Under the current interpretation of the ERISA law in the US, it is a fiduciary obligation to diversify investments among asset classes to reduce risk. The interpretation spawned a monumental asset allocation shift in the US, and worldwide, in the 1990s. In 1985, only $25bn (E27.86bn) of US tax-exempt funds were invested outside America. Fifteen years later, the total topped $1trn!
In the 1980s, it was demonstrated that adding foreign equities to a portfolio improved its risk/return profile. These studies – generally based on optimisations of S&P 500 and MSCI EAFE index returns – indicated a portfolio’s total return could be increased and the volatility of the returns reduced by investing 20–30% in the EAFE markets.
The move into foreign equities in search of high returns and less risk occurred with minimal analysis of why the EAFE index had historically had a higher return than the S&P 500 index. An attribution of the returns from 1970 (after which currencies began to float against the dollar) through 1990, would have revealed a large portion of the excess return over the S&P 500 index came from the underlying currencies in the EAFE index. The dollar generally fell against them. The chart illustrates EAFE priced in dollars (red line) and in local currencies (blue line). The difference between the two lines is the cumulative currency return.
Managers of international equities were paid a higher management fee relative to managers of domestic equities. The higher fee was justified by the more complex task of investing overseas, including managing the currency risk. Two complicated tasks should command a higher fee.
However, often loath to take the benchmark risk of hedging currencies, many international managers seldom hedged the currency exposure actively. Nor were they keen to present their returns by source: equity and currency. Whether by design or default, an attribution would have caused plan sponsors to think about why a manager hedging currencies was paid the same fee as a manager who left currencies unmanaged.
Managing equities to add value involves selecting securities that rise faster than the index in a bull market and decline less in a bear market. Managing currency exposures is very different. It requires skill at timing hedges correctly. This fundamental difference in needed skills gave rise to currency overlay specialists in the late 1980s.
Currency overlay managers were initially hired by some of the most sophisticated pension plans to manage the currency risk of their international assets more effectively. These overlay managers demonstrated they were better at hedging currencies than equity managers making top- down or bottom-up security selections with little thought about the currency.
Performance studies have shown equity managers seldom outperform the benchmark. However, Frank Russell Company and Watson Wyatt Investment Consulting have found that currency managers have added 100 or more basis points per year, on average, to underlying currency benchmarks since 1988. That is an excess return that deserves urgent attention by plan sponsors seeking high returns. In a world with diminished equity returns, one source of added alpha is improved management of the currency risk.
As plan sponsors award more currency overlay mandates, the issue of fees will become a bone of contention. When an international equity manager is asked not to manage the currency exposure, logic demands that the fee should be reduced. Simply put: less work, less fee. However, a currency overlay manager assuming that difficult task must be paid a fee.
A source of resistance to initiating an overlay programme has been plan sponsors’ unwillingness to pay fees. The resistance is overcome by realising a currency specialist may boost the return of an international allocation by an average of 100 basis points per year over the long-term. Simply put, the extra return justifies the fee. However, to ‘lessen the pain’ a plan sponsor can try to negotiate a reduction of the international equity manager’s fee when relieved of the task to manage currencies.

Currency overlay fees, which can start at 0.25% of the exposure managed, are highly competitive relative to the substantial added value active overlay managers have produced. This is especially the case when the added value the management fee buys is compared with the lack of added value most active international equity managers have achieved while being paid substantial fees.
When US pension plans began to invest overseas in the mid-1980s, currencies had been declining as the dollar rose from 1980 into 1985. There was a feeling, in 1985, that when it peaked an international investment would reap high currency returns. The dollar fell as expected but then strengthened at the end of 1990. It then began to rise against the yen and Europe’s currencies in 1995. Its rise is a major reason the return from an unhedged EAFE investment fell below that of the S&P 500 index in recent years. Plan sponsors with an overlay in place avoided most of that currency loss.
The large impact currencies have on international returns is why the currency risk must be managed. Plan sponsors that do not have a currency overlay programme can be seen as having abdicated their fiduciary obligation to reduce risk.
Since studies have shown a currency overlay can add extra return, it is remarkable it has taken a decade for currency overlay to take off. As more plan sponsors realise they can kill two birds with one stone with a currency overlay programme – fulfilling the fiduciary obligation to reduce risk and boost returns - currency overlay managers with strong track records and proven methodologies will find that their skills will be in high demand. And, plan sponsors will be willing to pay to achieve that extra return.
Alfred Bisset is president andUlf Lindahl is chief investment officer of AG Bisset & Co, based in Connecticut

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