01 December 2023
The following article was published in Markets Media on 29 November 2023.
Joe Hoffman, CEO of our specialist Currency Management partner at Mesirow Financial, spoke to Markets Media Group Senior Writer Julie Ros from his Chicago base about the systematic investment firm’s approach to currency management.
Tell me a bit about your background. How long have you been in the currency market and what brought you to Mesirow?
I’ve been in the currency market for over 25 years, starting in 1998. I joined Mesirow because of its employee-owned ownership structure, the board’s commitment to supporting investment in the currency business, and the firm’s entrepreneurial spirit. Before Mesirow, though, I spent about 20 years with Russell Investments, working primarily in currency, equity derivatives, and fixed income derivatives, before joining Mesirow in 2017.
Can you give me an overview of the three currency solutions Mesirow provides?
Our objective for our passive risk management strategy is to reduce the effects of volatility from unintended currency risk embedded in an international portfolio cost effectively, efficiently and in a low-risk manner. While our dynamic risk management strategy is used to systematically reduce our clients’ currency risk while attempting to add gains and limit losses by varying the hedge ratio during different economic cycles.
Our Currency Alpha product also employs a systematic process and benefits from a strategic combination of fundamental and technical approaches that seek to profit from short- and medium-term currency moves and is designed to perform well in varying market conditions. Its goal is to generate attractive risk-adjusted returns focusing on three core principles: diversification, dynamic allocation of risk, and active downside risk management.
Mesirow’s Fiduciary FX service is our agency FX execution solution. The purpose of this solution is to leverage Mesirow’s scale and technology to help asset owners and asset managers reduce transaction costs, improve transparency, enhance operational efficiency, and navigate regulatory reporting requirements.
All of our strategies are customized, though. We know that no two clients have the same needs or goals, so the team is very hands-on when it comes to figuring out and then creating the right strategy or solution for a client.
What can investors do to prepare for the arrival of T+1 settlement for US and Canadian equities next year?
First and foremost, become very familiar with the custodian cutoff times. Although CLS has a 6pm EST cutoff, the custodian banks often have earlier cutoff times. Next, implement a process for getting equity trades matched as soon as possible, allowing enough time to trade the FX and communicate the details to the underlying custodian. This will be challenging for investors who are trading on the close.
Investors may consider trading estimates earlier in the day and trade smaller residuals later once everything is finalized. For investors operating in an Asian base currency, it might be prudent to change the account’s base currency to USD, if possible. Some investors may seek a line of credit to bridge the gap. The important thing is to avoid overdrafts, which can be costly in this high interest rate environment.
On the hedging side of things, the benchmark providers, as far as I know, are not making any updates to their hedging methodology on the back of the T+1 changes. The current methodology assumes investors will invest any hedging profit at month-end once the contracts are rolled, and the profit is crystallized.
Since the near leg of the hedge settles in two business days, investors will receive cash in two days. If they buy US stocks at month-end that settle T+1, there will be a one-day mismatch. To address this mismatch, investors may need to change the settlement date of the near date of the forward to month-end plus one. Another option is to use futures to equitize the profit until equities can be purchased on month-end plus one, avoiding any mismatch.
We’ve written a couple articles about the topic: The future for hedged share class investors: Futures overlays and Does a shorter security settlement cycle mean more foreign exchange risk?
Why do you think FX is a risk factor that investors often overlook in their portfolios? What are the pitfalls of this approach and what can be done about it?
Outside of the U.S., investors are very aware of the potential hazards of not managing their currency risks. Within the U.S., we’ve observed that more investors intentionally do not hedge their currency risk, even as their exposure to foreign assets has increased significantly over the past decade. For investors with a hedging program, it’s important to assess that it’s being managed efficiently and cost-effectively.
Additionally, they need to determine if the structure is appropriate and customized to their specifications. Investors who are not hedging their currency risk should really evaluate this risk more closely. Currency risk is usually a top three risk, behind equities and interest rates. By hedging currency risk, investors can achieve a more efficient portfolio by lowering risk and redeploying the risk savings to return-seeking assets.
What trends are you seeing amongst investors looking to hedge their currency risks?
We are seeing investors looking for enhancements to their currency program, such as tenor management, where we look to add incremental value by varying the tenors we use. We’ve also been helping our clients manage their non-FX exposures, implementing beta overlays and exposure management programs. Additionally, we have clients wanting to use longer-dated forwards and options. We like to consider ourselves an extension of our clients’ investment teams, providing broad solutions.
In 2021, Mesirow released a paper looking at the benefits of diversifying into currency alpha to meet ESG investment demands. Can you explain the main thesis of that paper and does this still hold true?
The paper, “Enhancing ESG portfolio returns, could Currency Alpha be the answer?” basically assesses the impact on the risk and return of a typical ESG equity and ESG bond portfolio when an allocation to currency alpha is made. An allocation to currency alpha has neither a positive or a negative effect on a fund’s ESG score (it’s “ESG rating neutral”) and could, potentially, enhance returns and offer ESG managers a way to stand out from their competitors.
There have been a number of market events that brought counterparty risk management into the spotlight. How does Mesirow manage this?
We use a quantitative and fundamental process that we monitor daily. It’s been 15 years since the Lehman Brothers bankruptcy, and we just experienced the demise of SVB and the forced takeover of Credit Suisse this past year. As a risk manager, we place a lot of emphasis on the creditworthiness of our bank counterparties, but we know we can’t solely rely on them because of the lag in rating adjustments, especially in times of stress.
We use the ratings from the major rating agencies as an input in our selection and monitoring process, but we also manage our clients’ counterparty risk by analyzing performance and exposure limits among other considerations. We also place emphasis on news and funding metrics. If there is negative news that we think can impact the bank’s creditworthiness or reputation, we will cease trading immediately.
Because of our role as an agent, we maintain relationships with many trading counterparties to ensure we have access to liquidity even in the most challenging times.
Which regulatory challenges are on the horizon for investment management firms and do you think, as a whole, that the industry is preparing for them?
In Europe and Australia, EMIR and ASIC trade reporting is required. This has been in place for several years. The regulators have decided to try to enhance the harmonization and standardization of reporting by introducing REFIT. The new reporting will have 203 fields, an increase of 74 fields from the current format. In addition to the increase in fields, the files must be done according to a standardized XML structure.
As you can imagine, having the appropriate technology or partner to help with these issues is key to a successful implementation. Key dates for the REFIT are as follows: Europe: April 29, 2024; UK: Sept 30, 2024; and Australia: Oct 21, 2024. The industry is definitely preparing and we, at Mesirow, have continued to invest in technology and partner with regulatory experts in advance of these new regulatory requirements taking effect next year.
Have there been industry shifts or developments that stand out for you?
A big focus has been on using new technology, such as AI, to enhance the research process and operate more efficiently. We first introduced machine learning into our currency alpha programs a few years ago. Since then, we have continued researching and exploring new areas where this technology can be used in our investment process.
What market trends are you seeing and what do you think investors should keep an eye on?
We see the trend of continued investment in new technology (AI) and data, allowing investors to further enhance their research process and operate more efficiently. At Mesirow, we started machine learning in our currency programs over two years ago, introducing new deep neural network models. Since then, we have continued to research and explore new areas where AI can be used in our investment process.
Investors should keep an eye on their currency risk and how it’s impacting the overall volatility across their portfolios, especially as their foreign currency exposures increase. Investors can’t afford this risk.
I would also add that higher interest rates and market volatility have created more opportunities to generate returns using currency. As other asset classes struggle, currency can provide the uncorrelated returns investors seek without the liquidity issues of other alternatives.