The motive of risk reduction is primarily defensive, in that it seeks to defend or maintain the portfolio’s return within a given tolerance of overall risk. That for adding “alpha” on the other hand is quite different, in so much as “alpha” refers to the excess return generated by an active currency manager relative to a passive hedging programme.
Economic theory suggests that the long-term return of a currency is zero, so how can an active currency manager add value or “alpha”? There appear to be two aspects to this question. Firstly, currency markets are dominated by short-term movement. Thus, while their long-term return may be zero, their short-term returns (and losses!) may be significant. Secondly, it should be remembered that the same theory that suggested there were fundamental equilibrium levels for currencies also suggests that their long-term returns are zero. While not rejecting such a theory outright, it should surely be treated with some care, put in this context.
Indeed, there is a fine — and increasing — body of academic work that suggests that contrary to theory, managing currency risk can indeed add “alpha”. Among these, I will draw out several notable examples. Firstly, while formulating his “Universal Hedging Policy” in 1989, Fisher Black suggested that currency was, contrary to theory, not a zero sum game and investors could indeed increase their returns by holding currency inventories. Needless to say, this contradicted the widely held view that currencies could not provide added value because currency markets were perfectly efficient. A relatively short time after that, Mark Kritzman put forward the view that active currency managers could take advantage of the apparent serial correlation in currency returns. Subsequent research by Taylor (1990) and Silber (1994) targeted market trends as being behind persistent positive returns from currency managers.
Two further research reports that should be mentioned are those by Strange (1998, updated 2001) and The Frank Russell Company (2000). In the first case, the survey by Brian Strange, as published in Pensions and Investment (15/6/98), entitled “Do Currency Managers Add Value?” stated that of the 152 individual currency overlay programmes managed by 11 firms, these produced an average of 1.9% per year over a 10-year review period from 1988 to 1998, while simultaneously reducing the risk of the portfolio. In other words, not only did currency managers consistently add value, but their action of seeking to manage currency risk also helped lower the overall risk profile of the portfolio, thus boosting the Sharpe ratio from both sides! The second example is that of the Frank Russell study of May 2000 entitled “Capturing Alpha through Active Currency Overlay”, which analysed the historical performance of currency overlay mandates and confirmed the view that managing currency risk does indeed add value or “alpha”.
As noted above, a host of empirical studies have proven conclusively that active currency management can indeed boost the portfolio’s return, both on an absolute basis and in this context relative to not hedging, in contrast to classical exchange rate theory. In line with this, a number of studies have been published suggesting clear market inefficiencies, which might therefore be taken advantage of by active currency managers. For instance, the 1993 study by Kritzman, suggesting that the discount/premium of the currency forward contract “systematically and significantly overestimated the subsequent change in the spot rate”. Kritzman also introduced the concept of so-called “bilateral asymmetry”, referring to a bias by risk-averse investors for the perceived predictable returns of the interest rate differential as opposed to the unpredictable returns of the currency. Work by Choie (1993) supported these findings. Overall, a body of informed opinion has developed, supportive of the view that active currency management can add value.
After finally admitting that currency markets may offer profit potential, whether over the short or long term, academic theorists have suggested that such profit opportunities may exist in currency markets because there are some currency market participants that are not solely or even mainly motivated by profit. Classical theory suggests rational currency market participants are solely profit-seeking and moreover offset each other, with the result that any outstanding profit opportunities are instantly arbitraged away. Thus, from this, they seek to explain the existence of sustained profit opportunities within currency markets by suggesting that non-profit-seeking currency market participants such as central banks, tourists and national or corporate Treasuries effectively distort pricing. To me, such a view appears more reflective of the guesswork of someone who does not actually know the answer but is afraid to own up. Currency markets generate profits because it is the theory that they should not that is wrong rather than the currency market itself.
Active currency management can add value because there is value to be had in currency markets, plain and simple. Within this, an active currency manager will clearly favour the most flexibility possible to add that value, both in terms of the currency benchmark that they have to operate under and the currencies and financial instruments with which they are allowed to trade. For the active currency manager, the foreign currency return is not just a matter of currency translation of the underlying asset, but also of the excess return or alpha that the currency manager is able to add. The alpha an active currency manager generates is usually measured against an unhedged position. However, probably a truer idea of the alpha the active currency manager generates would come from comparing their returns to those of a passive currency management strategy of maintaining the benchmark hedge ratio. Historically, the typical mandate has allowed managers to vary the hedge ratio between 0 and 100% regardless of the benchmark.