Dollar's Drop Puts Pressure on Overseas Futures
Copyright 2000 Barclay Trading Group, LTD.
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For many non-U.S. investors an investment in managed futures is partly an investment in the U.S. dollar. This results from the fact that most U.S. and many off-shore funds maintain their non-margin cash balances in U.S. dollar deposits. Unfortunately for these investors, the U.S. dollar has declined 26.3% against the D-mark, 31.8% against the Swiss franc and 28.7% against the yen during the fifteen-month period ending March 31, 1995. These declines, while recently providing excellent trading opportunities, have resulted in very large losses for foreign investors.
During this same fifteen-month period, the Barclay CTA Index measured a total return of 3.81%. While this modest return put U.S. investors in the plus column, European and Japanese investors have taken large net losses.
The impact of the currency loss may have a significant effect on the managed futures industry as a whole. In large part, the growth of managed futures has been fueled by off-shore participants. At the end of 1994, approximately 55% of the assets under management in managed futures were from non-U.S investors.
In order to gain a better understanding of the alternatives as well as possible solutions, we've invited a distinguished panel of industry experts to comment on how to structure managed futures investments with minimal risk of foreign exchange loss. Our panel includes:
Paolo G. Cugnasca, Emcor. Mr. Cugnasca is a founder and managing director of Emcee. Emcee is a recognized leader in the field of foreign exchange risk assessment, hedging, and international derivative products development.
Madanda G. Machayya, ML Futures Investment Partners, Inc. Mr. Machayya is vice-president and manager of the research and product development department of MLFIP. Prior to joining Merrill Lynch in 1988, he worked for two years as an analyst in the economics department of Chase Manhattan Bank.
Shakil Riaz, Chemical Bank. Mr. Riaz is vice-president, Global FX Managed Funds Group at Chemical. The primary responsibilities of the Managed Funds Group include marketing of FX/interest rate execution services, portfolio management for proprietary capital invested with outside managers and management of client funds in the FX and interest rate areas.
Didier Varlet, Indosuez Carr Futures. Mr. Varlet is president and CEO of Indosuez Carr Futures, a global FCM, and Carr Asset Management, a trading manager for offshore alternative investment funds. Carr Asset Management currently manages 12 funds trading in the financial futures and currency markets.
Q: Since the beginning of 1995, the U.S. dollar has declined precipitously against the European and Japanese currencies. Has this created any problems for you with regard to selling funds to investors who do not want the consequences of dollar exposure?
Cugnasca: The problem, in our opinion, is not so much this year's sharp dollar decline, but rather that throughout 1994 (even earlier, from the standpoint of Japanese investors), the dollar's value eroded at the same time as trading advisors started turning in poor to mediocre performance. Another issue, of course, is that while non-dollar investors are fully aware they purchased a dollar-denominated investment (thus technically accepting the consequences of it), at the end of the day they still mentally convert their holdings into local currency.
So it is really the combination of lower returns and the dollar's decline which may be causing problems. Starting with the third quarter 1994,our Risk Management Consulting Group has seen a substantial increase in the level of concern expressed by institutional and private investors about this problem.
Machayya: The decline of the U.S. dollar certainly creates foreign exchange- related losses to overseas investors in managed futures. However, the same move has also caused these investments to show very nice returns over the last three months. We have experienced an increased level of redemption from both foreign and domestic investors who were looking for a suitable exit opportunity following a long, relatively flat period. Some of these redemptions may have been related to foreign exchange losses.
Riaz: I am not sure that the U.S. dollar's recent decline should create any surprising or unforeseen issues for portfolio managers. Firstly, for sophisticated investors, dollar-based products are utilized for the U.S. dollar component of a portfolio that is otherwise diversified along many lines, including currency exposures. So while the dollar component may have suffered if unheeded, the appreciation of other FX components may compensate.
Nevertheless, taken by itself, the U.S. dollar component would underperform on a relative basis making non-dollar based investments appear more attractive. But the decision to select a particular dollar product is independent of the process to determine the optimal currency composition of a portfolio.
To the extent that the dollar's decline creates a perceived need to reduce the U.S. dollar weighting of the currency exposure, it will reduce the market share that dollar-based products hold as a percentage of total portfolios. However, this same decline will increase the demand for currency exposure management products.
