provides for an uncorrelated revenue stream in a diversified portfolio of assets. Global sovereign wealth funds and institutional managers are, by investment mandate, susceptible to volatility and fluctuations in the currency markets, which can be reduced via FX hedging and fund investments. Due to the scalability of FX trading and the liquidity of the underlying market, FX investments are a crucial part of any asset allocation. As a syndicate of sovereign investors, Scepter believes their investment in a multi-strategy, predominately FX fund, will be the beginning of a trend in primary investment in this area,” says Matthew Feldmann, former partner and portfolio manager at Brevan Howard in Geneva, Switzerland, who is working with Scepter Partners to launch their alternative investment fund, Scepter Capital.
Currency alpha comes in a number of flavors. Strategies embracing a low-to-moderate form of volatility are the carry trade, also known as fundamental. Increasing volatility, currency alpha managers can embrace a CTA type of investing which is more technical, thus embracing proprietary models generating systemic trading signals. These trend followers have attracted mega institutions such as the California State Teachers’ Retirement System (CalSTRS) and giant wealth funds like the Abu Dhabi Investment Authority (ADIA). In fact, in April, CalSTRS announced they would be moving some US$ 16 billion in assets toward risk mitigation strategies such as trend-following. Last are strategies that engage in both fundamental and technical investment styles.
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