Currencies:

An Intelligent Tool to Help Manage Investment Risk

White Paper | November 2012

Not FDIC Insured | May Lose Value | No Bank Guarantee investor only. Not for by,the distribution or quotation to, the general public. For financial professional or usequalified only. Notinstitutional for inspection by, distribution or inspection quotation to, general public.

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VoyaTM Investment Management was formerly ING U.S. Investment Management

Table of Contents

“Investing is simple, but not easy.”— Warren Buffet

Introduction 2

There are a lot of investors today who would disagree with this legendary pearl of wisdom from the Sage of Omaha after riding the ups and downs of the markets over the past few years. A string of “once in a century” shocks has challenged many of the assumptions that once reliably guided the decision to invest one’s hard-earned cash. We have learned — the hard way — that house prices do not always go up, that stocks do not always outperform bonds over the long run and that the loss of a AAA credit rating does not always mean higher borrowing costs for a government. Clearly, the world is now filled with more sources of uncertainty than investors are accustomed to dealing with.

A Brief Primer on Currencies

3

The Link Between Currencies and Economics

4

Who Are the Players in the Currency Market?

5

Currencies Can Earn Positive Returns When Managed in a Portfolio

6

The Value of Active Currency Management for Investors

6

A Case Study in Active Currency Management as a Risk-Reduction Vehicle: 4Q08 9 Currencies Deserve a Permanent Role in Investor Portfolios

11

This higher degree of uncertainty can all be traced back to the 2008 U.S. financial crisis. The underlying reality is that a lack of liquidity — defined as the ease with which cash can be made available from banks, financial markets or the real economy — was the true culprit of the market collapse after the Lehman bankruptcy in September 2008. This was the case for households, corporations, governments and investors. Those who needed money immediately, or who feared substantial losses on their investments, sold their most liquid assets on a massive scale, forcing down the value of almost every asset besides risk-free U.S. Treasuries. The widespread financial paralysis created a funding crisis for normal business operations in the real economy — not just in financial markets — born out of mutual fear and distrust among banks and companies, which was the trigger for the subsequent sharp recession. A “liquidity event” became a real economic event in a very short period of time. While both stock and bond markets have recovered, rising since March 2009, many investors have not fully enjoyed the fruits of the strong markets because they are keeping higher allocations to cash than they have in the past. This may be a rational human response to a world of increasing complexity driven by the high degree of uncertainty about future economic and political outcomes, but it is a terrible way to earn money in an investment portfolio. Having more cash may make investors feel safer, but the low level of interest rates makes for unattractive returns. On top of all this uncertainty, there is now greater risk in investor portfolios because of the increased correlation of global markets and economies. This tendency toward uniform, lock-step movements across markets (i.e., higher correlation) suggests that diversification of returns is now more difficult to achieve, making it imperative to focus on finding sources of return that behave differently (i.e., exhibit low correlations to each other). Traditional methods of portfolio diversification seemingly failed during the crisis because of these rising correlations — investors had very few places to hide when market liquidity dried up. But did diversification truly fail? Or did investors simply not have the right investments in their portfolios? A true diversifier in a portfolio is an asset that has a low — or even negative — correlation to traditional asset classes like equities and bonds. An investor looking to have a truly diversified portfolio should actively seek out such low-correlation assets. The relatively healthy state of markets and banks should not mask what the world learned in 2008 — that stable situations can become unstable very rapidly. What should investors do to protect their portfolios against another “liquidity event”? Should they continue to run higherthan-usual cash positions in their portfolios, trading off return for safety and lower portfolio volatility? An alternative approach would be to own more higher-returning assets, while at the same time having exposure to an asset with low correlations to other markets that can protect wealth in times of liquidity crises and offer the prospect of positive returns in calmer markets.

