Some investment bankers, among them Goldman Sachs, are working to convince corporate finance executives, and the experts that manage pension and other corporate investment portfolios, to view currency as a stand-alone asset class and a new source of “alpha” returns.
But the sell will be a hard one.
Alpha is the measure of excess return (beyond market benchmarks) that investments throw off when managed successfully. It’s also been described as the measure of an investment manager’s return that cannot be attributed to the ups and downs of the market. Having a “positive alpha” associated with an equities portfolio, for instance, could mean that a manager beat the returns of S&P 500 Index.
But before pension sponsors and investment managers embrace currency as an untapped alpha source, they’ll need to feel comfortable about using it as something other than a hedging tool. Indeed, CFOs—especially ones who work for companies that conduct business with overseas customers and suppliers—tend to be at ease with currency risks because they know how to limit them via financial hedging.
Witness a hypothetical American company that sells $4 million worth of products to a German customer and provides a three-month term for payment in euros. During that contract term, the company could encounter euro volatility against the dollar or a dollar appreciation—two situations which could cut into the sale’s profit margin. To hedge those risks, the American company might use currency-forward contracts.
Yet, while hedging is routine for multinational executives, relying on the global cash markets to create alpha is unfamiliar territory. What’s more, it’s too risky an investment in terms of its potential rewards, some finance executives say.
Mark Buthman, CFO of health and hygiene products maker Kimberly-Clark, is a case in point “Actively managing currency for investment returns is not a priority for the company,” he says. Unlike the role currency plays at financial institutions, “currency is not a core element of our business strategy, and we view it as more of a source of volatility and risk, rather than an opportunity to create value,” he adds.
Further, most corporate executives believe that it’s hard to parlay currency investments into consistent benchmark-beating returns, says Louis Finney, a senior consultant at Mercer Investment Consulting. “Individual managers may have terrific alpha potential, but they tend to charge high fees” that could eat into the gains, he says.
Nevertheless, the demand for better returns and more diverse sources of investment return is mounting among corporate investors. Lackluster stock performance has left many pension funds, deferred-compensation plans, and philanthropic foundations underfunded. “The emphasis is [now] on how much alpha a manager can squeeze out over time,” says Finney.
Currency should be part of that new emphasis, currency specialists argue. Indeed, it bids fair to become “an asset class in its own right” alongside debt and equity, contends Scott Arnott, vice president of global fixed income and currency at Goldman Sachs Asset Management.