Currency overlay is a ‘must have’ for plan sponsors with cross border investments and processes that control risks. Currency risk has become important in today’s average pension portfolio and is increasing in importance. InterSec Research Corp., a consultant, projects pension funds globally will have one out of five dollars invested across borders in 2005. In a few years, $3trn in pension assets will be subject to currency risk.
Currency risk can be managed effectively by currency overlay managers. They have produced results superior to those achieved by underlying equity managers. InterSec has found that not one equity manager in its EAFE Plus performance universe of over 100 representative manager portfolios ‘added implicit or total currency value to their portfolio performance’ in the past 10 years.
Although equity managers often claim they hedge ‘opportunistically’, they seldom have reliable currency strategies. Hence, they do not perform as well as currency specialists whose sole focus is currency risk management. There is little reason to expect equity managers to excel in hedging currencies since managing equities and currencies is very different.
Equity managers buy securities expected to rise faster than a benchmark in a bull market and may decline less in a bear market. Securities are held long-term and are sold when price targets have been reached or the outlook has changed.
Currency managers do not buy and hold. They work with exposures that arise from the equity investments. An overlay manager’s task is to protect against currency losses and allow participation in gains when currencies appreciate. Currency managers actively place and lift hedges – a process of market timing – to meet their objective.
Plan sponsors usually require equity managers to be fully invested since a plan’s asset allocation is made at the plan level. Equity managers are not responsible for managing the market risk and remain fully invested in bull and bear markets. Their returns are measured as added value versus the benchmark.
Although equity managers can outperform their benchmarks, many do not and sponsors worry they will underperform. To reduce that risk, they may require a manager to produce returns that do not exceed a pre-determined tracking error, ie, the added value may not deviate from the benchmark by more than a certain percentage. Since equity managers may be terminated if the tracking error is exceeded, they limit the risks they take to minimise the risk of exceeding a tracking error.
When a plan sponsor initiates a currency overlay, the objective is to control the market risk of currencies falling. In a typical programme, the currency manager is constrained to hedge the underlying currencies and may not trade in currencies not included in the portfolio. Currency managers achieve their added value by taking positions with or against the currency benchmark. Since the process is very different from equity managers’ ‘buy and hold’ strategies, applying a tracking error to an overlay is not as easy.
Cross border portfolios are usually diversified among securities, industries and countries, which reduces the risk of a single investment having a large negative impact on a portfolio’s return.
The currency risk in an international portfolio is not diversified. From a US perspective, the MSCI EAFE index, which is a common benchmark, covers many countries. However, only three currencies, the euro, the yen and the pound represent 36, 25 and 21%, respectively, of the currency risk. From a European perspective, the currency risk can be equally concentrated. The dollar can represent 60 to 70% while the yen and sterling are also large risks. Remarkably, fiduciaries concerned with diversification to reduce risks have been slow in addressing the currency risk, which can be one of the largest risks in an international portfolio.
Because currency risk is concentrated and currency managers cannot diversify by investing in other currencies, there are implications for applying a tracking error. The consequence is that it is difficult for a currency manager to add value when a currency is rising long-term. Although there may be times when a currency is weak and a hedge can produce a gain, currency managers often only match or slightly underperform an unhedged benchmark when a currency’s long-term trend is up. However, when a currency is falling over two to three years, a currency manager will be largely hedged and the added value can be large (see chart). Thus, the added value overlay managers produce is very period specific.
Plan sponsors who fail to consider the differences in how and when currency managers add value may therefore impose a tracking error that is too restrictive. If a manager may only deviate X percent from the benchmark, the manager may be reluctant to fully hedge a currency. An incorrect hedge may cause a loss that is relatively large when compared to the loss an equity manager investing five percent in a stock that underperforms may suffer.
A restrictive currency tracking error may have the unintended outcome that the objective of an overlay-to be hedged when a currency declines and unhedged when it rises-is compromised. A currency manager may limit the size of a hedge to reduce the risk of exceeding the tracking error at the expense of leaving a portfolio less hedged.
A study of overlay managers by Brian Hersey and Jim Minnick at Watson Wyatt Investment Consulting, published in Global Pensions in February 2000, found that some overlay managers do not hedge as much as may be desired. They wrote: “Indeed, overlay managers seem comfortable in making only relatively conservative moves away from their assigned benchmark hedge levels. What we seem to observe then is evidence to suggest that active overlay managers are perhaps not active enough in implementing their convictions on currency. At times of rising foreign currencies, managers appear hesitant to move to the extreme position of maximum currency exposure, while they appear similarly hesitant about moving to fully hedged positions as foreign currencies are depreciating.”
One reason that may explain Watson Wyatt’s findings could be that plan sponsors have imposed tracking errors that reduce the willingness of overlay managers to take strong positions against the benchmark. Another reason could be that some overlay managers have processes that add hedges gradually or lack precision in the timing of hedges.
Overlay managers can be grouped in three decision styles; model-driven, dynamic and fundamentally based.
Model-driven managers identify price trends and their turning points. Hence, they work with information that permits them to move from 0% to 100% hedged with precision relative to the turning points at which currencies begin to rise or fall.
Dynamic hedgers increase hedges incrementally when a currency declines and may reach a fully hedged position only when the decline is almost over. Thus, a currency may be sub-optimally hedged during much of its decline and result in average hedge ratios and returns that track a benchmark closely. Complete protection may not be achieved when a currency makes a large move like the dollar did in the second quarter of 2002.
Fundamental analysis can produce a high conviction level that a currency will rise or fall, but is usually not precise in the timing of when to place and lift hedges. Fundamental managers may, therefore, be less inclined to actively move between the 0% and 100% hedged positions.
Due to the concentrated risk currencies represent and because overlay managers take positions against the benchmark to add value, while their processes vary, it is common practice to appoint a team of overlay managers to reduce single manager risk. Since the team approach is designed to reduce overall risk, it is important to measure the combined returns and how it evolves relative to a tracking error.
Since overlay managers with various styles produce added value at different times, plan sponsors may wish to have different tracking errors for individual manager styles as well as an overall tracking error for the team.
Currency overlay is an orderly process designed to reduce a pension plan’s risk of unnecessary currency losses. Consultants, Frank Russell Company, has made the following findings: “The tracking error of active currency overlay managers, using the 50% hedged benchmark, falls between the tracking errors of US fixed income and US equity managers and is well below the non-US equity managers. These low tracking errors position currency overlay in a ‘lower risk’ category of active investment strategies. Certainly, the managers we have studied have added value for their investors.”
Other consultants have come to similar conclusions and endorse currency overlay as a ‘must have’ for pension plans that have currency exposures and who manage their risks actively.
Ulf Lindahl is chief investment officer at AG Bisset & Co, in Rowayton CT

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