2

Currencies: An Intelligent Tool to Help Manage Investment Risk

Currency — one of the world’s least understood asset classes — is such an instrument. In this paper, we will discuss the structure and mechanics of global currency markets and offer some insights as to how active currency management can deliver a source of uncorrelated returns that provide some portfolio protection during periods of market stress and illiquidity.

A Brief Primer on Currencies What makes currencies different from any other financial asset is that the price of any currency is always a relative measure reflecting the balance between a long position in one currency (that is, owning the currency) and a short position in another (selling it). For example, a rise in the euro versus the U.S. dollar can reflect a stronger euro, a weaker dollar or some combination of both. While the convention is to quote currency values versus the U.S. dollar, any two currencies can be quoted and traded in pairs that make no reference to the U.S. dollar. (Note that the market convention dictates that you are long the first currency in the pair, and you are short the second currency in the pair.) Some of the most-quoted and -traded currency pairs include: USD/CAD

EUR/JPY

EUR/USD

EUR/CHF

USD/CHF

EUR/GBP

GBP/USD

AUD/CAD

NZD/USD

GBP/CHF

AUD/USD

GBP/JPY

USD/JPY

CHF/JPY

EUR/CAD

AUD/JPY

EUR/AUD

AUD/NZD

The value of a currency cross that does not involve the U.S. dollar can be derived from the values of those currencies versus the U.S. dollar. For example, taking levels from September 28, 2012: EUR/USD (1.2860)

EUR/JPY (1.2860 times 77.96 = 100.21)

USD/JPY (77.96)

The size of the global currency market is far greater than that of any other financial instrument. Daily trading volumes in global currency markets exceed $4 trillion, which is more than five times that of equities. Currencies can be traded 24 hours a day on weekdays in virtually every time zone in the world and at very low costs. Daily trading volumes are split between so-called “spot” transactions of actual currencies ($1.5 trillion per day) and transactions of currency-related instruments like options, futures and forwards ($2.5 trillion per day). As shown in Figure 1, the most traded currencies are the U.S. dollar (USD), euro (EUR), Japanese yen (JPY), British pound (GBP), Australian dollar (AUD), Swiss franc (CHF) and Canadian dollar (CAD), which together constitute 88% of the daily turnover in the global foreign exchange market.

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Figure 1. Market Share of Daily Global Currency Market Turnover

3.2%

1.1% 0.8% 2.4% 5.0%

2.6% 3.2% 3.8% 6.4%

42.4%

9.5% 19.5%

US Dollar

Canadian Dollar

Euro

Other Europe

Japanese Yen

Non-Japan Asia

Pound Sterling

Latin America

Australian Dollar

Middle East & Africa

Swiss Frank

Other

Source: Bank for International Settlements

One of the attractive features of currency management is its constantly evolving and widening opportunity set, which creates more opportunities to generate returns. Geopolitical developments, economic cycles and government intervention are continually changing the attractiveness of one currency relative to another. This is most evident in the rapidly expanding emerging markets, which are a growing source of currency diversification. Emerging market economies have evolved and matured to a point where their governments and businesses can now raise much more capital with their own currencies than they were able to in the past. This is an unstoppable trend; as the emerging world becomes wealthier and more influential in the global economy, their share of the currency pie will continue to grow, creating more opportunities for currency investors.

The Link Between Currencies and Economics At their core, currency values reflect relative economic fundamentals and the global capital flows that follow those fundamentals. For example, countries with higher inflation rates will tend to have weaker currencies than those of countries with lower inflation, as global investors will avoid putting money into those countries for fear of seeing their investment returns eroded by higher inflation (domestic investors will often flee their own capital markets for the same reason). Alternatively, countries with higher economic growth rates tend to have higher interest rates, which attract capital to their financial markets — and their currencies — to take advantage of the better return opportunities that come from faster growth. The same logic applies to countries that produce and export large amounts of global commodities like copper or wheat; rising commodity prices create global demand for currencies of countries that sell those commodities, which boosts the value of those currencies. There are many ways to select currencies as stand-alone investments, based on their sensitivities to the ebbs and flows of the world economy. For example, the currencies of countries that rely heavily on exports for economic growth, like Korea or Taiwan, would tend to appreciate when global growth is strong and there is heavy demand for the Korean won or Taiwanese dollar to pay for goods and services purchased in those countries. Alternatively, when there is a strong global appetite for investment risk, the more volatile currencies of countries with the highest interest rates, like Brazil or South Africa, would tend to appreciate as investors pour money into those currencies, bidding up the level of the Brazilian real or the South African rand.

