Structured Products convened a panel in December 2013, sponsored by Bloomberg Indexes, in which the outlook for foreign exchange investing, especially in relation to the development and use of indexes, and their use as underlyings for ETFs and structured products were among the topics discussed.
WisdomTree Asset Management
Rick Harper, head of fixed income and currency
Societe Generale Corporate & Investment Banking
Sébastien Galy, senior FX strategist
Srikant Dash, head of Bloomberg Indexes
What is the current state of the foreign exchange (FX) market?
Sébastien Galy, Societe Generale Corporate & Investment Banking: If we think about the world as the US dollar versus developing emerging markets, we expect slow, steady and reluctant dollar appreciation. But it’s not going to be a straight-line process, which is very unfortunate. We know that the US Federal Reserve will taper in January, but more interesting is foreign exchange (FX) trades, essentially two-year forwards. In 2014, going into Q1, and more importantly into Q2, Q3 and Q4, we’ll be pricing in the end of 2015 and 2016.
At that point, the Fed will be significantly behind the curve and trying to play catch up and normalise policy, probably through a fairly aggressive series of rate hikes. That is supportive to the dollar. Of course, the FX market doesn’t trade in 2016, it trades a little earlier. That means – as we go into 2014, into Q1, particularly in Q2 and increasingly in Q3 – the yield differential between the dollar and other currencies will move from an extremely low level – about 30 basis points on the two-year – to something higher. That process of unanchoring – moving from very low levels to much higher levels in the twos, but not massively so – will change the ranking of funding currencies globally.
The way an index works is by picking the top funding and the top investment currencies. One simple way it does this is by looking at yield differentials. As the yield makes it less attractive to fund in dollars, we’re going to move away from the buckets where everybody is short dollar, essentially short yen, to a world where people are going to start considering short yen. As they do so, the dollar will tend to increase. In the past few days, there has been an assessment of where the funding currencies should be, and you can see very large asset managers starting to consider where their funding should be, with the dollar starting to become less interesting.
We have seen the Canadian dollar discussed as an alternative to the US dollar, although the yen is probably going to be the most likely. We haven’t seen that hesitation on funding for many, many years. And, as that differentiation happens because of yields and because of opportunities, we will start to see the first movements in the dollar.
As well as funding, there is the asset side. Here you need to have something that is fairly attractive. That might be the New Zealand dollar for some people because the yield is higher. It may be Brazil because it is perceived that the yield is so high that, even though the fundamentals are really poor, it might be attractive.
Srikant Dash, Bloomberg Indexes: Investors increasingly realise that FX is an asset class and have dedicated allocations to FX. The correlation, for example, between the Bloomberg JP Morgan Asian Dollar Index and an Asian exchange-traded fund (ETF) is only about 50%. This means that if you want exposure to Asian economies, you have two ways of getting there. Similarly, if you look at the correlation of the Bloomberg Dollar Spot Index to an ETF of foreign equities, correlations are about 35%.
Investors are beginning to decouple the returns of most asset classes. In equities, it’s fundamental equity drivers versus movement of the foreign currency. In bonds, it’s credit versus foreign currency. As investors see that you can provide exposure or get exposure to different components of different risk factors, there is going to be more interest in trading or investing in FX-linked instruments directly.
Sébastien Galy: While emerging markets will be difficult, developed markets offer significant opportunities, one of which is sterling. We believe the UK is a great place to hold your money, which hasn’t been the case for many years. The process of normalisation in the Bank of England has started, albeit very slowly, which will make sterling more attractive.
That process is starting on the asset side and there are opportunities in Europe. In the short term, the euro is on the topside but, in the next few months, that process will reverse because the European Central Bank (ECB) will be forced to expand monetary policy and, as it does, the euro should eventually weaken. We know all of the problems about the euro – essentially deflation, low growth – and the ECB is significantly behind the curve and will be forced to act. But the ECB’s ability to influence the euro is much, much lower than the Fed’s ability to influence the dollar, so the Fed will remain the main driver of euro-dollar.
