The emergence of currency overlay management practices in the late 1980s has initially been along the lines of a passive hedging programme, small number of trailblazing pioneers pursuing returns as well. The degree of hedging of the currency exposure in international portfolios reflects the risk preferences of fiduciaries, which bear the regret risk at times when the base currency depreciates against major currencies coupled with the fact that the overall fund volatility does not disappear with passive hedging.
What is being eliminated from the international portfolio is the currency surprise, which is the effect of unexpected bilateral currency movements in the foreign exchange spot market to the overall portfolio. However, the currency volatility is translated into the cash volatility that is a function of the passive hedging programme. In the worst-case scenario, hedgers would pay out real cash for hedging losses, while the underlying stocks in their international portfolios have only paper gains.
It has become evident only within the last several years to convince plan sponsors of the value-added properties of currency overlay management programme due to the obvious inefficiencies in currency markets via different objectives and skill levels of participants. The currency overlay product is the active and independent management of the foreign exchange exposures associated with international investments by specialists. Currency might be called the only highly liquid yet fairly inefficient market remaining among all the financial markets in the world. An active currency overlay programme minimises the probability of short-term losses due to a passive hedging mandate that would be hard to recoup for investors with five to seven year investment horizon.
A well-structured active currency management program with minimal constraints is believed to generate superior risk-adjusted returns. Currency is lately viewed as a portable alpha engine by some practitioners due to favorable results produced by a number of currency overlay managers and the ability to place the overlay on any portion of the portfolio. Empirical evidence as presented by Brian Hersey and Jim Minnick in the February 2000 issue of Global Pensions magazine and further updated through the end of 1999 in Figure 1 demonstrates that the value added by currency overlay managers since inception stands at 1.34% with a success ratio of 0.511.

The growing foreign investments in institutional portfolios around the world coupled with more liberal regulatory environments such as the privatisation of pension systems enabled currency overlay managers attract more clients than ever before in the late 1990s. The formation of EU is forcing European pension plans reevaluate their asset allocation strategies toward increased allocations into international investments. This development will definitely make plan sponsors more interested in hiring currency overlay managers going forward and increase the number of pension systems that traditionally never considered currency management as the Japanese, Dutch and Australian institutional investors did since the introduction of the overlay product. There is also widespread belief about the benefits of active currency management for international bond portfolios as well should one make the assumption of treating currency as an asset class. It has been postulated that picking currencies and deciding on hedge ratios is a somewhat different process from managing a global fixed income portfolio. The more one finds evidence of currency overlay managers generating greater information ratios than global fixed income managers in foreign exchange management the larger will be the interest to initiate currency overlay programmes with global fixed income investments as well.
Currency overlay mandates operate generally under two sets of objectives: (i) the reduction of volatility that is due to currency movements linked to foreign investments; and (ii) return enhancement as a secondary goal. Institutional investors hire currency overlay managers hoping to benefit from both sides of bilateral currency return distributions. They would like to protect the downside from periods of base currency strength, yet participate in foreign exchange appreciation when it is favorable to do so. They are particularly risk averse against severe losses in the short-term. The desire of the plan sponsor as to which objective to overweigh has a direct impact on the development of overlay manager structures. Given the fact that currencies by themselves do not provide enough diversification as stocks or bonds, the differentiation among overlay managers in terms of their investment style and philosophy becomes crucial to achieving a smooth ride in the currency portfolio.
Even though there have been changes in the investment process of some firms, the broad categorisation of styles has remained the same over the years. Currency overlay management processes typically emphasise one of the three distinct styles: fundamental, technical, and quantitative. Fundamental managers utilise global macroeconomic variables along with short-term technical indicators to properly place their hedges. Technical processes focus on price trends in currency pairs to generate the highest possible information ratio, whereas quantitative managers concentrate on statistical and mathematical modeling of the currency data to decide when to increase or reduce hedges. Quantitative processes pursue dynamic hedging with the objective to replicate option-like behavior in currency returns either via forward contracts or options on currencies. As with any other asset class, it has been shown that different styles perform better at different times.
Moreover, as can be seen on Figure 2, some overlay managers are said to produce excess returns when there is a large currency move. To this end, they try to anticipate tail events in the distribution of currency returns or other economic variables, or inflection points in the bilateral exchange rate charts. There is little room for diversification at the hands of individual managers. In addition, couple of wrong bets by the manager might create a substantial cash outflow from the institutional portfolio. This, in turn, requires the prudent and efficient allocation of the currency exposure to a number of currency specialists. With this article, we hope to illustrate the benefits of diversification among managers with different investment styles and approaches to active currency management.
The selection of an appropriate benchmark has always been one of the heavily discussed topics in active currency management. The benchmark issue is another piece of the puzzle where the area of foreign exchange differs drastically from other investments. The so-called polar benchmarks provide plan sponsors with two extreme alternatives, namely fully hedged and unhedged. Overall, the discussions about the benchmark issue center around preferences of fiduciaries, which might bring different agendas and views to the table. Hedging 100% of the international portfolio’s currency exposure can be viewed as a defensive, yet costly move for it eliminates currency surprises from the portfolio with continuous periodic selling of forward contracts. Being fully hedged implicitly assumes that the home currency will remain strong in the future. It is hard to separate factors from one’s analysis of a benchmark choice for they are all related one way or another. Unhedged benchmarks carry no direct costs, other than the opportunity cost of missing the chance of shorting and the risk of the base currency outperforming other currencies. Actuarial methods and management of assumptions may actually prove to be more effective in smoothing short-term currency volatility effects on contributions and/or expenses than a hedged policy benchmark, thereby eliminating hedging costs while allowing for a higher return potential asset mix strategy. Thus, institutional investors with long-term investment horizons should have unhedged benchmarks against which to compare manager performance.
There have been many papers that emphasise the importance of a simultaneous market and currency decision as it relates to global investment management. Moreover, the appropriate decisions should be made after a thorough asset-liability study, which incorporates the funding level of the plan along with risk preferences of fiduciaries and distributional assumptions about the asset classes. The evolution of the institutional portfolio management dictates that one concentrates more on the total fund risk, which could be roughly broken down to benchmark risk and active risk. Active risk provides institutional investors with a framework to allocate risk in a more intelligent and intuitive way. The continuous monitoring and adjustment of active risk should be the proposed approach to investment management. Given a pension plan with a large international equity allocation, eg, more than 15%, hedging a portion of the currency exposure seems to be a prudent behaviour by fiduciaries. As institutions hire currency overlay managers to hedge away some or all of the uncertainties associated with foreign exchange movements, the active risk of the portfolio decreases as a function of the hedging activity. This creates an opportunity for the investment committee to evaluate alternative changes to the structure of the overall portfolio by allocating the unused portion of the active risk to new asset classes such as absolute return strategies or private equity funds. The combination of ideas within the scope of risk budgeting and dynamic portfolio rebalancing coupled with the active currency management proposition will lead the investment management community to the ultimate solution.