4

Currencies: An Intelligent Tool to Help Manage Investment Risk

Who Are the Players in the Currency Market? There are numerous participants in currency markets, some of which have vastly different motives behind their use of currency. For example: ■■ U.S. multinational corporations use currency markets to mitigate the “translation” effects of converting profits earned outside the U.S. back into U.S. dollars. ■■ Tourists exchange their domestic currencies for foreign currencies when travelling abroad. ■■ Governments manage, and in some cases directly manipulate, currency values so their export industries can be more competitive in terms of price; China has often been accused of manipulating its currency for self-serving reasons, but it is far from the only country that has done this over the years. ■■ Bond and equity investors manage the currency risk embedded in the foreign assets they purchase in financial markets. Figure 2 shows the distribution of currency market turnover by the major players in the market. One of the biggest developments in currency markets since the 2008 financial crisis has been the growth in trading by professional investors like hedge funds, pension funds, mutual funds, insurance companies and central banks; these so-called “currency investors” now are responsible for nearly half of all daily currency activity. Commercial and investment banks (“currency dealers”) conduct about 40% of the daily transactions in the currency markets, with trading by non-financial customers like corporate treasurers (“currency users”) making up the remainder.

Figure 2. Professional Currency Investors Have Grown Sharply (in billions of US$)

There has been a sharp rise in currency activity by professional currency investors over the past decade. They now represent the biggest share of daily trading activity.

Currency Users

4,500

Currency Investors

4,000

Currency Dealers

3,500 3,000 2,500 2,000 1,500 1,000 500 0

1998

2001

2004

2007

2010

Source: Bank for International Settlements

This increasing share of professional investor involvement in currency markets is evidence of how investors are looking for new and uncorrelated sources of return in their portfolios. Investors use currency most dynamically in their efforts to exploit market mispricings and price trends in order to directly earn profits. The fact that there are significant players in the currency markets who are not trying to directly earn profits — such as corporate treasurers hedging risk on their balance sheets and governments intervening to manage currency levels as a tool of economic policy — allows those profitable investment opportunities to exist. In fact, currency is now widely used as a stand-alone investment vehicle, rather than just an incidental source of risk inherent in owning foreign securities that must be hedged away. November 2012

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Currencies Can Earn Positive Returns When Managed in a Portfolio We believe that foreign exchange should be viewed as its own asset class to be actively managed for total return, similar to bonds and equities, for the following reasons. ■■ Currency markets are extremely liquid. They remain open for business even during the most severe market crises, like the week after the 2008 Lehman bankruptcy or following the events of September 11, 2001. The same cannot be said for equities and other riskier markets. ■■ Currency management has defined performance benchmarks. This is similar to the way equity investors define investment performance relative to benchmarks like large-cap growth or small-cap value indexes. There is a reliable history of data — going back more than 25 years in some cases — that can be used to help measure the risk/return properties of active currency management. ■■ Currencies generate income though passive ownership. Just as equity investors get paid dividends or bond investors receive interest, the income earned on currency is based on short-term interest rates — it is what you would earn if you held a currency in the bank of its country of origin (holding euros earns you German or French bank deposit rates, for example, while owning Japanese yen earns you Japanese bank deposit rates). In other words, currency has a yield. Adding foreign exchange to a portfolio of bonds and equities can increase average returns and do so in a fashion that is dissimilar to other traditional assets. Unlike equities and bonds, currencies cannot all rise and fall together in bull or bear markets. Hence, a currency manager can generate positive returns irrespective of the underlying financial market environment if he or she can forecast currencies correctly. This is difficult, but there are some standard approaches that have proven to be successful over time.