Varlet: We currently structure our funds so that they are denominated in the home currency of the investors. In other words, funds offered in France would be denominated in the franc. Because the funds are offered in the home currency, the investor is not exposed to any currency risk from the purchase of shares. Our U.S. dollar funds, which are sold globally, are purchased primarily by investors with a significant portion of their assets and liabilities in the dollar. Again, most of these investors are not faced with currency risk.
Q: What are you doing to deal with these problems at present?
Cugnasca: Our firm has developed a variety of risk management programs. For institutional clients in the fund syndication business, these consist of dynamic risk management programs which become incorporated in the structure of the fund itself. In other cases, we work with individual investors to design a strategy that best fits their investment objectives and risk parameters.
Generally, we find the best approach is a combination of dynamic "active" exposure management with a static "passive" risk management strategy, with the latter portion being further subject to periodic review to maintain the highest level of flexibility in case of structural market changes. Educating our clients as to the benefits and risk/reward profile of each risk management alternative remains an important aspect of what we do.
Machayya: We encourage our investors to take a long-term view of managed futures. Just as the dollar decline may have caused temporary foreign exchange mark-to-market losses, an expected rebound could lead to corresponding gains. Unless investors take the view that the dollar is likely to remain at these levels or sink further over the next year or so, redeeming at this point will cause them to miss potential benefits from an expected rebound, a view held by several macro economists.
Riaz: Most of our clients are either dollar-based or have allocated trading assets to us from their U.S. dollar pool component. For these clients, the dollar decline may require a re-examination of the portfolio's currency weightings. For those clients who have looked at a dollar-based fund as a way to take an additional speculative position versus the base currency, we would recommend a more formal review of their portfolio's currency composition to explicitly determine the dollar component.
Varlet: We will continue with our current policy to denominate the fund in the currency of choice for the investor.
Q: Do you foresee any changes in the way that you do business as a result of this prolonged weakness in the U.S. dollar?
Cugnasca: Addressing the issue of currency exposures as part of a comprehensive risk management strategy has been our business focus for15 years. We do not expect it to change--but we think we are going to be very busy in the future.
Machayya: If the dollar were to remain at current levels, it does not affect new investors. Even existing investors will redeem only if they expect the dollar to decline further since only under this scenario do mark-to-market foreign exchange losses increase further. Many of our funds have shown gains that offset the extent of depreciation. Hence, we do not expect to change the way we do business.
Riaz: We have had some discussions with selected Japanese/European-based clients on the concept of a multi-currency option product whereby most of the principal stays in the investor's base currency. I suppose eventually we will move in the direction of a different share class-per-currency within the same fund. But we still need to address various legal, regulatory and accounting issues if we want to trade all the cash markets.
Varlet: Other than offering excellent trading opportunities for our CTAs, the decline of the dollar has not significantly affected our clients. Therefore, we will continue to develop funds denominated in the currency of our investors.
Q: Some would argue that the best line of defense for a fund syndicator would be to denominate a particular fund in the local currency of the country in which it is being sold. Do you agree with this strategy and if so, what will you do when the dollar strengthens?
Cugnasca: There are a number of limitations to this approach. One, by confining sales to a particular country, the fund may not be as cost-effective for the fund syndicator as a fund which may be distributed in more than one country. Two, funds denominated in local currency would require the trading advisors to accept non-dollar equity, which we know is a problem for many CTAs. (Alternatively, it would require the fund syndicator to assume this currency risk). Third, depending on how the local currency denomination is actually achieved, there could be adverse cash flow impact to the fund should the dollar enter a protracted period of strength.
Finally, under a strengthening dollar scenario, fund syndicates resorting to a strategy of local currency denomination may find themselves at a competitive disadvantage: in their market, investors would surely perceive other, dollar-denominated funds to be a better product.
Machayya: Denominating funds in the local currency eliminates one level of transaction, i.e. converting investment proceeds back into home currency. It also reduces an additional level of volatility due to currency fluctuations. But the return expectations have to be no different from a dollar-denominated fund, otherwise the investor is taking the same kind of speculative bet as the trading advisor and could suffer from downside risk. Most globally traded portfolios already have currency fluctuations built into their long-term dollar returns--only short-term returns change according to the base currency.
