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This strategy participates in the $4 trillion-a-day foreign exchange (FX) market, which is composed of the spot, futures, forwards, and options markets. The strategy invests largely in short-term forward contracts of emerging market currencies.
In 2012, the strategy's benchmark was changed from the JPMorgan Emerging Markets Index Plus1 (ELMI+) to the Barclays Global Emerging Markets Strategy [GEMS] Index.2 The change in benchmark became necessary because of a decision by JPMorgan in February 2012 to remove the cap on currencies in the ELMI+ that cannot be freely traded. Previously, a cap on these currencies, including the Chinese yuan, was set at 2%. JPMorgan also announced that it would make the index fully trade flow-weighted. This new schema increased, from 30% to 42%, the weightings of currencies that are heavily managed to the U.S. dollar.
Traub believed the change in the ELMI+ did not reflect one of the main objectives of the Emerging Markets Currency strategy, which is to diversify U.S. dollar risk. Traub, therefore, decided to shift to the GEMS Index, in which the weightings of those heavily managed currencies amount to only about 14% (as of January 31, 2013).
Q. What is the strategy's investment philosophy?
A. Our philosophy is to evaluate countries from a macroeconomic perspective to determine which of them are most likely to attract more investment flows. These flows produce demand for a currency, which results in its appreciation. These flows can come in a variety of forms, such as foreign trade, foreign direct investment, or equity and debt purchases.
One of the economic fundamentals we examine is the interest rate. Higher rates typically attract investment, so we look at the interest-rate differential between one country and another as one sign that investment flows are likely to increase in one rather than in another.
We assess other fundamentals as well. We look at balance-of-payments conditions, of course, because if the amount of currency flowing into a country is greater than the amount flowing out, that encourages appreciation.
We also consider whether a country's terms of trade are becoming more favorable. That is, are its exports becoming more valuable in relation to its imports?
A country's investment climate is important, too, and political factors play a role here because they affect the economic environment. If, for example, an administration is elected that is less market-friendly, then that is likely to negatively affect the investment climate and the volume of flows entering the country. Other fundamental factors include currency-intervention policies and inflation pressures.
Ideally, we’d like to hold currencies that are on the positive side of all those factors—that is, higher interest rates, positive terms of trade, low government-intervention risk, a hospitable investment climate, and a moderate level of inflation. Countries with those conditions are the ones that we really want to overweight relative to the strategy's benchmark.
We typically hold all 15 currencies in the benchmark, but we also will hold others if we see value there. Since currencies often have a lot of idiosyncratic risk associated with them, we want to be diversified.
Q. What's the advantage of this approach over others?
A. There are a number of approaches to currency investment. Many currency funds trade strictly on technical factors, that is, on patterns in price movements and trading volumes. Those funds often operate with a short-term outlook, meaning typically one week.
Other investors simply engage in carry trades—[that is,] borrowing in low-yielding currencies such as the dollar in order to invest in high-yielding emerging-market currencies. These traders look only at the interest-rate differential between countries, not at the risk that the differential may represent. They merely buy the highest-yielding currencies and sell the lowest-yielding currencies.
The problem with investing strictly on the interest-rate differential is that countries with high interest rates are typically those that have to compensate investors for economic shortcomings, such as high inflation, high levels of debt outstanding, large current account deficits, or political corruption. These shortcomings tend to exert depreciation pressure on a currency over time, which can offset the higher interest rate. With the carry-trade approach, investors can be lucky for a while, but losses can be significant if they fail to monitor the other fundamentals and anticipate the risks.
In 2010, for example, many carry-traders who sold the U.S. dollar were hurt because the dollar strengthened versus major currencies. So that's why we take other fundamentals into consideration and don't focus merely on interest rates.
Q. How do you guard against the risk that a government will intervene in the currency market to counteract the effects of economic fundamentals?
A. Government intervention in the currency market is a risk, but we monitor which currencies are most susceptible to it. We’re also mindful of the possibility that the opposite could occur—that a government could stop intervening and allow market fundamentals to take over.