In the broader emerging markets, there are opportunities and risk. The risk is linked to tapering. There might be a mechanical relationship between tapering and alpha from emerging markets. We expect that process to be mean-reverting and have only a temporary negative impact.
We should see the broad eastern Europe, Middle East & Africa outperform in Q2, Q3 and Q4, although we generally prefer Latin America.
Has FX become more popular as an asset class as investor preferences have become more short term?
Srikant Dash: There are three different classes of investors for FX: one is speculators, people who are taking a short-term position, be it a week, one-month or three-month position in a currency or a basket of currencies. Second are the yield-seekers and third is the strategy investor, and there are a number of strategies in FX, such as momentum, carry, volatility and fundamental. If you are a speculator, yes, it’s a short-term outlook, and we’ve seen that with Japan in recent years.
Fundamental or carry strategies are popular for institutional investors or sophisticated advisers seeking alternatives. They like to have a small portion of their portfolio devoted to a variety of currency strategies, certainly less than 20%. For those investors looking purely for yield, the investment horizon depends on the yield environment in their local markets.
Rick Harper, WisdomTree Asset Management: The outlook for currencies focuses on emerging markets currencies. It’s more a strategic long-term plan and more about investing in developed markets. It’s more of a short-term, value play investing in the dollar against developed markets. To what degree do you define your exposure and how much do you draw down? Some investors will put currency strategies in their alternative buckets. Others – Srikant mentioned the yield seekers – would be more interested in something like a short-term fixed-income bond. They’re looking for yield.
In terms of the outlook, we favour the dollar against other developed market currencies. We’re particularly focused on interest rate differentials, as well as positive evaluations, current account and the US dollar deficit going down.
In emerging markets, we’re just starting to consider the risk of the taper chain, and investors need to be cognisant of it. But the local factors that were unsupportive last year are becoming much more supportive: worries over China’s economy have been taken off the table, so the fundamental backdrop is better, and so we continue to favour emerging markets as a long-term story, and see opportunities in developed markets in the dollar versus the others, particularly Japan, where we think Abenomics is going to re-energise.
What is the longer-term outlook for emerging markets? How difficult is it to decide what is and what is not an emerging market?
Sébastien Galy: EM is an acronym with a meaning that has become outdated. If you go to South Korea, it is essentially the same as sitting in New York City – these are developed markets. If you go to some parts of China, you will feel very much like you’re in New York City. Within these countries, there are parts that are completely Western in their development and others that aren’t.
The political structures are not necessarily the same between developed and emerging markets. But there are countries that are really in the emerging parts, Indonesia, for example, and Thailand, which is also up and coming despite some of the difficulties that we know. There’s a great dispersion. You can’t compare Thailand to Poland because, fundamentally, they’re not the same countries and yet we put them into the same baskets.
If we look in the way an economist would look at the development of an economy, they would think about it as a concave function: growth at the beginning is very, very rapid, but when you become a mature economy it’s very difficult to grow. It’s very difficult for the US economy to grow very quickly because we don’t produce Coca-Cola cans, we produce ideas. We produce goods that are heavy users of human services and humans are not the most productive things on earth. It’s much easier to produce 10 cans of Coke than to have two different ideas.
Does there need to be a recasting of the idea of emerging markets?
Sébastien Galy: Some developed markets have fallen aside and exhibited elements of emerging markets. So we should take a less holistic view of our investments and know exactly what we are buying. We’re not buying Brazil Russia, India and China; we are buying Brazil and not buying Brazil, for good or bad reasons. It’s the same with the countries such as Chile and Mexico. You can compare them in a slightly different way with countries such as Canada, Australia and New Zealand. If you go to Asia, Korea is in the same basket as Australia and New Zealand, but they’ll also do the same with some of central Asia or even Taiwan.
So you have gradations of developments, with countries very oriented towards commodities, which might have higher yields because their economies are performing better. But you’re basically making a combined bet on an economy that is better-performing, has an exposure to China, for good or bad, which is very specific, the same way as you do a sector allocation.