The Value of Active Currency Management for Investors Currency managers rank currencies based on common investment criteria and make decisions to buy and sell currencies based on those rankings. This is akin to equity managers who buy and sell companies based on their relative sensitivity to economic growth, their P/E multiples or their dividend yields. There are many currency management styles in common use by practitioners today, but they can be essentially grouped into the following categories: ■■ Passive currency exposure. This is simply earning the pure return of constantly owning a currency (for example, the U.S. dollar) versus a basket of major foreign currencies (such as the euro, yen, British pound and Canadian dollar). ■■ Currency “carry” strategies. These strategies involve buying currencies with the highest interest rates while selling those with the lowest interest rates. ■■ Currency momentum strategies. These strategies involve buying currencies that are rising in price while selling those whose prices are falling. ■■ Currency value strategies. These strategies involve buying currencies that trade at levels considered cheap relative to their long-term fundamental values while selling those that are considered expensive.

6

Currencies: An Intelligent Tool to Help Manage Investment Risk

Figure 3 shows the long-run correlation of market returns for U.S. equities, U.S. government bonds, U.S. corporate bonds, commodities and the four different styles of investing in currencies.

Figure 3. Active Currency Strategies Offer Range of Correlations to Traditional Assets

(1997 through June 2012) Inv-Grade Corporate Bonds

U.S. 
Stocks Commodities

Passive 
 US$ Exposure

Currency Carry Strategies

Currency Momentum Strategies

Currency Value Strategies

U.S. 
 Govt Bonds

Inv-Grade Corporate Bonds 1.00

0.21

0.13

-0.35

0.26

-0.05

-0.12

0.64

-0.27

-0.12

-0.17

-0.17

0.06

-0.05

1.00

0.05

-0.21

0.44

0.09

-0.12

1.00

-0.19

-0.19

0.15

-0.09

1.00

0.49

0.39

-0.25

1.00

-0.28

-0.40

1.00

Commodities

0.26

1.00

U.S. Stocks

1.00

U.S. Govt Bonds Currency Value Strategies Currency Momentum Strategies Currency Carry Strategies Passive US$ Exposure

Asset class definitions: U.S. Stocks = MSCI U.S. Index; Commodities = Goldman Sachs Commodities Index (GSCI); Passive US$ Exposure = DXY U.S. Dollar Index; Currency Carry Strategies = selecting currency based on relative interest rates; Currency Momentum Strategies = selecting currencies based on relative price trends; Currency Value Strategies = selecting currencies based on relative long-run valuation; U.S. Govt. Bonds = Barclays U.S. Treasury Index; 
Inv-Grade Corporate Bonds = Barclays U.S. Corporate Bond Index. Source: Bloomberg, Voya Investment Management calculations

As can be seen, differing approaches to currency investment can generate returns with a wide range of correlations to traditional financial assets. Picking currencies solely based on interest rates has a relatively high correlation to stocks and commodities, while picking currencies based on their price momentum or on their relative value has the low-to-negative correlation to stocks, bonds and commodities that investors are looking for in a true portfolio diversifier. The key point is that the decision to “own or not own” foreign currencies relative to each other, using defined strategies, can be useful in helping build a portfolio, because actively managed currency styles are an uncorrelated source of return. The returns that you are getting from the currency strategies are, for the most part, not going to move in the same direction as the returns that you would be earning from traditional equity and bond market investments.

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Figure 4 shows the returns and volatilities of those same asset classes. The top panel shows the returns for the past 15 years, while the bottom panels of the table show the same data for the period before 2008 and after 2008. Note that positive-return opportunities can only be found by actively rotating among the different currency management approaches — successfully investing in currencies is not just about buying and selling the U.S. dollar.

