Currency Overlay Managers Utilize CTA Trading Skills
Copyright 2000 Barclay Trading Group, LTD.
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The amount of money under management in managed futures has declined from approximately $26 billion at the end of 1993 to $22.8 billion at the end of 1995. This decline in assets has been attributed--among other things-- to a decided cooling of U.S. pension fund interest due to several well publicized cases of heavy derivatives losses and to a stock market that continues to defy gravity. Yet, even as many industry participants bemoan the apparent departure of U.S. pension fund assets, other forward-looking participants see an opportunity to expand and extend their money management and trading expertise into the area of currency overlay management.
According to the Pensions & Investments annual survey of the 1000 largest U.S. pension funds, pensions have an estimated $185.4 billion invested in foreign stocks and bonds. Although the pension fund community still debates whether the foreign exchange risk inherent in the ownership of these international stocks and bonds should be hedged, given the recent strength in the USD and the tendency to view portfolio returns over a shorter term time horizon, advocates of currency hedging and overlay management may be winning the day.
The Barclay CTA database currently follows the performance of approximately 70 currency trading programs. Of this group, only about 10 have ventured into currency overlay management. Is this an investment area where CTAs with currency trading experience would be competitive? In an attempt to answer this and other related questions, we've asked two CTA/currency overlay managers to discuss some of the relevant issues.
John R. Taylor, Jr., FX Concepts, Inc. Mr. Taylor is the chairman, chief executive officer and founder of FX Concepts. He has 25 years of experience in the foreign exchange and related fixed income markets. He is recognized as an expert in the management of foreign exchange and a pioneer in the analysis of the cyclicality of foreign exchange and interest rate markets.
Thomas E. Zimmerman, Zimmerman Investment Management Company. Mr. Zimmerman, a chartered financial analyst, is chief executive officer, portfolio manager and founder of ZIMCO. Prior to founding ZIMCO, Mr. Zimmerman was chief investment officer of the$12 billion Teachers' Retirement System of the State of Illinois where he developed and managed an in-house foreign exchange operation utilizing proprietary overlay models to direct trading.
Q: Several currency trading CTAs have successfully offered currency overlay management programs to institutional investors. What are the differences and similarities between a currency overlay manager and a currency trading manager?
Taylor: Certain skills are common to successful currency overlay management and currency trading management. First, there must be an understanding of risk and volatility. For a CTA, that takes the form of avoiding a catastrophic cash drawdown. For an overlay manager, it is more subtle and is dependent on each individual client's appetite for risk in its various forms. For example, we use a value-at-risk framework for certain clients, a drawdown-from-benchmark-constraints for others, and a drawdown-from-cash for yet others. Moreover, clients use widely different benchmarks which require adjustments in portfolio management strategy.
Second, successful currency managers must possess the ability to forecast foreign exchange rate movements over time and take positions in accordance with those forecasts with results that are consistently profitable. Increasingly, good currency managers must develop techniques to filter out positions where the risk/reward ratio is too high. The same things apply to overlay managers. In uncertain or high risk situations, overlay managers will retreat toward their clients' individual benchmarks while currency managers should sit on their hands.
There are also differences in the skills required to be an overlay manager. Overlay mandates are typically too large to trade in the financial futures markets. As a consequence, it is necessary to have traders and trading relationships capable of executing large amounts in the interbank foreign exchange markets. In addition, overlay management entails the management of a complex process which includes the analysis of a client's risks in order to jointly agree on several portfolio issues: the proxy portfolio, a benchmark which fits the client's needs, and risk constraints. In our case, this process includes an analysis of the client's foreign equity and bond portfolios in which we take on a consulting role before we actually begin managing the overlay assignment.
Zimmerman: It really depends upon the manager style. For instance, for overlay managers who simply replicate options to transfer risk away via portfolio insurance, managed futures would not be feasible. For Zima, there is little difference in the decision making with respect to the placing of a trade short a currency (to initiate a hedge) or buying it back or going long (a decision to be unhedged). The only difference in an overlay situation is that you only short the currency; long exposure is created by being unhedged so that the underlying currency exposure in essence becomes your long position. Additionally, in an overlay strategy there is no leverage; you are limited to the notional value of the client's foreign asset exposure. As you are being evaluated based upon an unleveraged result, your models had best be robust-- anemic returns cannot be masked through leverage.
