The arguments for using currency management have been widely publicised for many years, both from the perspective of lowering risk in a foreign portfolio, as well as enhancing active management returns. So why has it become even more important now for pension funds to re-assess their currency exposures? This is due to the emergence of several significant trends in pension fund investing. There are currency implications from the trend towards holding a greater proportion of foreign equities; from the move towards multi-manager structures; from the search for alternative sources of excess returns; and from the growing use of risk budgeting.
The first of these trends has been the steady rise of foreign assets held within pension fund portfolios. The overriding reason for this trend has been the desire to diversify equity holdings and to lower risk in the overall portfolio. Importantly, for diversification to be achieved as this trend continues, it is essential to consider the resulting increase in currency exposures, as they become a greater element of the risk and return of the total portfolio. Analysis by William M Mercer suggests that as the percentage of foreign equities rises, the difference between the risk levels of an unhedged and a fully hedged portfolio becomes significant. As the percentage of foreign equities increases, the benefit from the improved diversification of the equity portfolio can be completely offset by the increased risk from the larger unhedged currency exposure and, in some situations, can actually increase the overall risk in the total portfolio. Critically, however, if the increased foreign holdings are hedged, then the total portfolio risk can be reduced. Hence it is vital to consider the currency impact as one increases the percentage of foreign equities, particularly if the intention is to lower total portfolio risk through diversification.
The second trend is the move towards a more specialist manager structure. If a pension fund employs several regional specialists rather than a single balanced manager (who previously managed all currency risk), this raises the question of how the overall currency exposure at fund level should be managed. The advantage of using a currency overlay manager is that it can control the overall currency exposures by managing all of the exposures embedded in the underlying portfolios. The overlay approach leaves the underlying bond and equity managers undisturbed to manage their own specialist mandates.
The third trend is the search for alternative sources of uncorrelated excess returns. Excess returns from active currency management are likely to be uncorrelated with both bond and equity returns, and so the addition of an active currency overlay program can add value and also diversify the source of excess returns. Furthermore, there is increasing evidence of the ability of overlay managers to consistently generate excess returns. Also, excess currency returns compare favourably with the added value from active equity and bond managers. Some pension funds will consider hedge funds to deliver these extra returns. Whilst hedge funds can provide a solution, currency overlay has the advantage that it is not necessary to reduce any current investments within the fund’s asset allocation. Moreover, currency exposures in many pension funds remain unmanaged.
Finally, the growing use of risk budgeting has led to a greater focus on currency risk. Currency exposures are an unrewarded risk in the portfolio as no long-term return is expected. So why do many funds continue to accept this risk? Passive currency hedging can either reduce or eradicate this risk. In a risk budgeting process, once this risk has been ‘saved’, it can be re-allocated to a strategy that is expected to generate a return in the long-term, including active currency management.
With all these trends likely to develop further in the future, it is becoming even more important for pension funds to carefully consider their currency exposures – now is the time to re-assess the opportunities presented by currency overlay management.
Tony Spence is associate director, currency overlay at First Quadrant in London

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