John Lappin reports on the growth in local interest in currency overlay techniques

The extent of awareness among European pension managers and other institutional investors about currency risk manage ment varies between those who have a comprehensive overlay programme in operation and those who regard it as a low priority or a risk that can be borne without recourse to expensive hedging strategies.

Trends are difficult to identify but there is evidence of increasing interest with the recent set-up of a joint venture between Dutch bank Rabo-bank and Zurich-based consultancy Olsen & Associates, which will offer currency overlay services to its clients. Research into the needs of the bank's institutional customers revealed that though they had only been considering the issue for the last two years at most, they were now looking to de-velop a strategy to manage currency risk.

Many pension managers remain sceptical especially of explicit management, often regarding currency risk as an integral part of international equity and bond management, or in the case of smaller funds believing that the risk does not merit expenditure on what they see as costly hedging activities.

Views from larger funds range from that of British Airways which believes that currency management should be carried out solely through simple hedging to Siemens which is fully committed to explicit currency overlay. Others are still considering the issue with two large public funds, the Dutch health workers fund PGGM and the Canton of Zurich Civil Service Insurance Fund having awarded currency overlay mandates on a trial basis.

Currency risk management was pioneered by European corporations based in hard currency countries in the early 1980s, but its adaptation to pensions investments first took place in the US. US funds began to manage their currency risk either passively or actively in the late 1980s. This demand spawned a number of specialist management firms while prompting investment banks to offer currency management separate from other investment activities.

Alfred Bisset, president and founder of Connecticut-based overlay manager A G Bisset & Co is one of those who would like to convince the European pension market of the merits of currency overlay. He believes that the term overlay was coined by one of his US clients in the 1980s. His definition is: The application of a dedicated currency manager to an exposure in an equity portfolio from the manager who is buying and selling stocks in different countries."

Noting that it applies more to equity than fixed interest managers because they have a currency component in their process, he continues: "It means hiring a specialist to manage the currency for the assets that other managers choose to be in".

Turning to the European sphere, Haijo Dijkstra managing director of the Rabobank-Olsen & Associates venture known as Rabo Olsen Global Overlay Strategies says: "More and more people realise that because the foreign exchange risk they implicitly run is significant, they should actively manage this risk as a separate asset class different from stocks and bonds. They can manage currency risk in a separate way, not implicitly but explicitly."

Commenting on investors' attitudes from Rabo Olsen's survey, Mark Lundin, research scientist with Olsen, says: "Once investors had re-alised there was a problem and a potential for increased returns, they wanted to do something about it."

Lundin, who has carried out his own statistical research into the subject of currency risk, adds: "You almost al-ways induce risk to your portfolio when it involves foreign exchange," although he adds that where foreign holdings are under 5% it actually reduces risk because of the diversification effect.



One complaint made by pension managers is that the array of strategies is confusing. Rabo Olsen's methodology, for example, described as 'dynamic hedging using a quantitative approach' does not fit easily into Bisset's categories. But such confusions may be a surmountable obstacle if market conditions are right.

In the strong sterling environment, Rabo Olsen cites the UK as a target market. "A lot of fund managers were exposed in foreign currency and they never hedged this because sterling was on a stable trend downwards. In the last year and a half they have realised that the climate requires management of foreign currency exposure," notes Dijkstra.

Consultants in the UK also point to the need to consider currency risk as a result of the minimum funding re-quirement (MFR) but managers may not be easily convinced.

The obligations of MFR with regard to currency are recognised by David Gamble, chief executive of British Airways Pensions International Management, but he is very sceptical about active strategies preferring, as many other managers, to use simple options strategy.

"There are people who believe they can predict currencies, there are those who take a quantitative black box approach and there are people who hedge through a fairly simple programme which I think is the best way."

He continues: "Are you trying to increase reward or reduce risk? The answer is that you should reduce risk."

This view is endorsed by Robert McMicking, director of international pension funds for computer multi-national Digital Equipment Corporation. "All our investments are done through professional investment firms and they have tactical currency management skills. Sometimes we allow them to hedge, sometimes we do not," he says.

He adds pointedly: "Our experience has been that most of the time they get it wrong."



Multi-national funds in Belgium such as Unilever and Monsanto similarly delegate currency management to their general money managers. Andre Callaerts, treasurer of Monsanto's pension fund, says: "We have outside management for all our investment classes and it is up to all our individual managers who are specialists to decide how much they should hedge. We leave it to the ex-perts."

McMicking is more forthright in his rejection of the concept. He comments: "We considered it and it is not for us. It sounds like a decision easily arrived at, but it is the result of an enormous amount of research and I don't see us changing our minds about it in the near future."

Some continental funds, however, are proving more open to the idea. PGGM have just extended a one-year trial for external currency overlay applying to NGL100m of investments for another 12 months. Depending on the results this could be extended to cover the whole of its international portfolio, while the Canton of Zurich Civil Service Insurance Fund has outsourced currency overlay management of its international bond portfolio to State Street since 1994 in a trial that will continue for two more years. The State Street system known as SafePort is portfolio insurance approach.

Daniel Gloor, head of asset management at the fund says: "For a Swiss in-vestor, if you are going to invest in foreign bonds, apart from the interest risk the currency risk makes a majority of the total risk. We decided we would like to have a hedging instrument to reduce the volatility of the portfolio regarding currency risk in the long term."

Expressing cynicism over the ability of analysts to predict currency movements he adds that the fund had two alternatives to do nothing or to implement a hedging programme.

The fund's annual report in a description of the system says: "SafePort may be described as an insurance policy which pays out in the case of a loss (devaluation of the foreign currencies) but for which a premium must be paid in return."

However Gloor is disappointed that the reduction in volatility has only amounted to 0.4% according to the benchmark.

He concludes: "Our goal is that if we have the reserves of the pension fund overall and depending on the annual investment concept then we will probably stop the programme be-cause apart from this we have no hedging transactions on the assets and are broadly diversified geographically and in different instruments."



By contrast, German company Siemens, regarded domestically as a company with a very sophisticated investment strategy is fully committed to the practice. Most currency management in Germany is carried out internally by the larger financial institutions but Siemens isan exception employing both internal and external overlay management in an activ e approach.

Wolfgang Lotze, an in-house portfolio manager divides the process into hedging and managing. He explains: "In the long run, as far as asset allocation is concerned, currency movements are an important part of our business but day to day our actions depend on the overlay strategy."

"Hedging is done on a very regular basis and flows into our asset allocation decision. We set a limit for the degree a portfolio manager is able to hedge or not to hedge. For example, if we are neutral on a particular currency we might argue that in the asset allocation we will take a 50% hedge," he explains.

But managers can also adopt a more active strategy. "If the internal portfolio manager or external currency adviser believes that he can make money by overweighting more than 50%, say 60 or 70% this is included in concept. They are allowed to deviate from the benchmark," he adds.

Siemens has been managing currency risk internally since the mid 1980s employing their first external manager in 1994 and as such are have been at the forefront of adopting such practices. But considering the cynicism of some managers and the way in which others are subjecting overlay strategies to the closest scrutiny while keeping a wary eye on hedging costs, it remains to be seen if Siemans is in the vanguard or simply the avant-guard. IPE"

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