Mesirow Makes ESG Argument for Investor Currency Allocations

A new paper published by Mesirow Currency Management argues that fund managers can respond to the growing demand for ESG investments by diversifying into currency alpha, which carries no impact.

The paper, Enhancing ESG Portfolio Returns: Could Currency Alpha be the Answer, and authored by Mesirow SVP and currency specialist Amy Middleton, observes that portfolio managers are consistently searching for ways to enhance the return to risk ratios of their funds versus those of their competitor’s, without negatively impacting their ESG rating. Noting, “this is not always a straightforward task given that investing in non-ESG assets usually impacts the overall fund’s ESG rating in a detrimental manner”, the paper argues that one solution could be an investment in currency alpha given its ESG neutral effect on the overall portfolio rating.

The paper continues by pointing out that while most portfolio managers are aware of the risks in unhedged international exposures, far fewer are aware of the potential for returns from a specific investment in currency. In addition to the ESG-neutral effect, the paper also says allocating to currency alpha does not necessarily require funding as managed accounts can be used. “Therefore, an allocation to currency would not involve having to raise additional capital and/or liquidating part of the underlying investment in the ESG equities or bonds,” it states.

The paper conducts analysis using the MSCI World ESG Leaders Index; a capitalisation-weighted index that provides exposures to companies with high ESG performance relative to their sector peers. For bonds, it uses the Bloomberg Barclays MSCI US High Yield Liquid Corporate Sustainability SRI Index; a high-yield, dollar-denominated benchmark that negatively screens out issuers with substantial revenue derived from sources such as alcohol, adult entertainment and tobacco. The analysis also uses a proxy for currency alpha – the BarclayHedge Currency Traders Index; an equally-weighted composite of managed programmes trading solely in currency.

Unfortunately, the majority of investment choices open to such managers will not be ‘ESG rating neutral’ and may have a detrimental impact on the ESG rating a credit agency awards the fund.

The study uses data from October 2007 for the equity analysis and January 2007 for the bond analysis – the dates at which each of the indices commenced – to the end of December 2020. The analysis indicates that a 20% allocation to currency alpha over that time would have added 53bp of performance to an equity portfolio. Additionally, from a return-to-risk perspective, currency alpha outperformed the ESG equity portfolio mainly due to significantly lower annualised standard deviation, 2.44% versus 16.84%. Currency alpha also had a substantially lower maximum drawdown over the period, -2.98% versus -55.65%.

The returns of the ESG equity portfolio and the currency alpha were also negatively correlated over the period of study, -0.24, which suggests that adding an allocation of currency alpha to the ESG equity portfolio would result in diversification benefits and the aforementioned 53bp improvement in performance.

In the 14 years of the study, only 2017, at a miniscule -0.01%, failed to produce an excess return for the ESG Equity + 20% Currency Alpha strategy. Overall, with a peak excess return of 0.95% in 2020, the 14-year span produced 6.89% excess return for the blended strategy.

The picture was similar in ESG Bonds, where again currency alpha had a lower standard deviation 2.4% to 6.04%, a lower maximum drawdown of -2.98% versus -16.07% and a correlation of -0.09.

As was the case in equities, only one year– 2017 again, the only negative return for the currency alpha strategy – failed to produce an excess return for a strategy with a 20% allocation to currency alpha, again it was -0.01%. Again 2020 was the best year for excess return, and again it was by 0.95%, while over the course of the study the cumulative excess return was 7.22%.

The picture was very similar across a combined ESG equities and bond portfolio with a 20% allocation to currency alpha. Currency alpha had a lower annualised standard deviation of 2.44% compared to 10.16% for a combined equities and bonds ESG portfolio, while the maximum drawdown was -2.98% compared to -35.15%. There was a negative 0.23 correlation. 2017 was the only year without an excess return – again -0.01%, while the cumulative excess return was 6.89%.

Using ESG Within Currency Alpha

Mesirow also looked at how ESG ratings can be used to generate signals within the currency alpha programmes themselves. The paper says that up until recently, ESG ratings have only been published at a corporate-level, however, they are now becoming more widely available at a country-by- country level.

A previous paper by Middleton found that MSCI country level ESG ratings could be of use in predicting G10 currency prices. She also found that the ESG currency factor, developed as part of this research, exhibited low or negative correlation with other more traditional currency trading strategies such as carry and trend, “Thus, highlighting how incorporating ESG country-level ratings as part of the decision process within a currency strategy could offer benefits from a diversification stand point also.”

Mesirow also cites other research that finds “significant relationships” between a country’s ESG rating and the future path of its exchange rate. Specifically, that countries with higher ESG ratings had substantially better performing currencies compared with the currencies of countries with lower ESG ratings.

The firm has created a bespoke ESG indicator for its four systematic currency alpha programmes and incorporated ESG country ratings in 30 currency pairs across both G10 and emerging markets. The ESG indicator, alongside other economic data, is then used to rank currencies to create a long/short portfolio. “What has been noted thus far is that the signals generated by the ESG indicator exhibit low correlation with those produced from other economic data. Thus making the ESG indicator a complimentary addition to Mesirow’s current currency alpha model suite,” the paper says.

“As ESG equity and bond investing becomes ever more popular, many managers are seeking ways to enhance the returns of their portfolio without impacting their ESG rating,” says Middelton. “Unfortunately, the majority of investment choices open to such managers will not be ‘ESG rating neutral’ and may have a detrimental impact on the ESG rating a credit agency awards the fund. However, an allocation to currency alpha has neither a positive or a negative effect on the overall fund’s ESG score and therefore may offer a solution to this problem.”