Are All Currency Managers Equal?
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Average Correlations Are Misleading
• Correlations vary
• As a result diversification gives less protection than expected
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Diversification Often Fails When It Is Needed Most
• In turbulent markets all asset returns
become more volatile and more
highly correlated
Hedge Funds and Global Equities
• When global equities produce returns
more than one standard deviation
above their mean their correlation
with hedge funds is only 6%
• When global equities produce returns
more than one standard deviation
below their mean their correlation
with hedge funds rises to 80%
Source: Hathersage, Hedgefundresearch and MSCI
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True Alpha (Uncorrelated Return) is Hard to Generate
• Return = Beta + Alpha
• Beta is systematic market risk:
asset classes with higher risk
have higher expected return
• Betas are easy to capture: buy
the index or ETF
• Alpha is zero sum: for every
winner there is a loser
• What is often labeled as Alpha
turns out to be Beta
For every winner there is a loser.
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Active Currency Return Attribution: Alpha or Beta?
• The return on any investment can be divided into alpha return and beta return
• The returns of currency managers can be divided into alpha return and beta returns coming from
exposure to FX risk factors (carry, trend, value and volatility)
• Most FX manager returns exhibit significant beta exposure
Index
Alpha
F1
(Carry)
F2
(Trend)
F3
(Value)
F4
(Vol.)
DB FXSelect
0.1 bps
(0.31)
0.14
(6.03)
0.40
(10.88)
-0.08
(-3.85)
0.12
(1.53)
R2
0.534
Source: Pojarliev and Levich. “Trades of the Living Dead: Style Differences, Style Persistence and Performance of Currency Fund Managers?”
Journal of International Money and Finance, 2010. Based on 156 weekly returns (April 05 – March 08). T-values in parentheses.
Barclay Currency
Traders Index
-9.0 bps
(-0.72)
0.70
(3.30)
1.28
(17.44)
-1.01
(-2.25)
0.04
(0.43)
0.660
Source: Pojarliev and Levich. “Do Professional Currency Managers Beat the Benchmark?” Financial Analysts Journal, Sep/Oct 2008.
Based on 204 monthly observations (Jan 90 – Dec 06). T-values in parentheses.
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New Study: Are All Currency Managers Equal?
“All animals are equal, but some animals are more equal than others”.
George Orwell, Animal Farm, 1945
Motivation – Questions we want to address
• Can currency managers provide meaningful diversification to investors with large equity
exposure?
• Are all currency managers equally adept at offering diversification?
• Can we identify managers better suited to provide diversification?
Methodology
• Make use of an earlier study (published results) to distinguish between alpha hunters and beta
grazers
• Evaluate performance in a post-sample analysis
Alpha Hunters, Alpha Generators, and Beta Grazers:
In-Sample and Post-Sample Results
Alpha
R-Square
Panel A:
In-Sample Results
April 6, 2005 until
March 26, 2008, 156
weekly observations
Panel B:
Post-Sample Results
April 2, 2008 until June
30, 2010, 118 weekly
observations
High (Alpha Generators)
L29, L42, L28
L29, L28, L15
Low (Underperformers)
L15, L50, L6
L6, L50, L46
High (Beta Grazers)
L58, L52, L50
L52, L6, L58
Low (Alpha Hunters)
L30, L28, L35
L46, L28, L35
Source: Pojarliev and Levich. “Are All Currency Managers Equal?” Journal of Portfolio Management, 2011, forthcoming
Evidence of alpha persistence - managers who were top performers over
the 3-year in-sample period also performed at the top in the following 2-year
out-of-sample.
Categorizing Investment Managers
R Square
Beta Grazers
Alpha Generators
Underperformers
Alpha
Alpha hunters
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Impact of Currency Managers on Global Equity Portfolios
• Portfolio 1: The Total-Return Portfolio. The currency allocation is invested in an equalweighted exposure of the top 3 managers with the highest total return generated during the insample period.
• Portfolio 2: The Beta-Chasing Portfolio. The currency allocation is invested in an equalweighted exposure of the top 3 beta grazers from the in-sample period, i.e. those with the
highest estimated R-square.
• Portfolio 3: The Alpha-Hunter Portfolio. The currency allocation is invested in an equalweighted exposure of the top 3 alpha hunters, i.e. those with the lowest estimated R-square.
• Portfolio 4: The Alpha-Generator Portfolio. The currency allocation is invested in an equalweighted exposure of the top 3 alpha generators during the in-sample period, i.e. those with
the highest point estimate for alpha.
Alpha Hunters and Beta Grazers
Global Equities and the Impact of Adding Currency Managers (10% Allocation )
• Investing in currency managers
provides diversification benefits
120
110
• Choosing the „right‟ managers
increases the benefits considerably
100
90
• Alpha hunters significantly outperform
beta grazers
80
70
• Investors should pay closer attention
to the return attribution of their
managers
60
50
Mar-08
Jun-08
Sep-08
Dec-08
Mar-09
Jun-09
Sep-09
Dec-09
Mar-10
Jun-10
MSCI World Index + Alpha Generators
MSCI World Index + Currency Beta Grazers
MSCI World Index
Source: Pojarliev and Levich. “Are All Currency Managers Equal?” Journal of Portfolio
Management, 2011, forthcoming
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Conclusions and Implications
All returns may appear equal but some returns will be more equal and more beneficial than
others.
Empirical Results
• Evidence of alpha persistence - managers who were top performers over the 3-year in-sample
period also performed at the top in the following 2-year out-of-sample
• Investing in currency managers provides diversification to investors with global equity exposure
• A global equity portfolio which diversifies using alpha hunters would have outperformed a
portfolio invested in beta grazers
Implications
• Institutional investors should consider currency investments to diversify their global equity
exposure
• Paying closer attention to the return attribution of currency managers is beneficial
• The distinction between alpha hunters and beta grazers may lead to some re-pricing for active
currency products
References/Selected Research
• “Are All Currency Managers Equal?” Forthcoming in Journal of Portfolio Management, 2011
• “Detecting Crowded Trades in Currency Funds” Financial Analysts Journal, vol. 67, Jan/Feb 2011
• “Trades of the Living Dead: Style Differences, Style Persistence and Performance of Currency
Fund Managers” Journal of International Money and Finance, vol. 29, issue 8, 2010, pp. 1752-1775
• “Currency Management Indexes: What Do They Tell Us”? Foreign Exchange: A Practitioner’s
Approach to the Market, Riskbooks, 2009
• “Trading the Forward Rate Puzzle” Journal of Alternative Investments, vol. 11, no. 3, 2009
• “Do Professional Currency Managers Beat the Benchmark”? Financial Analysts Journal, vol. 64, 2008
• “Alpha and Style Persistence for Currency Managers” Centre for Economic Policy Research, Oct 2008
• “Hunting Out the Alpha Seekers” Global Pensions, Sept 2008
• “Separating Alpha and Beta Returns: Are Currency Managers Measuring Up”? Centre for Economic
Policy Research, February 2008
• “Performance of Currency Trading Strategies in Developed and Emerging Markets: Some Striking
Differences” Financial Markets and Portfolio Management, vol. 19, no. 3, 2005
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For More Information
Lynnelle Jones
[email protected]
203.434.5966
www.hathersage.com
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