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Pension funds are increasingly considering investing in currency hedge funds instead of using a currency overlay programme. Emmanuel Acar, head of London Risk Management Advisory at Bank of America, says this is one of the trends emerging in the currency management sphere.
“Pension funds are now considering allocating to currency hedge funds rather than currency overlay,” he says. “The reason being that they realise most of the currency overlay programmes are by their nature constrained, meaning they can only marginally depart from an underlying currency exposure, which is fixed and imposed on the currency overlay manager.
“From the currency overlay manager’s perspective, it is not a choice, it is a constraint,” he says. The two main constraints - the currency allocation and the hedge ratio - will affect the performance that the currency overlay manager can deliver, he says. “It’s well known that the information ratio delivered by constrained currency overlay programmes are lower than those on unconstrained overlays.”
Such constraints are damaging and so, whenever you can get rid of them, it is a good thing. Now pension funds are realising that they can allocate to currency hedge funds instead of currency overlay programmes, while still managing and quantifying risk.
Acar says that pension funds can get as good an understanding of the risk taken by the hedge fund manager, as that of a currency overlay manager.
Before going down the hedge fund route, ideally a pension fund would quantify currency risk and decide how much risk reduction and/or return enhancement it wants to achieve. Passive hedging could be implemented mostly for risk reduction purposes, this would in turn free a risk budget that can be allocated to active currency management. Additional active risk may be sought to correspond with high alpha objectives. The implementation question can finally be asked: overlay or hedge fund?
In the past 15 months, there has been an additional advantage in allocating to an unconstrained currency hedge fund. Once the decision has been taken by the trustees or board to allocate to such a hedge fund, then it becomes very clear that the goal is to add alpha. This leaves the way open to compare the different hedge fund managers and their programmes.
Whereas currency overlay programmes are not easy to compare, because they are tailored to the currency hedging requirements of a specific client or specific portfolio, hedge funds share the single goal of achieving high risk adjusted returns.
“It is a very competitive market,” says Acar. “You cannot hide behind your constraints.”
This is why currency overlay managers are now beginning to launch their own currency hedge funds, he says. “Because they know it meets the demand from pension funds for alpha transparency and portability.”

However, David Buckle of Merrill Lynch Investment Managers, argues that currency overlays can offer the same kind of returns that currency hedge funds can.
“It can be the case that constraints impact on performance, particularly if they’re very restrictive,” he says. It is possible for pension funds to do their hedging separately from the return-enhancing currency management they put in place, and this can do free the currency manager up.
“You can do hedging separately, but I’d dispute that going to a hedge fund was the only possibility of adding_value,” he says. A popular solution is to allow the currency manager to run an unrestricted, segregated account.
“The advantage of having a segregated account is that you can still choose specifically which positions you would like to take,” he says. For example, you can choose not to take positions in the Polish Zloty or Brazilian Real. You can also decide how much is buy in any one currency, opting, for instance, to limit US dollar to 10% of the exposure. In this way, segregated accounts give you a level of control that is impossible when simply buying into an existing hedge fund.
“Alternatively, if you invest in a hedge fund, the administration is a lot easier, but you lose control,” he says.

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