Pension funds in Europe have been stepping up their use of external currency managers. Bill Muysken, global head of research at Mercer Investment Consulting in London, says there has been a rise in the number of pension funds seeking external currency managers. During 2004, he says, 28 of Mercer’s clients hired currency managers, 24 of which were European pension funds.
However, currency management by pension funds is a relatively recent phenomenon. Mercer says it believes the first specialist currency management mandate in the world was awarded by the Water Authorities Superannuation Fund - the pension fund for the then nationalised UK water supply industry - to Record Treasury Management, now Record Currency Management, in April 1985.
The first Japanese currency overlay mandate was awarded by a Japanese financial institution in 1987. The first US mandates were awarded by a corporate pension plan that hired three currency overlay managers in 1988. The first Australian mandates were awarded in 1991, and the first continental European mandate was awarded in 1992.
But still, in those early years, only a minute proportion of pension plans were using currency overlay managers.
International investment did not become common among pension plans in Europe until the 1980s. In some cases there were legal restrictions preventing it. For example, in the UK, pension plans were not allowed to invest more than £1m (e1.5m) internationally until 1979, at which point the limit was abolished.
The international investment that was done was usually unhedged to keep it simple. There are arguments that have been used for pension funds to leave their currency exposure unhedged, but most experts these days do not believe these stack up. Some people say that currencies may fluctuate against each other, but sooner or later revert to their earlier levels – that they ‘mean revert’.
Marek Siwicki, senior investment consultant at Aon Consulting in London, says there is evidence to support this, but that it is over a period of around 27 years – a long time even by pension fund standards. And there are no guarantees that a pair of currencies will ever mean revert.
Pension funds which choose to take on external currency managers today are often doing so with a primary goal of adding value to the overall portfolio. And Muysken says there is now clear evidence to show that managing currencies can create alpha.

In May 1998, Brian Strange, who was then at Currency Performance Analytics and is now with JP Morgan, published a research paper called, ‘Do currency overlay managers add value?’. It was seen as the most comprehensive study of the performance of specialist active currency overlay managers, and found that 121 (80%) of the 152 accounts included in the study had outperformed since their inception.
The average level of outperformance -including those accounts that underperformed - was 1.9% annually.
“Beyond that, we have been tracking (currency manager performance),” says Muysken. “Our own data suggests that the median currency manager has been outperforming.”
Even though there are far fewer currency managers to choose from than there are managers specialising in, for example, equities, there is still quite a range of them. Consultants say it is best for funds to hire their independent services in order to find which managers are right for them.
“There are differences as with any other investment management,” says Muysken. “There are a much greater number of currency managers than there were five years ago… The market is competitive and the standard is high. They are constantly upgrading their processes and working the squeeze a little bit more out of it.”
Siwicki says figures available on currency manager performance do indicate they are able to create extra value. “It does look as if currency managers can put out a relatively good return relative to their benchmark,” he says.
“There have been some quite powerful arguments as to why they’ve got such a high information ratio,” relative to those for other asset classes, he says.
One characteristic of the currency markets is that many of those who participate in it are not doing it for the purpose of making a profit. For example, certain banking activities, and notably tourists. Even for most companies, currency losses or profits are just something they accept, and they do not manage their currency actively. All of which means there are many opportunities in the currency markets for currency managers to make a profit.
This is not the case in the equities markets. “In the equities markets there are lots of sharks but not many goldfish,” says Siwicki.
In theory, with so many new clients now keen to have managers making profits out of currency trading on their behalf, the currency markets will eventually become more keenly priced, thus reducing the opportunities for profit. But in reality, there is such a long way to go, says Siwicki. It is estimated that only around 5% of the currency markets are managed in this way at the moment.
And the currency markets are enormous, with a daily trading volume of $1.9trn (e1.5trn) according to a recent Bank for International Settlements survey.

From a technical point of view, there has been no radical change to the way currencies are traded. Managers says that currency markets are already so cheap to operate in and transaction costs so low that it is hard to imagine any technological advances could improve on this.
The process of selecting currency managers for a pension fund depends on the size of that fund. But generally, Aon would put a list together of the managers it likes, “similar to a normal beauty line up”, he says.
Managers are able to cater for most types of investor now, with pooled offerings as well as segregated accounts. Currency management can be used in conjunction with different asset classes, for example with US equities. A pension scheme can sell the US equivalent of its portfolio, to realise cash, and then enter into a futures contract on the S&P 500 to retain exposure to the asset class. The capital - less the margin payments - can then be put to efficient use in the currency markets.
Often currency management for the sake of adding value is only sought in conjunction with efforts to hedge against swings in foreign exchange rates. “Trustees are interested in lowering the risk by hedging,” says Siwicki. “They don’t just like to add risk.” They prefer to be able to say they have reduced risk by hedging, but added some for the sake of adding value.
“By passive hedging and active overlay, then you can have lower risk than you had in the beginning. That looks quite attractive to trustees,” he says.
There are several different approaches to currency management, and it is important for pension fund trustees to be educated about this. “Some of it is quite complicated,” says Siwicki. “I think it’s quite hard to get trustees up to speed on it.”

Topics