It just requires a bit more effort to go beyond the first level when buying a broad global emerging index. If you want to do better, then you should do a form of sector allocation: perhaps Korea versus Taiwan, Taiwan versus Poland, Poland versus South Africa and the like. That process requires more rigour and effort, but there are limits to what you can do individually, although that doesn’t mean the job shouldn’t be done at some point.
Will there be development of emerging indexes so that you may see Emerging Markets ex-Korea, perhaps?
Srikant Dash: Yes. One of the most widely followed measures in currency markets is the value of the dollar. It’s of enormous importance for everybody, from policy-makers to traders and investors. And the value of the dollar depends on which currency you’re comparing it to. We talked about emerging markets: if you look at the biggest trading partners of US, as published by the Fed, there has been a sea change in the last 20 years. In the last 10 to 15 years, you have countries such as China, Mexico, South Korea and Brazil showing up in that list of the top 10.
Similarly, if you look at the most widely traded currencies, as published by the Bank for International Settlements, you have currencies, again, such as the Chinese yuan and the Korean won, which didn’t show up 15 years ago and are now sixth, third, fourth, fifth on the list. In the index business, you’re in the business of providing metrics for people to measure the value of something. So, if you are in the business of providing a measure of the US dollar, you have to factor in emerging markets or the leading emerging markets as part of the basket against which you’re measuring the value of the US dollar. In the Bloomberg Dollar Spot Index, for example, about 15% of the constituents are from emerging markets.
We believe that investors will look increasingly at thematic exposure to emerging markets, so we have indexes for the American currencies and Asian currencies. These indexes have the right sort of hedges or speculative plays, depending on your orientation, for people who want exposure to those economies.
Rick Harper: One of the important things, as Srikant and Sébastien mention, is drilling down and knowing what you hold. Investment products based on indexes or strategies have the transparency that exchange rates offer on a daily basis, giving investors flexibility. There have been a lot of concerns in the past about FX and some fixed-income strategies over their lack of transparency. The daily transparency afforded by ETFs gives you that drill-down potential to refine your exposures.
Over the next five to 10 years, investors – and they’re already starting to switch this way – are going to be increasingly cognisant of their daily exposures. It’s increasingly important for them and especially for advisers to know exactly what they hold.
If you’re looking to invest in FX and you’re looking at what might be the most effective wrapper, what do you make of ETFs and structured products?
Rick Harper: ETFs provide building blocks and investment strategies for which dealer transparency is available every day. Structured products offer less visibility, since it is often a more bespoke exposure. Because, in some respects, you’re appealing to a smaller audience with structured products, an ETF is a little more of a broader play and a little more liquidity-focused because there is a 24-hour trading cycle. It’s knowing what you hold, and the amount of transparency in either investment is very important. And some investors will sacrifice a little bit of transparency for increasing the speciality of the exposure they are looking for.
Transparency is why ETFs have grown so much, with mutual funds taking the hit – and the hint. They’re offering their holdings a little more frequently and that’s going to be a defining element in the markets: investors are going to demand it. A lot of this is a by-product of what happened in 2008, when commercial paper suddenly became something you had to be concerned about.
I’ve had several calls about Treasury Bill positions over the past year. Up until a few years ago that never would have been an issue but, obviously, we’re in a different world right now.
How do ETFs and structured products measure up as access tools for FX?
Srikant Dash: It really depends on the investor. If you’re looking for transparent exposure with the liquidity of an exchange, there are very few structures that beat an ETF. But if you’re looking for something that’s customised to your strategy, structured products offer a unique opportunity. If you want exposure to the Bloomberg Dollar Spot Index, for example, then an ETF is a very elegant structure to get exposure. But if you want a twice-leveraged exposure to the dollar via that index but with protection and some caps, a bank can offer a very elegant structure. It depends on your investment objective and capital commitment. If you’re only putting in $20,000 or $500,000, maybe the ETF is better.
The structured products market has grown, at least in the UK, despite the hiccups post-Lehman Brothers, because advisers have learnt there are benefits to some bespoke qualities. ETFs have grown as well. And then you have exchange-traded notes, which sit somewhere in between.
