Wild swings in the relative value of the world’s major currencies can have a huge impact on investment portfolios. Some institutions take a philosophical attitude – like the weather, ups and downs on the foreign exchanges are inevitable – and leave it at that. But increasingly, pension funds and other big investors are doing something about it. They are using currency overlay management to manage the risks they face.
Currency overlay, says Bill Muysken, head manager of research, global, at Mercer Investment Consulting, is managing the currency exposures of an investment portfolio separately from the underlying asset exposures. The point is to keep currency losses to a minimum, while at the same time benefiting from any currency gains.
He says currency overlay has to be done by an external manager. “It’s a specialist activity that requires specialist skills that most equity managers don’t have.” Currency hedging – a more familiar term – is all part of currency overlay management.
For investors, the problem of how to avoid the sometimes heavy losses caused by currency fluctuations is a relatively recent one. Up to the mid-1980s, investors and corporations did not hedge their currency exposure at all. Muysken says the very first currency overlay management mandate was awarded in 1985.
“It’s only in the last decade that it’s become more commonplace for large investors,” says Muysken. But it is still only a minority activity among pension funds, with between 5% and 10% of European funds making use of the service.
This is changing. New mandates are awarded regularly, and pension funds that have programmes in place tend to be happy with them, says Muysken. In a report, Deutsche Bank points out that the popularity of currency overlay mandates has been strongest in the US, UK, Netherlands, Ireland and Australia, reflecting the highly internationalised investment portfolios in these countries.
In the past, says Deutsche, investors have tended to ignore currency risk and return. The thinking has been that, over time, exchange-rate fluctuations iron themselves out. The reality, the bank’s experts say, is that it takes a long time for this ‘mean reversion’ to happen, and so it is not prudent to ignore currency risk.
Currency overlay has two purposes – to reduce risk and enhance returns. On the one hand, passive currency hedging is used to cut risk and, on the other, active currency management aims to boost returns. This is the space that State Street Global Advisors occupies, offering both the active and passive approaches. According to an IPE survey of players in the September 2003 issue, the group ranked number two in term of total currency assets under management, including overlay programmes.
Mercer has 36 currency overlay managers on its list, from all around the world. The universe of currency overlay managers can be divided into three types: passive hedgers, risk reducers and return enhancers.
Within active currency management, there are different types of approach, though all are grounded in fundamental analysis, technical analysis or a combination of the two. Overlay managers often recommend that pension funds go with more than one approach to diversify risk.
When a pension fund has decided to implement a currency overlay programme, the question is how much of its foreign exchange exposure will be hedged passively. Consultants are able to advise. “We advise them to look at the long-term risk and return consequences of different options,” says Muysken. But in the case of European pension funds, the answer is almost always that at least 50% should be hedged passively.
But why should any of a fund’s currency risk be left unhedged? Experts at Mercer think a certain degree of unhedged exposure is actually good for a fund, because of the low level of correlation between foreign exchange returns and the returns of other assets.
Institutional investors are increasingly moving from the hedging approach towards the ‘alpha side’, says Paul Duncombe, head of currency management. “More investors are coming to us directly at the start of a search say they are looking for an absolute return as an objective. But existing clients are moving from a defensive hedging approach to a more return-oriented outlook and changing their guidelines to permit that. They are being much more proactive .”
He points out that clients are not changing anything drastically when they make the move from the defensive to the more active. “Even in a hedging mandate, a manager is expected to anticipate currency moves and hedge appropriately. But that skill can be used to generate alpha.”
In a hedging mandate the currencies used are usually restricted to those currencies being used in the underlying portfolio and to the corresponding amounts. So in order to diversify the sources of alpha in the portfolio, those restrictions are lifted to spread the exposure across a wider range of currencies to provide a more diversified portfolio, says Duncombe.
“But even if you are limited to hedging one way, for example, back into your base currency. You then just take advantage of moves on one side. Or you can allow the position to be symmetrical so you can make money both in periods of currency strength and weakness.” In his view, it is a question of just taking a modest step that allows the investor to move from using that manager skill inefficiently or efficiently.
Finding a currency overlay manager is basically the same as finding any other investment manager. A fund can use a consultant to produce a selection of suitable managers, or can offer the mandate on its own. “There are plenty of managers out there, some good, some not so good,” says Muysken.
But is it really possible to add value through a currency overlay programme? After all, currency is not an asset class in itself. Even return enhancers admit that you have to be very cautious in terms of the returns you can expect.
The currency market is the biggest and most liquid financial market in the world, by far. It is efficient too, so currency returns should be random and therefore impossible to forecast.
But despite this, higher returns can be achieved, says Dan Lass, managing director of global marketing at Pareto Partners. “You wouldn’t receive any positive returns by just buying and holding currencies… the only returns you get are through manager skill. It’s true that statistically it’s almost impossible to forecast currency returns less than one year. However, you can forecast risk and the ability to forecast that allows you to generate alpha.”
He explains that analysis of volatility clusters allows certain information to be gleaned. For example, if there is volatility on day one and day two, there is likely to be volatility on day three. If you can control the risk during periods of volatility but allow yourself more exposure in less choppy times, this will generate positive returns, he says.
Over the past 12 years of managing currency, Lass says that on average Pareto Partners has been able to add roughly 1% a year to portfolios.
Duncombe at SSGA reckons on an information ratio of 0.7 to 1.0, is where most manager operate including themselves. “So if you want 2% risk, you can have 2% return and if you accept 3% risk, you can expect a 3% return. We can run it according to the level of risk you are prepared to take.”

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