Figure 4. Benchmark Asset Returns, 1997–2012

Selecting currencies based solely on interest rates has been a profitable, yet volatile, approach over the past 15 years, while there has been essentially no return to owning the U.S. dollar. However, the exceptional returns to currency carry strategies came in the years prior to the 2008 crisis. Since then, carry has been a losing strategy (with even more volatility), while value-driven strategies have maintained the same average returns as prior to 2008.

8

Benchmark Asset Returns

Annualized 
Returns (%)

Volatility Of Returns (%)

January 1997-June 2012 Commodities

7.2

U.S. Govt Bonds

4.7

Inv-Grade Corporate Bonds

6.7

Inv-Grade Corporate Bonds

5.3

Currency Carry Strategies

6.2

Currency Value Strategies

8.5

U.S. Govt Bonds

6.1

Passive US$ Exposure

8.5

U.S. Stocks

3.6

Currency Momentum Strategies

9.3

Currency Value Strategies

2.9

Currency Carry Strategies

Currency Momentum Strategies

1.1

U.S. Stocks

16.6

-0.8

Commodities

23.6

10.5

Inv-Grade Corporate Bonds

Passive US$ Exposure

9.4

January 1997- December 2007 Commodities

4.4

Currency Carry Strategies

9.8

U.S. Govt Bonds

4.5

Inv-Grade Corporate Bonds

6.5

Currency Carry Strategies

6.9

U.S. Govt Bonds

6.3

Passive Us$ Exposure

7.3

U.S. Stocks

5.8

Currency Value Strategies

8.2

Currency Value Strategies

3.0

Currency Momentum Strategies

8.6

Currency Momentum Strategies

1.6

U.S. Equities

15.0

Passive US$ Exposure

-1.8

Commodities

21.6

Inv-Grade Bonds

7.2

U.S. Govt Bonds

5.1

U.S. Govt Bonds

5.3

Inv-Grade Corporate Bonds

7.1

Currency Value Strategies

2.6

Currency Value Strategies

Passive US$ Exposure

1.8

Passive US$ Exposure

0.1

January 2008 - June 2012

Currency Momentum Strategies

9.4 11.0

Currency Momentum Strategies

11.0

U.S. Stocks

-0.1

Currency Carry Strategies

13.6

Commodities

-0.3

U.S. Stocks

20.0

Currency Carry Strategies

-1.4

Commodities

28.4

Source: Bloomberg, Voya Investment Management calculations

Currencies: An Intelligent Tool to Help Manage Investment Risk

A Case Study in Active Currency Management as a Risk-Reduction Vehicle: 4Q08 In addition to providing a profitable source of uncorrelated returns, currencies can also deftly be used as a defensive portfolio management tool during periods of extreme market distress. This is because active currency management can create uncorrelated sources of potential positive returns, helping to mitigate large losses elsewhere. Figures 5 and 6 show the return data over the last four months of 2008 — the worst period of market distress, illiquidity and wealth destruction that we have seen since the Great Depression. Rather than the currency benchmark returns presented earlier, these figures depict the performance of the following actual currency pairs corresponding to each investment “style”: ■■ Passive currency exposure. Buying the U.S. dollar versus a basket of major currencies (long the DXY index) ■■ Carry. Buying the Brazilian real/selling the U.S. dollar (long BRL/USD) ■■ Momentum. Buying the euro/selling the Norwegian kroner (long EUR/NOK) ■■ Valuation. Buying the Japanese yen/selling the Swiss franc (long JPY/CHF)

Figure 5. While Equities Collapsed During the 2008 Financial Crisis . . . August 29, 2008 = 100 135 130 125 120 115 110 105 100 95 90 85 80 75 70 65 60 55

EUR/NOK JPY/CHF BRL/USD Passive US$ S&P 500

Aug 28, ‘08

Sept 29, ‘08

Oct 28, ‘08

Nov 28, ‘08

Dec 29, ‘08

Source: Bloomberg, Voya Investment Management calculations

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Figure 6. . . . Momentum and Value Currency Strategies Surged Benchmark Asset Returns

A strategy of buying currencies based on price momentum and value, and not buying (or even selling) currencies based on relative interest rates, was very profitable in 2008.

