Institutional investors have available an established set of procedures with which to structure a strategic asset class benchmark. Along with their consultants, investors:
q Assess the asset/liability conditions and define a target return necessary to meet these demands
q Map out a set of asset classes along with their long term risk and return characteristics
q Utilise an optimiser to marry together the above and to provide a range of return-maximising portfolios across the risk spectrum
q Define the level of risk comfort for a stated horizon, and select an optimal portfolio
q Rebalance periodically or according to a decision rule
This approach is reviewed periodically or upon significant change to the asset/liability situation or to the risk comfort of the decision-making body.
The process is pretty straightforward. But how much of this now well established road map is followed by investors? As it turns out, much of item five above is ignored, allowing the mix to sit on auto pilot. Doing this presents risks to a portfolio that can easily be overcome by tactical asset allocation (TAA) management. Let’s examine why this is critical.

The Importance of asset allocation
Asset allocation is the single most important determinant of portfolio performance. In well-diversified portfolios, studies have shown that asset allocation decisions explain over 90% of the difference in plan returns1. Despite the importance of asset allocation, many investment plans do not have professional and regular monitoring of the overall asset mix and plan exposures. Ironically, a plan may spend substantial time and money identifying, employing, and monitoring a manager for a small portion of the plan (as little as 1% sometimes), while leaving the asset mix of the whole plan unmanaged the majority of the time.
Let’s put some numbers on this point. A typical plan that infrequently adjusts their plan asset mix will incur greater risk relative to their long-term policy benchmark than from a given active equity manager. Specifically, we looked at the tracking error of a plan with the following policy benchmark: 60% Russell 3000, 30% Lehman Aggregate, and 10% MSCI EAFE. Assuming the plan implemented via index funds (to isolate the impact of asset drift), and rebalanced back to policy benchmark once per year, annualised tracking error since 1979 would have been 0.5%.
Conversely, a single active equity manager in a plan line-up might represent 3% of the total plan. With a normal active risk of say 4%, and assuming the remainder of the plan is indexed, the active equity manager would contribute risk relative to policy benchmark of just 0.1%. So in this example, risk is about four times greater from allowing asset weights to drift than from the typical active equity manager. Often, despite these statistics, many investors allow their asset mix to drift without professional management
Given that it makes sense to have professional management of the asset class mix, the next step is to determine if this is done passively or on an active basis designed to add value.

Active or tactical asset bets?
A key benefit to employing a tactical manager is that they will typically eliminate the risk coming from the passive drift. Once the passive part of their strategy is in place, a tactical asset allocation (TAA) manager will attempt to identify trades that will add value relative to the policy benchmark. Depending on the level of risk coming from asset class drift and the aggressiveness of the tactical bets, it would be fairly common in fact for the TAA manager to reduce overall portfolio risk in an absolute sense and relative to the policy benchmark.
A global TAA manager will also monitor currency exposure. This would work similarly as at the asset class level in the sense that it can often reduce risk resulting from currency exposure. With plan’s international exposure at historically high levels, this issue has become more important, but again an area that is often left unmanaged. Hiring a Global TAA manager would address this risk (and opportunity) as well.
So, overall benchmark risk can come down if the risk reduction from the elimination of asset class drift is greater than the risk introduced by the tactical bets. In effect, even if the tactical manager has only modest ability at adding value, the overall plan impact of a tactical asset allocation strategy will increase returns and in many cases reduce risk.

International exposure in the mix
By now institutional investors understand the diversification benefits to their portfolio of moving some exposure to international equity and fixed income markets. Investors, regardless of domicile, tend to harbour some level of home market bias ie, hold higher concentrations in domestic equity and fixed income markets, than say, a world cap-weighted mix of those same asset classes. From a practitioner’s view US investors are more likely to hold 10-30% overseas, while 20-50% overseas exposure would be more typical of investors domiciled in Europe, the UK or Australia. Mercer’s Consulting2 survey of 111 pension plans corroborates this notion. An average of 27% was allocated to international for all plans surveyed, with lower international holdings, closer to 20%, among US plans. In all cases, shifting domestic to international exposure is diversifying from a risk perspective. Taking on international exposure can improve risk-adjusted performance, but the accompanying currency exposure must be addressed at the outset.

Currency Benchmark Definition
The decision to use an unhedged, a partly- or a fully-hedged currency benchmark is a function of a few factors: the domicile of the investor, the weight of international relative to domestic exposure, the degree to which limiting currency volatility from driving overall international returns is desired, and the investor’s view of long term currency returns.
In a 60% equity/40% fixed income portfolio, of which 25% is international equity, investors have tended to choose one of the three currency benchmarks shown on the right, an unhedged or fully hedged or partly hedged currency policy. More recently, as institutional investors have increased their international exposure, some have selected the 50% benchmark hedge ratio as their currency neutral exposure. Recent usage has shown that larger allocations to international exposure are being accompanied by higher hedge ratios.

Structuring active currency
Active currency in portfolios is used in two primary ways. Either via an active overlay to a plan’s international exposures or by taking on currency as a separate or alternative asset class. While active currency alpha is quite portable, in that it can be done as a long/short currency approach combined with futures for any asset class, most often investors choose to overlay active currency management on top of existing international exposure.
However for all intents and purposes, active currency has zero correlation to the major equity and fixed income asset classes. Thus, adding active currency overlay provides an uncorrelated source of active risk. Say an overlay strategy that has 200 basis points of tracking error in a 50% hedged mandate is applied to 12.5% of a portfolio. If the overall portfolio tracking error is 250 basis points and the return of currency is uncorrelated, the addition to total portfolio tracking will be minimal and the contribution to the portfolio’s active risk from currency is just over 2 %. In the search to add non-correlated series to achieve diversified returns, active currency can play a significant role.
Specialist managers with expertise in currency overlay management are best placed to provide the combination of alpha and risk control sought by investors with international exposures.
Kathleen Mann and Heydon Traub are principals with State Street Global Advisors in Boston
1 Brinson, Brown and Beebower, “Determinants of Portfolio Performance”, Financial Analysts Journal (July-August 1986) pp. 39-44.
2 William M. Mercer Global Investment Forum, “Currency Risk Management: Key Strategic Issues”, Tokyo, Japan, December 2000.

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