China is one extreme case: its government intervenes all the time to keep its currency from appreciating. For the first few months of 2012, for example, Chinese officials kept the yuan largely flat versus the U.S. dollar before allowing some volatility in response, first, to outflows and then to inflows in the fourth quarter. On the other hand, between July 2005 and July 2008, when commodity prices were rising, the yuan appreciated more than 17%. Knowing when the Chinese authorities will be more likely to allow appreciation is critical to investing in the currency.
We monitor developments in the political and economic environment to determine whether it is likely that a government will change its policy on intervention. We assess whether a currency should be stronger or weaker, based on the fundamentals, and determine whether a government will act to prevent appreciation or depreciation.
Q. How does the strategy approach valuation?
A. Because every trade essentially involves selling one currency and buying another, we look for currency pairs in which we believe one is likely to outperform the other. We make trades in which we sell currencies that have weak fundamentals and are likely to depreciate in order to buy currencies that have strong fundamentals and are likely to appreciate. In other words, what we do is relative valuation. We don't try to predict that the spot rate on the Mexican peso, for example, is going to be 12 versus the U.S. dollar.
In terms of relative performance, it doesn't necessarily matter how these currencies perform versus the dollar. Even if the dollar were appreciating versus all 15 currencies in our universe, the strategy could still beat the benchmark.
As for absolute returns in such a scenario, this would depend on how much the U.S. dollar appreciates. Since the strategy is always earning a yield, there is always a positive component to the index returns and to our absolute returns. If the U.S. dollar appreciates modestly, then the yield we earn may be high enough to overcome this appreciation's negative influence on returns, resulting in positive absolute returns. However, if U.S. dollar appreciation is significant, as it was after the fall of Lehman Brothers in September 2008, then our absolute returns will definitely be negative.
Q. With currency forwards, there can be some counterparty risk. How does the strategy manage this?
A. We make sure that we don't hold all of our positions with only one counterparty. For each currency, we instead make sure that our positions are spread among several counterparties.
In the forward market, participants are also required to have ISDA contracts, that is, contracts that have been approved by the International Swaps and Derivatives Association [ISDA]. ISDA regulates the derivatives markets, and these contracts specify what happens in the event of default. In this regard, the ISDA contract itself may not reduce the risk of default; however, it does provide agreed-upon terms in the event of default.
These contracts specify how much collateral must be exchanged, depending on whether a position is in the money or out of the money. So, if a counterparty were holding a position that was out of the money, it would have to post collateral in the form of securities or cash to ensure that it would be able to make good on the contract. If a counterparty's position gets further and further out of the money, it will have to post more and more collateral. [The measures do not eliminate the risk of default; however, they are intended to reduce that risk.] In the futures market, counterparty risk is mitigated because trades are processed through an exchange.
Q. Does the strategy employ a sell discipline?
A. Yes, but it's not a hard and fast rule. It depends a lot on the currencies involved in a particular trade. We track all of our positions versus a risk model, and the model identifies where our exposures are on various risk factors.
One such factor is commodity exposure. We'll monitor our positions in currencies that are sensitive to commodity prices. And we calibrate the strategy to the amount of exposure we want. Another factor we consider is volatility. Some currencies are much more volatile than others, so we track the exposure of the strategy to currencies that are the most volatile.
We monitor how our currency positions and relative value trades are performing relative to what the model indicates is most likely. For example, if a currency we buy appreciates by an amount that our model tells us is more than two standard deviations, it could indicate that we should take some profits, since additional appreciation is unlikely.
By monitoring these risk factors, we're able to avoid reacting to "noise" in the market. If a particular trade, or currency pair, is especially sensitive to investor sentiment about the U.S. stock market, for example, we may allow more leeway in its movement. If these currencies move because of a volatile day in the U.S. stock market, it may have nothing to do with the currency's underlying economic fundamentals.