We do have funds denominated in local currency. These have been investor-driven to suit those investors who want that particular denomination. No currency hedges have been used.
Riaz: As a general rule it would be rather impractical to denominate a particular fund in the local currency of the country where it is being sold. For example, a lot of our Mideast based investors are really not in the market with us for local currency investments. Much like a multinational company a quarter century or so ago, the question that today's global investor has to learn to wrestle with is "What is my base currency?" Just because I happen to live in Karachi does not necessarily make the Pakistani rupee my base currency, although I may choose to do my accounting in rupees.
Although they may find the idea difficult to implement, most global investors probably should utilize some type of a basket weighting to diversify currency in their portfolios.
Varlet: We very much agree with this strategy. All of the balances of our non-dollar-denominated funds are completely hedged into the currency in which the fund is denominated. We accomplish this through one currency margining provided by our brokerage firm or by hedging through the use of futures and options. A strengthening of the U.S. dollar will have no affect whatsoever on these non-dollar funds.
Q: Investments that are denominated in non-home country currencies can provide an additional level of portfolio diversification to the investor. Given the costs of hedging coupled with the resulting reduction in portfolio diversification, do you believe that hedging the currency risk for the non-dollar fund investor would improve the long-term risk/reward trade-offs?
Cugnasca: First of all, I don't think that the cost of hedging is a relevant consideration. The bigger issue should be with the concept of hedging itself, which takes many forms and includes permanent or "passive" as well as dynamic hedging. Someone once made the statement that under certain circumstances, being fully hedged and not being hedged at all can both be potentially and similarly dangerous.
Under a strengthening dollar scenario, such as during 1980-1984, "passive" hedging strategy would have been potentially devastating for a fund. Just think of the negative cash flow on those hedge contracts! On the other hand, the penalty for ignoring currency risks is becoming increasingly harsher, as we have seen during the past year.
In our opinion, funds should specifically incorporate a risk management strategy for the underlying equity. A "dynamic" hedging approach is better than no strategy at all, and over the long term is definitely more rewarding than a "passive" hedging strategy (and than that of denominating a fund in local currency). Fund investors want their fund to be in dollars when the dollar is going up, and want their dollar risk to be hedged when the dollar goes down. As unrealistic as it may seem, this is an integral part of their expectations. This objective can be more effectively chieved through a professional risk management strategy than by passively hedging the currency exposure.
Machayya: Hedging currency risk isn't recommended unless it is very client-specific. A currency hedge is, in effect, another trade on top of the managed futures portfolio and carries with it mark-to-market gains and losses. To be profitable with a high degree of probability, a hedge has to be dynamically managed (as dealers do in managing their books); otherwise, it represents a high premium cost which reduces assets committed to trading, and its impact on the reward-risk trade-off is unclear. A short-term hedge may be used to contain business risk: i.e. if a fund is launched under volatile currency conditions, use a short-term hedge to retain investor confidence at the expense of a small reduction in upside gain.
Riaz: Actually, I have heard the opposite being argued: that over the long run currency risks will balance out, so for the long-term investor, paying the cost of hedging does not make sense. One must take the investment time horizon into the discussion of whether to hedge or not to hedge. Introducing currency exposure into a portfolio without explicit understanding of its volatility or correlation with other components in the portfolio can be a very dangerous exercise.
As I mentioned earlier, selection of a specific investment must be analyzed independent of its currency denomination. Currency composition is a portfolio-level decision which should vary by investor. Some have argued in the extreme that the most appropriate currency exposure for a diversified portfolio is the inclusion of currencies as an asset class separate and distinct from all other portfolio components, with the remaining assets/liabilities in the portfolio being matched on a currency basis.
Once a portfolio manager has decided on the level of currency risk that is acceptable, hedging must be utilized to make sure that the actual currency exposure does not exceed the desired level.
Varlet: We would prefer that the investor make a conscious decision as to his allocation of currencies rather than be forced into it through the purchase of this product. We believe that the gain achieved by the additional diversification does not outweigh the additional currency risk that is accepted by the client. As for the cost of hedging, our brokerage firm provides one currency margining for the margin money on deposit. The only exposure to currency risk is on the unrealized gain on open positions. We do not believe that this represents a significant risk.
Copyright 2000 Barclay Trading Group, LTD.