Shell pension fund in the Netherlands attributed one-third of its equity returns last year to currency overlay.
Of the 21.8% generated by overseas investments, 7.3% came from hedging currency risk, according to the petroleum giant’s pension fund annual report for 2003.
By any standards this is exceptional, and not the kind of number a currency overlay programme would promise. But with the euro appreciating 40% against the US dollar in the past three years, it is understandable why management of even the major currencies can be significant for global investors.
Other major funds are now keen to add overlays. A €1bn programme for a large Danish fund is currently out to tender on IPE Quest and consultants report record business.
“We’ve had more currency searches to July this year than in the previous three years combined,” says Bill Muysken, global head of research at Mercer Investment Consulting.
He adds that all but one have been from UK clients.
It is hardly likely that these interested parties expect annual returns
of the order of 7.3%, in spite of the evident volatility of currency denominations (before 2001 the euro had a miserable first three years versus the US dollar, depreciating by 25% after a short-lived euphoric launch).
Overlay programmes are generally about reducing risk more than adding alpha and this is reflected in their measurement. A lot of global investors simply want to go passive, passing up the desire of most currency managers to bet actively on currency movements.
Results from the Russell Mellon universe of currency managers show that over the past seven calendar years, for currency mandates 100% hedged, the annualised mean return was 1.04%. Active management did not fare better over the same period, according to Russell Mellon’s data. With a benchmark of 50% passive hedge into the client’s domestic currency, the annualised mean return was 0.72%.
Passive management seems to have been more effective, although constituents of the Russell Mellon universe were not entirely satisfied with its methodology.
Two concerns regard the definition of active currency management and the aggregation of separate mandates’ performance.
A benchmark of 50% passive hedge gives currency managers freedom to increase or decrease exposure to the various currencies within the mandate. It has been typically used to signify active currency management although active management does not require a starting point of 50%. It really depends what the client is trying to achieve.
Figures from AG Bisset show that a 50% passive hedge is not the greatest indication of what active currency overlay can achieve. For its euro-denominated pension fund clients, Bisset has achieved double-digit returns for the past six calendar years.
The vertiginous fall and rise of the euro versus the dollar is evidence of the need for active rather than passive currency management, if only to make the vital switch at the euro’s nadir in 2001.
So although a passive currency hedge is often seen as a first step in the process, Muysken believes that active currency management is the method to adopt ultimately for Europe’s global investors, so long
as they have international equity portfolios worth €50m or more.
Mercer’s performance data comes from asset-weighted composites of currency managers. All the portfolios are actively managed. The median excess return for five years to the end of June 2004 was 0.6%; the median information ratio was 0.2%. It is worth noting that over three years the median information ratio jumps up to 0.7%, which goes to prove that currency management can be a volatile business.
Not that managers’ approaches necessarily have changed. AG Bisset is proud to announce that the model on which its management rests has not changed in 20 years. How many managed futures hedge funds would be that honest, or could be that honest, on the record?
The universe of currency managers is not much greater than 25 now, and going back in time to 1997 reduces the universe to as few as 10 constituents. But in the search for alpha, currency management has wider appeal.
Stuart Cowley is the highly regarded manager of Newton’s Global Bond Portfolio in London. He looks for themes in bonds and currencies and takes the fund to where returns can be made.
Such flexible exploitation of trends is going to bring currency management into the mainstream. Newton’s decision to launch a long/short version of the International Bond is evidence of that.
In the future clients will not choose between active currency management or not; the choice will be who actually gets the job of doing it.

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