Pension fund consultants have found a currency overlay programme can increase global portfolio returns by 100–150 basis points a year while reducing currency risk. Impressed by these results, Frank Russell Company recently concluded in a research commentary, “The combination of positive success ratios, consistent excess returns, and low tracking errors present an intriguing case for considering active currency overlay strategies to enhance an investor’s global portfolio.”
In an earlier study of overlay managers, Watson Wyatt International Consulting also found that overlay managers had produced high added values relative to client-selected benchmarks. The authors of the study concluded, “It is reasonable to segregate the currency and asset decisions because the properties of currency are so distinct from those of financial assets.”
Currency overlay emerged, soon after US pension funds began to invest globally in the mid-1980s, as a way to manage currency risk independently of underlying assets. Some 25 money management firms now offer currency overlay programmes. But how should a plan sponsor select the ‘best’ manager? What criteria should it apply in the selection process?
Plan sponsors have seen currency overlay as a method to reduce the portion of the volatility in investment returns caused by fluctuating exchange rates. As a result, they have preferred overlay managers that provided risk reduction or dynamic hedging strategies. However, this preference is changing. Pension funds in America and Europe increasingly look to select managers that can add high extra returns.
Overlay managers can be ranked by the added value they have produced, but high returns are not the sole criteria for selecting one manager over another. As in other manager selections the process and the people are also important factors to consider. However, since the currency risk is highly concentrated in most global investment portfolios, pension funds need to work with two or three overlay managers to control risk.
The birth of the euro reduced the currency universe to four major currencies – or three key currencies, since one of the four acts as an investor’s base currency (Figure 1). For pension funds in Europe and the US, the dominant risk is the dollar/euro exchange rate. As a result, it is risky to appoint only one currency overlay manager. The failure to place or lift a hedge on a large exposure in a timely fashion can result in a loss that is hard to recoup. For example, when the Japanese yen jumped 16% against the dollar in October 1998, some overlay managers remained hedged. As a result, their clients did not benefit from the yen’s rise. That is an extreme example, perhaps, but it highlights the risk of working with only one overlay manager.
Currency managers can be sorted into three basic decision styles. Overlay managers that focus on producing high returns tend to be model-driven, while risk reducers tend to hedge dynamically. The third group attempts to forecast currencies with fundamental economic research.
When Frank Russell examined the returns of the 18 leading overlay firms with $85bn (e93.7bn) under management, its currency analysts found that all of the overlay managers had been successful over the long term. However, the added value they produced varied from year to year. The variation in the returns highlights why it is risky to rely on only one overlay manager when the currency risk is concentrated in only three major exposures.
Working with a team of two overlay managers reduces the manager risk while it increases the probability that the overlay returns will not deviate too much from the benchmark return in the short-term. The selection of a two-manager team can be guided by the correlation of their returns. Not much research has been done in this area. However, Ranga Nathan at Sakura Dellscher in Chicago has demonstrated it is preferable if two overlay managers have a high correlation over the long term and a low correlation in the short term.
A combination of high returns and a high correlation over the long term indicates both managers successfully identified the major currency trends and that they placed and lifted hedges correctly most of the time.
However, it is desirable that two managers have a low correlation in the short term, since it indicates they normally differ in the timing of placing and removing currency hedges. These timing differences can be due to the rapidity with which their models or research react to new trends. Since a new trend may not be sustained, differences in the timing of hedges provide some protection against one manager acting too soon or too late at a perceived turning point.
Working with a two-manager team may appear complicated. However, by assigning 50% of the currency exposure to each manager, a pension fund can deal with its two overlay managers independently, just as it manages value and growth managers independently to diversify risk among equity managers and to benefit from their special skills.
The high added values that currency overlay managers have achieved over the past 10 years, working with different base currencies, benchmarks and exposures, highlight the fact that plan sponsors need to consider adding an overlay programme to boost global returns while reducing the risk of currency losses. Since a pension fund with international investments has already assumed the currency risk, why not manage it effectively? Adding an overlay programme involves little additional risk but the potential extra return can be large.
Alfred G Bisset is president of AG Bisset & Co, based in Rowayton, Connecticutt