Ten or 15 years ago the world seemed a simpler place. "Most trustees were not interested in currency as a source of risk or return and had no reason to be because they hardly invested abroad," recalls Neil Record, founder and chief executive of Record Treasury Management. Corporate treasuries led the way, looking to the hedge multi-national currency risks off their balance sheets. Across Europe, notably in the UK and Netherlands, diversification by pension funds into assets denominated in foreign currencies gathered pace only during the 90s.

"There is no a priori limit beyond which a pension fund must start hedging currency risk," says Diane Miller, senior investment consultant at Mercer Investment Consulting, "but uncompensated risk builds up as foreign exposures increase".

Risk, in this context, is the relative volatility of assets and liabilities. The dollar or yen may be down, but pensions still need to be paid in euros and sterling.

By the late 90s large pension funds were making strategic allocations to assets denominated in foreign currencies via specialist mandates. Bond managers tended to hedge their currency risk, but many equity managers lacked and still lack this capability. "Passive hedging of at least some of this risk offered a means of reducing aggregate uncompensated risk and particularly of portfolio volatility relative to that of liabilities," recalls John Collins, senior consultant and head of currency research at Watson Wyatt Investment Consulting.

A passive overlay is not about alpha generation and is always about the relative value of a single currency pair. It is also directly linked to physical assets, stocks, bonds, commodities and so on, that are owned by the pension fund. For instance, a passive hedge of 110% is a 100% passive hedge combined with a 10% active bet on the relevant currency pair.

Passive hedging back into the currency in which pension liabilities are denominated functions like an insurance policy. In the years when foreign assets fall in value because their currency of denomination is weak relative to that of the liability currency, the pension fund receives compensatory cash flow.

This will match part or all of the fall in these asset values depending on the extent to which this risk has been hedged as a ratio of their balance sheet cost. The cost of passive hedging varies depending on the currency pairs in question. For instance, the expected total cost of a standard dollar based passive 100% hedge is 13.4 basis points (bps), composed from a rolling cost of 2.1bps, rebalancing cost of 1.3bps and cash flow transaction cost of 9.9bps, according to Record Treasury Management.

Passive overlays need to be rolled over and in the very long run any currency pair always trades back to parity. Positive and negative cash flows generated over the same period will cancel each out.

If there are no liabilities or if these are already matched by assets denominated in the same currency, there is no value added by a passive overlay. But given the inefficient nature of currency markets, overlay managers have noticed that they could take more active bets on currency pairs. These could provide the same "insurance" for investors, but permit the manager greater freedom to trade a wider set of currency pairs as a means of generating some alpha on top of the required passive hedge.

If successful, this new alpha component would pay some or all of the cost of the passive overlay, generate some excess returns, and let the currency manager charge big, performance-based fees. Fewer and fewer overlay providers are prepared to offer passive overlays on a stand alone basis; it is not a profitable business for them.

Active overlays also evolved towards the aggregation of currency risk into a single account. Instead of running a series of separate passive overlays, albeit often from the same provider, a single active overlay could be run to compensate for part or all of a scheme's aggregate currency liability. Both types of overlay can be constructed with capital efficiency and without disturbing the asset allocation of a portfolio.

They do not require capital up-front, and can use a cash or equity benchmark such as the S&P500 with an outperformance target above the benchmark. Like passive overlays, active ones require an agreed risk budget, expressed as a tracking error against a benchmark. Active overlays continue to be linked to underlying physical assets owned by the pension fund, but they weaken this link by introducing alpha to the equation of managing currency risk.

By the 90s, investment banks,
CTAs, hedge funds and a motley
array of boutiques were already trading currency for alpha , unconstrained by any other assets or liabilities. A large body of academic research had accrued, arguing with plausibility that currency could be traded for alpha on a sustainable basis.

After the equity market bear market of 2000 to 2003, pension funds and their consultants were belatedly applying the lessons of portfolio theory to scheme assets. A key driver behind this has been the move to marking scheme liabilities to market. There has also been wider use of scheme specific risk budgeting and the application of notions such as portable alpha. These disparate changes, arriving over a relatively short period, have made currency for alpha acceptable as a "new" asset class for pension funds.

Here a little caution is needed. Comparing currency for alpha to either passive or active currency overlays is like comparing chalk with cheese. Matters are complicated by the frequent description of currency for alpha as an overlay.

Passive and most active overlays are run on a segregated client specific basis, currency for alpha typically in a pooled fund basis. This is because these alpha funds are scalable, with economies of scale, designed as efficient portfolios with a frontier that comprises a set of return characteristics that the provider expects to fit into investor risk budgets. Whereas overlays are capital efficient, these unitised funds are not. The investor is required to put forward capital, but their downside risk is limited to the amount invested.

 

urrency for alpha funds will typically use a LIBOR, LIBID or other cash benchmark on an absolute return basis. "These funds are purely about manager skill, a genuine source of alpha," judges Colin Robertson, senior investment consultant at Hewitt Associates. Expect them to target an information ratio ranging from 0.5 to 1.25. Annualised volatility can vary enormously from as little as 5% to 30%. The most popular lie in the range of 25% to 30% because of the way they are used by pension funds. This is also where currency for alpha is described as an overlay product in a quite different sense to the use of the term when describing passive or active overlays. Consultants describe currency for alpha as an overlay relative to the beta in the aggregate pension fund portfolio and not relative to the currency of denomination of any assets held in the portfolio.

Arguments for investing in currency for alpha use a set formula. Suppose total active risk in the portfolio is 2%. Trustees decide to allocate 33% of this active risk to currency for alpha. If the selected fund targets an active risk of 15%, this is then divided by 33% to yield an allocation of 4.95% of scheme assets.

More volatile funds permit a lower allocation, hence their popularity with trustees. Of course, the amount allocated will vary according to the level of active risk accepted by trustees at the overall fund level.

"It is therefore quite possible for a pension fund to have no currency passive or active overlays but an allocation to currency for alpha, or to run 100% currency overlays without any allocation to currency for alpha," says Collins. The current paradigm is for most pension funds to run a combination of the two; passive hedges of 50% to 100% and a separate 1-3% allocation to currency for alpha. Needless to say there are volumes of proprietary and academic data on the correlation of asset classes which demonstrate the potential benefits of including currency for alpha in a portfolio.For instance, ABN Amro present five year data to the end of 2006, showing a correlation of the Barclays Currency Traders index of 0.08 to the MSCI World index, 0.28 to the Credit Suisse Tremont Hedge Fund index, and 0.60 to the JP Morgan Global Government Bond index. Adding currency as an asset class rather than an overlay is a useful source of further portfolio diversification.

"The question is whether we can afford to leave currency out of our portfolio," judges Chris van Gent, investment director at Dutch industry wide scheme Metalektro, "alpha currency can now be bought easily on a stand along basis or as part of a global tactical asset allocation overlay."

The build up of pension scheme money in overlays and currency for alpha funds has been very rapid. Some participants now express doubts over whether this could end badly. "Take UK pension funds," argues Ulf Lindhal, vice-president at AG Bisset & Co, "which have enjoyed positive cash flows from their passive overlays year in and year out for the past ten years."

Over the same period, sterling has been strong against both the dollar and the euro. According to Lindhal, the strength of sterling is just another currency trend that must soon turn.

"At that point trustees will become very unhappy about having to pay out for five or 10 years to meet the cost of their passive overlays," he adds. AG Bisset & Co argues that passive overlays should be converted to active ones and investment into currency for alpha funds scaled back.