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The Benefits Of A Currency Overlay

By: Alfred G. Bisset & Ulf J. Lindahl

Currency overlay, which emerged in the 1980s when pension funds found that their international equity managers did not hedge currencies effectively, has been shown to reduce risk while adding return. Alfred G. Bisset and Ulf J. Lindahl, of A.G. Bisset & Company, show how pension funds can benefit from currency overlay.

The U.S. dollar’s 14 per cent drop against the Canadian dollar in 2003, and declines of six per cent in the euro and 10 per cent in the Japanese yen, have brought home to Canadian pension funds with investments in the United States, Europe, and Japan that currency losses can be large. Fortunately, these losses can be reduced with a currency overlay program.

Currency overlay, which entails separating the management of the currency exposures that arise with cross border investments from the management of the underlying assets, has been shown to reduce risk while adding return. Studies by pension consultants have found that currency overlay managers have added an average of one per cent per year relative to their currency benchmarks since 1998.

Currency overlay is becoming a ‘must-have’ for investors seeking superior performance. Currency overlay emerged in the 1980s when pension funds found that their international equity managers did not hedge currencies effectively. Inter- Sec Research Corporation, a pension consultant, confirmed those findings in a study. It found that 80 per cent of the international assets that were actively managed for U.S. pension plans were subject to some currency hedging, although only 10 per cent were hedged frequently, 33 per cent occasionally, while 38 per cent were seldom hedged.

InterSec also found that not one equity manager in its EAFE Plus performance universe of 100 representative portfolios had “added implicit or total currency value to their portfolio performance” in the 10 years through 2000.

Place And Remove Hedges

It is clear why equity managers cannot hedge. They invest in securities that are likely to outperform a benchmark in a bull market and may decline less in a bear market. The strategy is to pick stocks and hold them for long periods.

Currency hedging is different. Its focus is to place and remove hedges actively – often several times per year.

In May 2000, Frank Russell Company, a consultant, published a study of more than 10,000 monthly currency overlay returns provided by two dozen overlay managers with $85 billion under management. The study covered 10 years and found “positive excess returns for the vast majority of active currency overlay accounts.”

Watson Wyatt Investment Consulting has also measured overlay managers. It found that “across all accounts, the values added number since inception [were] 1.55 per cent as of year-end 1998, while dollar and non-dollar accounts generated 1.52 per cent and 0.93 per cent in excess return respectively.”

The returns overlay managers produce have led to more and more investors taking the currency management away from their asset managers to ensure that they capture the added value currency managers can provide.

A survey of the world’s leading overlay managers published by Investment & Pensions Europe in September 2003 revealed that these 17 managers managed 362 overlay accounts with C$325 billion in assets for clients worldwide. They added 146 new accounts in 2002 – up 68 per cent.

In the same issue of IPE, Alan Wilcock, a director at Russell/Mellon CAPS, confirmed that overlay managers continue to deliver. In the seven years through March 2003, the mean excess return per year was 1.09 per cent for all accounts. The added value was 1.36 per cent for the most recent year. The survey covered 19 managers with 149 separately managed accounts.

Strategic Currency Allocation

Most pension plans have allocations to different asset classes. Consultants advise that investors who initiate a currency overlay begin by setting a strategic currency allocation that should be determined by relating the returns and risks of currencies to those of the other assets in a portfolio. Sounds simple, but it is not. Several studies have found that there is no universal hedge ratio for currencies that has an optimal risk/return profile. The strategic allocation is investor specific.

In practice, most investors with currency exposures are pragmatic and appoint currency managers to hedge the actual currency exposures that their asset managers create when they invest. After all, it is that currency risk they seek to reduce.

Selecting a currency benchmark is also problematic. However, since many believe currencies have no expected return, pension funds in the U.S. have often selected a 50 per cent hedged benchmark for their overlays. However, zero per cent and 100 per cent hedged, and other ratios, are also used.

Currencies are assumed to have no expected return because they do not pay dividends, interest, or have claims on appreciating assets. However, they have short- and long-term returns that can be large. The German mark, for example, appreciated at an annual rate of +2.1 per cent against the U.S. dollar from 1950 to 2000, while the yen rose at a rate of +3.3 per cent.

Yearly price changes are larger. The U.S. dollar’s value versus the German mark and the euro, for example, rose or fell by 10 per cent, or more, in 60 per cent of the past 30 years. It is this volatility that investors seek to reduce with an overlay program. Movements in the euro and the yen have been equally large against the Canadian dollar.

Investors have tried to eliminate currency fluctuations from their investment returns with passive hedging programs. It is true that they remove that volatility from investment returns, but it is actually only moved to the cash that supports the program where the losses and gains create other headaches.