Non-Annualized 
Returns (%)

August 31, 2008 - December 31, 2008 Long EUR vs Short NOK

24.1

Long JPY vs Short CHF

16.2

U.S. Govt Bonds

9.6

Passive US$ Exposure

4.7

Inv-Grade Bonds

-2.8

Long BRL vs Short USD

-25.6

U.S. Stocks

-28.6

Commodities

-51.5

Source: Bloomberg, Voya Investment Management calculations

Equities lost over a quarter of their value during the last four months of 2008, while commodities lost one-half of theirs. At the same time, a currency position based on valuation (long EUR/NOK) returned 16%, while a currency position based on momentum (long JPY/CHF) returned 24%. However, a currency position based on carry (long BRL/USD) returned an equity-like -26%, highlighting the importance of diversifying among currency strategies (and showing the inherent riskiness of currency strategies that are purely driven off of interest rates). Active currency management was of immense value in the 2008 financial crisis — even more valuable than owning risk-free U.S. Treasuries.

10

Currencies: An Intelligent Tool to Help Manage Investment Risk

Currencies Deserve a Permanent Role in Investor Portfolios When actively and properly managed, currencies are a valuable investment tool that can generate consistent positive returns that are uncorrelated to the returns of other asset classes. The unique liquidity characteristics of currency markets can help in the implementation of profitable strategies, even during periods of extreme duress and illiquidity in traditional equity and fixed income markets. The goal of active currency management is not to eliminate the currency risk of owning foreign stocks and bonds, but to choose which currency risks to bear to help mitigate the risks of holding other assets. One of the more attractive features of active currency management is that it can offer a diversified source of returns for investors looking to benefit from the inherent — and persistent — inefficiencies of currency markets. As such, active management of currencies should be considered by investors to be a core component of any global bond or equity portfolio. For investors, hiring an experienced and well-resourced global investment manager is the most efficient way to successfully exploit the nuanced opportunities of currency markets.

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Copyright © 2014 Voya Investment Management. This material may not be reproduced in whole or in part in any form whatsoever without the prior written permission of Voya Investment Management. DISCLAIMER This material has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this presentation regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Portfolio holdings are fluid and are subject to daily change based on market conditions and other factors. Currency Investment Risks. Investing directly in foreign currencies or in securities denominated in, or that trade in, foreign (non-U.S.) currencies, is subject to the risk that those currencies will decline in value relative to the U.S. dollar or, in the case of hedging positions, that the U.S. dollar will decline in value relative to the currency being hedged. Currency rates may fluctuate significantly over short periods of time. Currency rates may be affected by changes in interest rates, intervention (or the failure to intervene) by U.S. or foreign governments, central banks or supranational entities such as the International Monetary Fund, by the imposition of currency controls, or other political or economic developments in the United States or abroad. As a result, investing in foreign currency or foreign currency-denominated securities may reduce the value an investor’s initial investment. Past performance is no guarantee of future results. General Risk(s): All investments in bonds are subject to market risks. Bonds have fixed principal and return if held to maturity, but may fluctuate in the interim. Generally, when interest rates rise, bond prices fall. Bonds with longer maturities tend to be more sensitive to changes in interest rates. ©2014 Voya Investments Distributor, LLC • 230 Park Ave, New York, NY 10169 Not FDIC Insured | May Lose Value | No Bank Guarantee For financial professional or investor only. Not for by,the distribution or quotation to, the general public. usequalified only. Notinstitutional for inspection by, distribution or inspection quotation to, general public. BSWP-CURRENCY 032114 • 8971 • 164943

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