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Skittish about using currency for anything but hedging, corporate finance executives are getting an earful from investment managers about the case for global cash markets as a new source of investment returns.
Marie Leone, CFO.com | US
February 17, 2005
Some investment bankers, among them Goldman Sachs, are working to convince corporate finance executives, and the experts that manage pension and other corporate investment portfolios, to view currency as a stand-alone asset class and a new source of "alpha" returns.
But the sell will be a hard one.
Alpha is the measure of excess return (beyond market benchmarks) that investments throw off when managed successfully. It's also been described as the measure of an investment manager’s return that cannot be attributed to the ups and downs of the market. Having a “positive alpha” associated with an equities portfolio, for instance, could mean that a manager beat the returns of S&P 500 Index.
But before pension sponsors and investment managers embrace currency as an untapped alpha source, they'll need to feel comfortable about using it as something other than a hedging tool. Indeed, CFOs—especially ones who work for companies that conduct business with overseas customers and suppliers—tend to be at ease with currency risks because they know how to limit them via financial hedging.
Witness a hypothetical American company that sells $4 million worth of products to a German customer and provides a three-month term for payment in euros. During that contract term, the company could encounter euro volatility against the dollar or a dollar appreciation—two situations which could cut into the sale’s profit margin. To hedge those risks, the American company might use currency-forward contracts.
Yet, while hedging is routine for multinational executives, relying on the global cash markets to create alpha is unfamiliar territory. What's more, it's too risky an investment in terms of its potential rewards, some finance executives say.
Mark Buthman, CFO of health and hygiene products maker Kimberly-Clark, is a case in point “Actively managing currency for investment returns is not a priority for the company,” he says. Unlike the role currency plays at financial institutions, “currency is not a core element of our business strategy, and we view it as more of a source of volatility and risk, rather than an opportunity to create value,” he adds.
Further, most corporate executives believe that it's hard to parlay currency investments into consistent benchmark-beating returns, says Louis Finney, a senior consultant at Mercer Investment Consulting. “Individual managers may have terrific alpha potential, but they tend to charge high fees” that could eat into the gains, he says.
Nevertheless, the demand for better returns and more diverse sources of investment return is mounting among corporate investors. Lackluster stock performance has left many pension funds, deferred-compensation plans, and philanthropic foundations underfunded. “The emphasis is [now] on how much alpha a manager can squeeze out over time,” says Finney.
Currency should be part of that new emphasis, currency specialists argue. Indeed, it bids fair to become "an asset class in its own right” alongside debt and equity, contends Scott Arnott, vice president of global fixed income and currency at Goldman Sachs Asset Management.
Currency managers buttress their case for currency by pointing to the vast liquidity and gaping inefficiencies of the global cash markets. Those conditions provide the currency-investment managers plenty of chances to exploit market imbalances to generate extra returns, they say.
Consider the alpha potential: The average daily trading value of the global cash markets is $1.9 trillion, dwarfing the world’s most liquid trading markets. (The New York Stock Exchange, the world’s largest equities market, generates $4.1 billion in daily trading, while the U.S. bond market— including Treasuries, long-term corporate debt, and municipal debt—spawns $533 billion.)
The inefficiency of currency markets is said to stem from the disparate motives of the various market players. In those markets, for instance, there are corporations trading goods, tourists spending money abroad, investors seeking international exposure, and central bankers hatching monetary policy. “There are few other markets where such a large number of participants are so accepting of price and unconcerned with profit,” Arnott explained in a report he wrote in June.
Unlike the equities market, in which the players seek a profit, currency-market participants behave with other goals in mind. For instance, central banks try to nudge currency exchange rates for macroeconomic or geopolitical reasons, while corporate managers use hedging strategies to protect transaction revenues generated abroad.
Making the case for currency investing, Arnott contends that currency-price movements are more discernible than they've been before. That may be a result of what he and other currency advocates see as the market's new-found maturity.
Currency management, in fact, is relatively new, having burgeoned only after the United States abandoned the gold standard for international trade in 1971. In the ensuing decade, market players, notably in the United Kingdom, spent time getting used to the idea of floating exchange rates. By the time active currency management reached the United States, it was 1988. Thus, the technique “grew up during the 1990s”, adds Bill Muysken, global head of research for Mercer Investor Consulting.
Since then, investors—even some corporate ones—have become aware of currency management and grown more comfortable with the modeling technology used to pinpoint price movement, according to Muysken. Further, greater numbers of currency-investment managers have been pushing their wares. In 2004, for example, Mercer advised clients on 28 currency manager searches, a considerable leap from the seven such searches the firm was under contract for in 2003. Most of the searches involved pension funds.
The managers are making a fairly good case. Besides the heightened quest for returns, actively managed currency offers diversification because currency returns aren't correlated to the movement of the debt and equity markets, Arnott asserts.
Mercer’s Finney, however, doesn’t believe currency will displace debt or equity in pension fund portfolios any time soon. The decision to invest in currency is company-specific, depending on a plan sponsor’s risk appetite, liability profile, plan maturity dates, and liquidity requirements, he says. If currency is used at all, he and other experts reckon, it's most likely to crop up as an overlay to protect a portfolio’s international stocks and bonds from currency risk.
In an overlay, the currency risk of a company's international assets is managed separately from its overall risk portfolio. The management is done, for the most part, by means of forward foreign-exchange contracts. The overlay doesn’t affect the existing asset allocation mix of stocks and bonds, and little or no cash is used to buy the contracts. Instead, the parties settle the profit or loss of the contracts at the end of a predetermined period, such as quarterly.
Pension-plan sponsors might find currency overlays a less jarring way to improve their returns than reallocating their stock and bond mix, currency-investment experts contend. “It’s a big deal to reallocate [pension fund] assets,” posits Finney, especially if the fund is significant compared to the company’s market capitalization.
An asset-allocation change, after all, can entail heavy lifting. It often involves the approval of many stakeholders, including the board and shareholders, management, human resources officials, corporate lawyers, money managers, and pension consultants.
Straight currency asset allocations in pension portfolios, however, are much less popular than overlays. Part of the reason, thinks Tom Hazuka, chief investment officer at Mellon Capital Management, is a widely held misperception among corporate executives that currency investments don't generate decent risk-adjusted returns and consistent results over time.
That misperception is based on the execs' use of currency derivatives as hedges. Since currency-derivatives markets lean toward efficiency, they don't pack a great deal of alpha. Corporate executives incorrectly conclude from their experience in those markets that active currency management will also fail to generate appropriate returns compared to its risk profile, Hazuka, whose company actively manages currency, contends.
But managers would do better to focus on currency's underlying asset class, global cash markets, rather than derivatives, he argues. That's because currency prices, rather than being affected by supply-and-demand market forces, are moved by central bank decisions. And those tend to produce anything but efficient markets.
Another qualm about currency markets is that they tend to deliver inconsistent returns because the factors affecting price movements of underlying assets are hard to pinpoint. To be sure, sophisticated macro-economic models are needed to track such price movements. But consistently strong returns are still possible, Hazuka asserts. A “properly structured economic-valuation approach provides superior performance,” he adds, cautioning that "the investment must be handled vigilantly."
Indeed, if general market conditions continue to coax portfolio managers to chase new and diverse ways to generate returns, actively managed currency is likely to find a secure place as an asset class in some pension portfolios. For now, however, most CFOs and their portfolio managers are proceeding with caution when it comes to trying to turn the alpha and omega of currency into a lucrative investment vehicle.
Marie Leone's "Capital Ideas" column appears every other Thursday. Contact her at MarieLeone@cfo.com.