How do the two investments compare for cost?
Srikant Dash: By virtue of providing simple exposure, the ETF is going to be cheaper. But, if you want double long exposure to the Bloomberg Dollar Spot Index with a cap and a floor and a payout every three months, you can’t get that from an ETF. So I don’t know if it’s fair to compare the costs. If somebody is getting pure, simple beta-one exposure to an index and a structured product format without any optionality and is paying twice as much as ETFs they probably shouldn’t, but I doubt many people are doing that. They’re doing it for the optionality and for the structural aspects customised to their needs.
Rick Harper: How unique do I want the exposure to be versus costs and risks? Structured products offer a higher level of customisation for individual clients, as Srikant mentioned, than ETFs currently might be able to offer. But, for more straightforward and transparent exposure, there are few alternatives that have the same kind of low-cost advantages as an ETF.
Sébastien Galy: The bespoke nature is very important, but it’s also the ability to leverage, and it’s a form of leverage that is not available to everybody. It’s restricted, it’s wealth management, it’s a bank level. It’s basically higher wealth that has been targeting these products for the higher premium and not everybody can leverage because they don’t all have the same credit quality.
There’s a certain democratisation of the process, whereby you start with structured products. But then there’s the development of the ETF, which reaches the masses, including myself, and it’s a very welcome process.
Srikant Dash: There might be an adviser looking at a bespoke structured product or a traditional currency ETF and asking: ‘Where do I get more fine-tuned exposure for my portfolio?’ As the the two worlds collide, you’re seeing a lot of structured products based on baskets of ETFs because of the ease of structuring and the transparency of the underlying.
I see a lot of questions about the mutual fund versus the ETF versus the structured product market, where the question of which structure almost becomes secondary. The primary consideration is ‘what is the outcome that I’m trying to achieve here, and what is the most efficient way to achieve that outcome?’ Most advisers look at it from that perspective.
Would investors still sometimes prefer an ETF because it’s based on a fund, rather than a bank?
Srikant Dash: Yes, we’re definitely not in the world of 2007.
Rick Harper: As an ETF sponsor we are still seeing a bias towards the ETF versus something that has bank risk, although do not discount the bespoke nature and the need for leverage and exposure.
What is the future like for FX-linked investing?
Sébastien Galy: FX has been more difficult because the world’s central banks were printing money. Carry trades didn’t really exist, except in emerging markets. If you wanted longer-dated fixed-income flatteners, you’d buy a five-year position in fixed income versus a two-year and then you would have some of that position un-hedged from an FX basis.
We’re going to see more widening of policies, in the sense that the Bank of England might tighten, the US might tighten eventually, and we’re going to start to see yield differentials widen across the world. That is the typical environment for short-term carry trades. It might take a year or two but, generally, that is really good news in the sense we’re going to start to see some trends. We might have to wait a while, but it’s going to come.
Srikant Dash: You have to differentiate between the tactical and the strategic. There is increasing investor appetite for strategic investment in currency markets. This could be motivated by portfolio diversification or ‘I have a long-term view about the US dollar or emerging markets currencies’, or something like that. As investors begin to decouple different sources of risk from traditional assets and recognise the importance of currencies, the outlook is positive in terms of products and the assets in those products.
Sébastien mentioned carry indexes haven’t really worked over the last few years; momentum indexes not so much; volatility-based strategies, maybe a bit. But they all got burnt in 2008, although since then they have been working. It may take some time for investors to get comfortable with, and accept, quantitative strategy indexes after their experiences over the last few years.
Rick Harper: Exchange rate funds might continue to evolve and proliferate, and they’re going to get more precise and specific exposures. The outlook is very positive for currency investing, on a strategic and a tactical basis. But Srikant is right: it will take time before everyone is comfortable enough to put their toes in the water on the carry strategy. Has risk-on/risk-off really gone away? I think the outlook for currency investing in general looks extremely positive – we’ll see more products and there’ll be more options for investors to incorporate currency into portfolios.