In this article, various alternative combinations of overlay managers are compared and analysed using Watson Wyatt Investment Consulting’s proprietary currency overlay database. We isolated the accounts with a partial hedging benchmark; ie, MSCI 50% hedged, and randomly formed portfolios using the three investment management styles explained above, namely fundamental, technical and quantitative (dynamic hedging). Every effort is made to include accounts with the same constraints as they relate to the allowable range of hedge ratios and permissive versus restrictive guidelines. In this initial study, dollar-based accounts are used due the significant number of $US-based mandates relative to other base currencies. Since the objective is to illustrate the benefits of diversification among styles, the choice of the base currency should arbitrary. Despite the fact that more of the accounts have unhedged benchmarks in the database, the industry has been moving toward the middle ground between the unhedged and fully hedged benchmarks, 50% being the natural and regret minimising choice. Having said that, the choice of the benchmark should be unique for each institutional client derived from an asset liability study under various currency hedging policies. The chosen symmetrical benchmark has the benefit of eliminating the performance bias, which comes up for polar benchmarks; i.e., fully hedged and unhedged. From a risk budgeting perspective, the move from an unhedged to a 50% hedged position results in significant volatility reductions. Nevertheless, as one moves further to a fully hedged position, this reduction gradually disappears.
Numerous studies have shown that investors do not always act in a rational manner, which makes the existing models irrelevant for many investment management decisions. Watson Wyatt’s ‘Structured Alpha’ concept addresses these behavioural issues by seeking to combine financial and non-financial factors in the design of manager structures for institutional portfolios. The purpose of this article is to illustrate the need for multi-manager structures in the active currency overlay programs. As the data shows the possible behavioural biases toward one style and/or currency overlay firm might result in unnecessary cash outflows, which would create a snowball effect during market crash-like environments.
The results indicate the importance of diversification among styles as a wrong selection of a currency overlay manager might end up being very costly to the plan sponsor. The allocation of the currency exposure to various managers also makes the resulting distribution more compact, an appealing property for risk-averse investors. Since the chosen time period is a function of the availability of useful data to perform this kind of analysis, the performance comparisons might be misleading. Figure 3 shows the monthly information ratios of five managers with the same policy benchmark, base currency, the degree of active management flexibility and time horizon, which spans from January of 1996 through December of 1999, along with the five randomly created portfolios that are equally weighted among three managers with different investment management styles. The range of information ratios for individual managers is between –0.02 to 0.23, whereas for the diversified portfolios between 0.04 and 0.2. If one is also concerned possible monthly minimum and maximum returns, diversified portfolios provide institutional investors with lower monthly drawdowns, as shown in Figure 4.
The main conclusion is that plan sponsors should definitely consider correlations among managers /investment styles before designing a currency overlay program. There are obvious benefits of structuring a currency overlay programme. To this end, product differentiation from an investment process perspective becomes a challenge for overlay managers, who work diligently to create new strategies to increase excess returns generated by active currency management component of the overall portfolio. The potential use of currency management as a portable alpha strategy also increases attention toward these specialist managers. Risk budgeting will open up doors for the managers with these product lines for it allows investors to combine portfolio rebalancing and restructuring from a total risk management perspective. Since active currency risk exists in portfolios with an allocation to foreign investments, the design of an active currency overlay structure could lead the way to enhanced returns with no increase in active risk
Institutional investors with long-term investment horizons such as pension plans with good funding levels and university endowments should seriously currency management as an asset class, which provides excellent portable alpha properties not found in any other investment product. If one is looking for a specialized niche to boost returns over policy benchmarks, the currency overlay area promises to be the next undiscovered yet full of potential layer in the institutional portfolios. The combination of these strategies with other long/short ideas seen in equity management opens up the door for alternative products to be assembled in the near future.
Brian Hersey and Kurtay Ogunc are with Watson Wyatt Investment Consulting in the US

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