In other words, we don't use a simple, absolute rule. We don't decide to exit a trade if a move of, say, 2% occurs. A 2% move in a volatile currency may be normal. In another currency, it may be extraordinary, and an extraordinary move could indicate that we should get out of our position.
So each currency, or more precisely, each currency pair, needs to be treated individually. The Mexican peso, for example, may be very volatile versus the Chinese yuan, but not versus the Brazilian real.
Q. Why does the strategy hold high-quality U.S. dollar fixed-income securities in addition to investing in currencies?
A. In a forward contract, no money is exchanged until the contract matures. So we might not need to make good on a contract for three months. While we’re waiting for that contract to mature, we place the funds into securities of high quality and short duration that yield more than LIBOR [London Interbank Offer Rate].3
This allows us to earn more interest than if we had deposited the funds in the bank. So we might invest in a short-duration corporate bond and receive 1% instead of getting 10 basis points on a bank deposit. This offers some yield enhancement.
Q. Thank you.
Using U.S. dollars to purchase a forward currency contract is essentially identical to converting dollars into that currency in the spot market and investing the proceeds in an interest-bearing security denominated in that currency. Purchasing a 30-day forward contract in Mexican pesos, for example, is the same as converting into pesos via the spot market and investing the proceeds in a 30-day peso-denominated government bond.
To illustrate this concept, we can give an example. We'll use a one-year period instead of 30 days, so we don't have to annualize the interest rate. Let's assume the following:
Spot rate = 12 pesos per dollar
Forward rate = 12.5 pesos per dollar
Mexican interest rate = 5%
U.S. interest rate = 0.75%
Table 1 shows that purchasing a 30-day forward contract in Mexican pesos is the same as changing dollars into pesos via the spot market and investing the proceeds in a 30-day peso-denominated government bond.
Table 1 shows that the result is essentially the same in either case. The forward rate reflects the disparity in interest rates of the two countries—a higher rate in Mexico is offset by a forward rate that makes the peso worth less: 12.5 per dollar versus 12 in the spot market.
Source: Lord Abbett.
Profiting from a Forward Contract
For investors, currency purchased via the forward contract must be converted back to the original currency—in this case, dollars. The question for investors is this: what is the spot rate in one year, when the forward contract has matured?
If the spot rate in one year is less than the forward rate of 12.5, that is, if the currency purchased via the forward contract appreciates more than indicated by the forward rate, the investor then will earn a positive return. Suppose the spot rate in one year is 12.2. This means that in one year the investor will have $103.23 (1,259.38/12.2), for a return of 3.23%.
However, suppose the spot rate in one year is 12.5, or equal to the forward rate. In that case, the investor ends up with $100.75 (1,259.38/12.5), for a return of zero. This is exactly what would have been earned if the investor had just put the dollars in a one-year security and had not invested in Mexico at all!
If the spot rate in one year is more than the forward rate of 12.5, then the investor loses money. So, if the spot rate in one year is 13 pesos per dollar, for example, then the investor ends up with $96.88 (1,259.38/13), or a return of -3.12%.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
A Note about Risk: Foreign currency exchange rates may fluctuate significantly over short periods of time. They generally are determined by supply and demand in the foreign exchange markets and relative merits of investments in different countries, actual or perceived changes in interest rates, and other complex factors. Currency exchange rates also can be affected unpredictably by intervention (or the failure to intervene) by U.S. or foreign governments or central banks, or by currency controls or political developments. Foreign investments generally pose greater risks than domestic investments. The securities markets of emerging countries tend to be less liquid, to be especially subject to greater price volatility, to have a smaller market capitalization, and to have less government regulation, and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities markets in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. The risks associated with derivatives may be different from and greater than the risks associated with directly investing in securities and other investments. In addition to other risks, derivatives also involve the risk of mispricing or improper valuation and the risk that changes in the value of the derivative may not correlate with the value of the underlying asset, rate, or index. Because derivatives may involve a small amount of cash relative to the total amount of the transaction, the magnitude of losses from derivatives may be greater than the amount originally invested.
The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.