When pension funds began looking for additional sources of return to mainstream asset classes, foreign exchange was an obvious choice. It was easy to understand, highly liquid and had a record of supplying returns that were uncorrelated to schemes’ core holdings of equities, bonds and property.

Many pension fund trustees had previously used currency overlay strategies to hedge their overseas holdings, so it was a natural progression to view FX as an asset class.

But in 2008, returns from FX strategies went the same way as those from equities. The much-coveted uncorrelated returns looked decidedly correlated.

FX managers knew it was time to adapt. “It’s a bit like innovation in war,” says Neil Record, chairman and chief executive of Record Currency Management. “When you have to, you tend to develop new thinking.”

Pension funds have traditionally gained exposure to the FX markets though three main investment strategies: forward rate bias or carry trade, value plays and momentum, which looks to exploit volatility. Carry trading was the more popular strategy, but it was also the most susceptible to the financial crisis.

Craig Nowrie, research consultant at Aon Consulting, is keen to advise schemes that relying on a single strategy is inefficient and that a well diversified currency allocation will make use of all three strategies.

“The most important thing in our mind is making sure the philosophy in the process is quantifiable, repeatable and understandable and the people actually implementing it know what they are doing,” he says.

Active management is not the only way pension schemes have been accessing FX. In recent years a number of currency indices have been launched purporting to offer exposure to currency market beta – the return available from FX strategies that is said to be systematic due to the varying motivations of the players that make up the
market.

However, some consultants question the value of the indices due to the discretion involved in building them. Some indices use all currencies, while others use a small selection. Some are calculated monthly, others quarterly.

“How do you know this isn’t just back-tested data?” asks Neil Smith, investment consultant in Hewitt Associates’ global investment business. “If you’ve got an index provided by a bank then essentially it’s like another product. The bank wants to attract investors so it needs to look good professionally.

“So how do I know that having three currencies versus five isn’t just a symptom of what looks good historically?”

Mr Record estimates there are about 12 currency carry indices on the market, most of which are sponsored by investment banks to market their own products. Six months ago he launched the Forward Rate Bias Index series (FRB5) with FTSE. This charts the 10 currency pairs of the five largest currencies by volume and offers what Mr Record calls alternative beta. But there are some who argue that passive currency exposure is unsuitable for pension funds. Elizabeth Para, currency investment strategist at Overlay Asset Management, believes pension schemes are much more interested in hiring an FX manager to deliver absolute returns with certain risk-
return objectives.

“I don’t think these do-it-yourself, cheaper options are really an alternative for most pension funds,” she says. “I don’t think they’re having a direct impact on active currency managers.”

However, one area where indices are starting to have a big impact is on fees. Pension funds have typically paid similar fees for actively managed FX as for other alternative investments, of 0.5 per cent to 2 per cent a year of assets under management and 10-20 per cent of profits.

The performance fee has been based on how well the fund does against cash. But there is a growing feeling among consultants that the fees for active managers should be based on how they perform against passive currency funds, in the same way as active equity managers base their performance fees on outperformance of an index.

“If active currency managers are saying they can add value relative to passive, then it’s on that basis they should be remunerated,” argues Mr Smith. “There should be more of a link between their skill and the passive benchmark.”

Mr Record adds: “It hasn’t happened yet, but we’re waiting for our first client, either new or existing, to have a currency alpha mandate with a benchmark of FRB5. That would be a really big change for the perception of currency.

“I think it will happen this year and really quite soon. If it gathers momentum it could be a really big thing.”

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