It used to be that currency management was low down on the priority list for pension funds. Many argued that currency was a zero sum game, and not worth looking at. Now of course, all this has changed. Pension funds are focusing on matching assets and liabilities, and are looking at their risk budgets, and the risk from underlying base currencies. Many have adopted innovative approaches to currency as a result.
“Explicit currency management is spreading much more widely than it was even three years ago,” explains Georg Inderst, an independent pension fund consultant. He points out that even medium-size pension funds have put hedging policies in place, or have some sort of currency overlay manager. “In the good old days, when pension funds had balanced managers, currency would have been the balanced manager’s problem. Now, as pension funds go international, they have had to think about the hedging approach, and ask whether they wanted foreign currency exposure or not,” he points out.
It is hardly surprising then, to see the amount of mandates being tendered by pension funds. Recently, the £8.5bn (€12.6bn) Strathclyde Pension Fund, which looks after public sector workers in the west of Scotland, hedged the currency risk on its investments for the first time, and awarded £150m in active currency overlay mandates to Mellon Capital Management, Millennium Global Investments and Record Currency Management. Another Scottish scheme, the £2.4bn City of Edinburgh Lothian Pension Fund, has also hired three managers for an £800m active currency overlay programme. AG Bisset, and Record Currency Management, both specialists, won the tender alongside JP Morgan Asset Management.
“We changed our allocation away from UK to overseas, which meant we had to take into account currency risk and how to mitigate it. There is also a need for consistency in employer contributions, so currency management is a way to manage risk without moving from equities to bonds, for example,” explains a spokeswoman at the fund.
With pension fund interest at a record high, the industry is booming. Mercer Investment Consulting, for example, was responsible for 44 currency manager selections, accounting for $15.1bn of assets, in the three years to 2005. Record Currency Management says its assets almost tripled in the past five years, although it declines to give specific asset figures. Other managers are quickly launching currency teams and products. Earlier this year, AllianceBernstein announced its plans to create a currency management operation, and AXA Investment Managers made two senior hires from Barclays Global Investors, recruiting Andrew Dales and Jean-Philippe Gruvel to launch its currency business.
“At the beginning, many managers decided to wait and see. The last couple of years have really shown that pension funds want to use currency strategies, and so many managers are coming to the party,” says one consultant.
Hedging your bets
Pension funds are approaching currencies in many different ways. Passive hedging, the traditional approach, varies in the amount actually hedged, depending on the asset class and the fund itself. In its 2004 report Rethinking Currency Hedging, the Pictet Strategic Advisory Group argued that the hedge ratio for foreign bonds should be between 70% and 100%, while other asset classes, such as equities, property, and hedge funds, should range from 30% to 80%.
Whatever the percentage, the passive hedge clearly has an upper limit, points out Scott Jamieson, a senior investment consultant at Hymans Robertson, the UK firm. “There is no point in hedging more than you’ve got. From a risk perspective it is possible to demonstrate that actually, the minimum risk result from passive hedging tends to be a proportion somewhat less than 100%, typically at 50-70%, depending on the assumptions you use from a risk perspective.”
He believes that selecting currency talent is the same as selecting managers in other areas. “Fundamentally, it shouldn’t be any different. It is about the business platform, the quality of the people, and the rigour of the investment process.”
An active approach
More and more, however, pension funds are looking at active solutions. “A lot of pension funds have shortfalls and they are looking at various ways of adding alpha to the portfolio,” says Pierre Lequeux, head of currency management at ABN Amro Asset Management.
Other managers agree. “In the last three years, our prospective clients have moved to adopting an approach of pure currency alpha. Our most common mandate now is from an investor who five years ago would have chosen an active ‘insurance-type’ overlay and now uses a passive hedge with a currency alpha approach on top of that,” explains Robert Bloom, portfolio manager at Record. He argues that pension funds are giving managers more room to make money from the asset class. “With currency alpha, we have a wider set of currencies and the ability to go short the home currency. We can also be active in amounts that best diversify and add value, as opposed to the using the exact currency weights associated with the client’s international assets,” he says.
Pension funds often add alpha through a currency overlay programme that uses derivatives like forwards and is typically implemented independently of the underlying asset class. They can also access alpha through using currency as its own strategy, one that is often deployed by global macro hedge funds as the third component of the fund - bonds, equity and currency, says a report from Goldman Sachs Asset Management (GSAM). And with the advent of high volatility currency funds, active currency management has become more accessible, says the report.
However, not all pension funds are convinced. One large European scheme doesn’t have an active approach because its chief investment officer says managers have still to demonstrate that they can make money consistently over time.
For his part, Inderst believes it is a legitimate concern. “In my view there are still not recognised standards of performance measurement. People use different strategies to try to create alpha. Some would do very short term intra-day trading, while others take a view on a long-term trend, and we don’t want to compare apples and pears. You have to go through and say, it’s not just a question of adding 2% per annum, but a question of, how did the manager add it. Many pension funds are sceptical about these things and still believe that currency is a zero sum game. You get it right sometimes, and wrong sometimes.”
It is an argument that irks active managers. Andy Bound, head of fundamental currency strategy at GSAM argues that there is evidence to the contrary. “We have an established track record over the past 15 years that suggests currency is potentially a good source of active return. If you look at the data compiled by consultants, it’s not the case that the top five managers add value and everyone else loses. The currency markets are inherently inefficient, providing opportunity for active managers to exploit. According to a Russell/Mellon study, 87% of currency overlay accounts generated excess positive returns over five years.”
The firm argues that not only are currency markets both highly liquid and inefficient, but at $1.9trn a day, currency markets are the world’s single largest capital market, dwarfing both bond and equity markets in daily trading volume. GSAM also points out that long-term active currency returns are not correlated to the economic factors driving equity and bond returns.
In fact, the information ratio that the firm has generated in active currency is about 1 over its 15 year-period. Other managers say their information ratios range from 0.7-0.9.
But Inderst believes there are other factors to consider. “There has to be big picture consistency in the hedging programme. You may have a currency overlay manager, and then you may have a specialist fund manager in emerging markets who has the ability to trade currency. So on one level you might be hedging the dollar exposure out, and then someone else might hedge it in. So you’re spending a lot of money doing inconsistent things. You need to take an overview with currency.”
It is an argument that pension funds do acknowledge. “We carefully select managers and we try to diversify styles properly so that they don’t neutralise each other. We try to have uncorrelated alpha, because if managers neutralise each other’s exposure and we still have to pay fees for it, then that would be an issue,” says Gerlof de Vrij, head of global tactical asset allocation at the €200bn Dutch scheme ABP. He believes that pension funds should select a few good currency managers, rather than selecting too many just for the sake of diversification.
Other managers say it is a case of looking at the advantages of the strategy. PME, the industry-wide pension fund for the Dutch engineering sector, and the third largest scheme in the country, says that there is always a danger that different managers doing different strategies will cancel each other’s alpha out. But, points out the fund, the trading costs are so low that the benefit of having different views is higher.
But both managers and pension funds agree on one thing. Currency management is getting more and more sophisticated, and in a market where every basis point counts, and risk budgeting is paramount, it is likely to be embraced by a wider array of institutional investors. “I think currencies will be big business in the future, because it’s something that started very recently. The pension industry is expected to grow strongly because of demographics, and we know that funds are looking to increase their risk/return profiles. So every kind of asset class that can generate a positive return has a bright future,” says Thomas Kressin, a portfolio manager at Pacific Investment Management Company (Pimco).