Gain Offsets Decline

In a passive program, currencies are hedged continuously by placing hedges on a rolling basis. When a currency drops, the hedge has a gain that offsets the decline. It is realized on the value date of the hedge and is paid to the investor. But when a currency appreciates, its gain is offset by a loss on the hedge, which must be paid. In a year when currencies rise 10 per cent, an investor must pay out cash equal to 10 per cent of the underlying assets that are hedged. That cash can come from a cash reserve or from selling some of the underlying assets. It is through these cash flows that currency fluctuations reappear in portfolios that are passively hedged.

Sometimes currencies rise for several years. When a pension fund with a passive program pays the associated hedging losses, it must sell more and more of its assets. That upsets the asset allocation while the fund foregoes the return on the assets that were sold. This is why passive hedging programs are abandoned in favour of active currency programs.

In an active overlay, the manager will place hedges whenever a currency declines to avoid the currency loss. When a currency begins to rise, the manager will lift a hedge to allow participation in its rise.

An active overlay has several benefits. Protection is provided when currencies fall with gains on hedges flowing back to a fund while currency gains are retained when hedges are lifted and currencies rise. Since an overlay manager will be mostly unhedged when currencies rise, the cash flow profile will be superior to that of a passive hedge. And, as hedges are placed and removed, the overlay permits a fund to boost its overall return. As mentioned, overlay managers have produced added values that have averaged around one per cent per year.

Average returns are nice, but what do they hide? For overlays, one must understand that when a currency is rising and it is unhedged, the manager can only capture that return and will be unable to add value relative to an unhedged benchmark. However, when a currency declines and it is hedged, the added value can be large. If a currency drops 10 per cent in a year and it is hedged, the added value will be 10 per cent compared to an unhedged benchmark. The added value overlay managers provide is, therefore, periodic and requires pension funds to measure returns over several years.

Ten years ago, there were only a few overlay managers. Today, there are about 25 investment firms that offer stand alone currency overlay programs, while several consultants keep performance databases. Thus, pension funds can now make informed manager selections.

Since overlay returns differ and depend on the underlying exposures, it is difficult to rank returns to find the ‘best’ manager. One approach is to compare added values. However, one must ensure that the added values relate to similar benchmarks. It is unfair to compare a manager with an unhedged benchmark with one that has a 100 per cent hedged benchmark.

The strongest candidate usually wins the appointment in a manager search. However, to set up an effective overlay program, it is advisable to have at least two managers with the exposures split between them. Why?

Limit Single Manager Risk

International equity portfolios are welldiversified with guidelines often prohibiting investments of more than five per cent in a single security. The currency exposure of these portfolios, take MSCI’s EAFE index for example, is not diversified. The euro, sterling, and the yen represent more than 80 per cent of the EAFE’s currency exposure. Since even the best currency manager will underperform at times, it is prudent to have at least two overlay managers to limit the single manager risk.

Currency overlay managers can be grouped into three decision styles:

They can also be divided into groups that are return or risk reduction oriented.

A few years ago, pension funds tended to create teams of overlay managers with different decision styles. That method is evolving into a process in which the returns are examined to create teams that have returns that are loosely correlated. This method is also flawed, although better than the naïve ‘one of each’ approach.

Ranga Nathan, an independent consultant, has demonstrated that the best results are obtained when overlay managers have a high correlation over the long-term but are less correlated in the near term. Why?

If two managers are skilled, they will attain high added values over time by correctly identifying the major ups and downs in currencies as they unfold. Being loosely correlated in the near term ensures that they do not place and remove hedges at the same time. Thus, it can be advantageous to have two model-driven managers.

Dynamic Hedgers

There is a difference between risk and return focused managers. Risk oriented managers tend to be dynamic hedgers, who increase a hedge gradually when a currency declines and may reach a full hedge only when the decline is near its end. They produce returns that track a benchmark’s ups and downs, but do not provide full protection against large declines. In a 10 per cent decline, a dynamic hedger may reduce the loss to five per cent while a manager with a return strategy may hedge a currency completely when a declining trend has begun. Return oriented managers can, therefore, provide more protection but with returns that are more volatile relative to the benchmark.

Investors must be clear on what they want their programs to achieve:

The growing interest in appointing currency managers to add alpha suggests that the return focused managers are gaining ground. Many sophisticated pension plans are restructuring their programs to reap higher returns. If managers have the skill, they reason, a higher return is preferred.

One thing is clear; currency overlay has emerged as a ‘must have’ for investors seeking superior performance. Some of the larger pension funds in Canada have now hired overlay managers. In April 2003, Mercer Investment Consulting surveyed Canadian pension funds and found that four out of 47 plans used specialist currency managers. That number will grow.


Alfred G. Bisset is president and Ulf J. Lindahl is chief investment officer of A.G. Bisset & Company. (www.agbisset.com)

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