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Currency overlay was born in 1988 when US pension plan sponsors realised that their international investments had reaped un-usually large currency returns in 1985 into 1987 due to the dollar's steep decline.

As they became concerned that the dollar would begin to rise and produce losses instead, a handful of currency managers seized the opportunity and began to offer currency risk management as a separate investment product.

Pension funds initially 'experimented' with passively hedging a portion of their currency exposures since statistical studies indicated that equities and currencies correlated to a certain degree. Thus, it should be possible to determine an optimal 'hedge ratio' that could be maintained to optimise a pension plan's overall risk/return profile. However, as currency risk was studied in more detail by pension plan consultants, it was discovered that stable 'hedge ratios' did not exist. At the same time, pension plans with passive hedging programmes discovered that even though they reduced the volatility of the currency returns, it had merely been moved to the cash portion of their assets supporting these programmes. Whenever a hedge re-sulted in a gain, cash was received while cash had to be paid whenever a loss occurred. As a result, pension plans began to abandon passive hedging in favour of active currency overlay programmes with objectives of reducing currency risk and adding value over time from skill-based currency management.

Currency overlay was not em-braced as rapidly as the idea that portfolios should be diversified in-ternationally, partly because the dollar had historically been weak since the early 1970s and also because international money managers preferred to avoid discussing currency risk issues in depth when the move to diversify internationally got under way in the mid-1980s in the US. However, as cross- border investments grew in the 1990s, the currency risk increased proportionally relative to domestic assets. As a result, an increasing number of plan sponsors began to appoint currency overlay managers, while European pension funds began to make their first appointments in Belgium, the Netherlands and Spain.

As pension plan trustees gained experience investing across borders, they began to realise that currency risk is highly concentrated in most portfolios. From a European perspective, almost all of the risk is foundin the dollar and the yen, while from a US perspective, most of the risk resides in the yen, sterling, and the DM block of currencies. When the Euro is introduced, the risk will be even more concentrated, but it will not be diminished with respect to the yen and the dollar. Since this concentrated risk cannot be reduced by diversifying exposures into other currencies, pension plans found that to dilute the risk properly, it was necessary to build teams of overlay managers with different decision styles. The team approach reduced the risk of one manager or decision style un-derperforming in any particular year. Hence, many large pension plans now have teams of overlay managers that apply three basic decision styles: models, fundamental analysis, and dynamic hedging.

Although all currency managers do not fit neatly into one of the three categories, most of them aim to place hedges when currencies de-cline and then lift them when they rise. This investment process differs from traditional investment management in which the goal is to find securities that rise faster than a benchmark in a bull market and that fall less in a bear market. In currency management a premium is placed on timing skills. Given the different nature of the two proces-ses, it is not surprising that most international equity managers lack the necessary skills and processes to actively hedge currency exposures successfully over time. It is this weakness that has fuelled the emergence of some 20 currency overlay specialists. These firms and groups within investment firms manage the currency risk of portfolios for which the underlying assets are managed by traditional investment managers. Hence, the term 'overlay.'

Most currency specialists operate out of the US or the UK. While the growth in assets under management has been rapid, it has not matched the acceleration in commitments to international assets made by pension plans worldwide in recent years. With pension re-forms now under way in Europe and Japan, the number of currency ov-erlay managers, and the assets they manage, can be expected to continue to grow. Investing overseas without a currency risk programme in place is like crossing a street with closed eyes hoping for the best.

Alfred Bisset, is president, A G Bisset & Co in Connecticut.

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