Q: What are typical fees for a currency overlay manager? How are assets under management defined?
Taylor: Historically, the fee structure for an overlay manager has been a straight management fee, a low one in comparison with speculative accounts. With the advent of different types of benchmarks and client guidelines and restrictions in executing overlay mandates, fee structures have changed to accommodate these hybrid strategies. Fee structures today frequently are combinations of management and incentive fees. Additionally, fees may differ depending on the definition of assets under management.
Typically, assets under management are defined by the client's underlying portfolio. While the currency exposures under management closely approximate the exposures associated with a client's underlying international assets, the managed exposures may differ from actual exposures according to the proxy portfolio which is created by the manager. Exposures or assets under management may also be defined as passive versus active.
Zimmerman: It depends upon the size of the account, but management fees range from.1% to .3% of the notional value per annum, generally with the possibility of a performance fee for exceeding the return of a benchmark. On the surface the fees sound light, but many CTAs work for 2% and use seven times leverage, so they are essentially receiving .3% of the exposure. Assets under management are defined as the dollar amount of the international holdings in the underlying portfolio-- i.e., a $50 million dollar Nikkei 225 investment would have $50 million dollars of currency exposure.
Q: A prospective client can easily evaluate and compare CTAs against each other on the basis of risk-adjusted rates of return. How would a client evaluate a currency overlay manager in light of its client- specific nature?
Taylor: The best way for a prospective client to evaluate overlay managers is to first exclude those without a sufficiently long and verifiable track record of performance. The next level of evaluation by the prospective client should be to ask the manager to construct an actual performance composite for accounts in which the base currency, underlying portfolios, starting points, benchmarks and mandate guidelines/constraints are the same as the prospective client's. The performance results of the portfolio can then be compared across managers by the prospective client himself.
There will still be potential performance discrepancies between these composites based on several things which are much tougher to analyze in retrospect, such as proxy portfolio creation techniques, tracking error, hedging techniques (e.g., timing, maturity and choice of instrument), execution costs and period of compounding. In the same way that currency managers are evaluated on the basis of a Sharpe Ratio or other similar standard, overlay managers are evaluated in terms of the manager's return and volatility compared to the prospective client's benchmark. A detailed due diligence session with each of the remaining managers to more clearly understand and get comfortable with their styles, decision making processes, people and future prospects would then be the next logical step in evaluating managers.
Lastly, as in the case with any portfolio management decision, multiple managers may be the most appropriate way to take advantage of diversification benefits. Therefore, decisions as to the styles of managers that would best complement each other also need to be addressed.
Zimmerman: It is generally difficult for plan sponsors and consultants to evaluate, but it comes down to the same principles as any other investment. The overlay manager should be evaluated based upon how he performs over several market cycles in meeting the client's stated objective. Whether it is to reduce volatility or generate raw alpha, this can be demonstrated in a table representing each of the following: underlying currency return, client benchmark return (this should reflect his attitude towards risk reduction or alpha generation), the currency overlay manager return, and the net return of the underlying and the overlay manager. As in grouping similar accounts into composites, a separate table should be shown for each unique mandate.
Q: Mandates for overlay managers can vary tremendously from client to client. How does a client or manager determine an appropriate benchmark for purposes of ongoing evaluation of their currency overlay program?
Taylor: It is true that currency overlay mandates today vary more frequently from client to client. A client or manager should first determine an appropriate benchmark based upon the client's overall objectives and/or perceptions of the future. Ongoing evaluation of a currency overlay program should be based upon performance of managers relative to that benchmark.
Zimmerman: The benchmark should indicate the preference of the plan sponsor with respect to risk reduction or alpha generation or a combination thereof. A zero percent benchmark would generally indicate a preference for alpha generation while the other end of the spectrum would be a 100% hedge benchmark which clearly calls for the elimination of risk or volatility reduction. One of the most frequently seen benchmarks is a 50% hedge benchmark. This is a good benchmark to evaluate a manager's skill in either capacity as it allows for overperformance in strong and weak dollar environments.
Copyright 2000 Barclay Trading Group, LTD.