Mitigating cross-border concerns
In the decade since the first issue of IPE, investors have become keenly aware that the currency risk attached to their investment allocations has a substantial and continuous impact on their returns.
For example, UK pension plans invested in US equities, which rose 13.6% in 2006, saw that return erased by the dollar’s 12.3% drop against sterling. The experience was similar for investors based in euro and it was not confined to investments in the US.
As Japanese equities rose, the yen’s decline against the euro and sterling more than erased the equity gain. However, US investors profited since the euro rose and enhanced their European investment returns.
Despite large changes in the value of currencies from year to year, many investors continue to incorrectly believe currency is a “zero-sum” game and leave their exposures unmanaged (at their peril).
In the long run, they believe (and hope) that the back and forth of currencies will have little impact. This is in stark contrast to companies operating internationally. Every treasurer knows that profitability can be crucially impacted by currencies and FX risk management is a universal practice.
IPE has published numerous articles on currency (see IPE’s archive) and has followed the evolution of the currency management industry. Some facts stand out.
The most important fact is that currencies can be managed profitably. Numerous studies by pension consultants have found this to be true. A decade ago, there was little data on the results overlay managers had achieved. That changed with Frank Russell’s industry-wide study of overlay managers published in May 2000 (currently continued by Mellon Analytical Solutions). It found the average currency overlay manager had produced excess returns that annualized around 1%. That figure has been confirmed in updated studies and by other consultants.
Since currency specialists can add value, the optimal solution to the currency risk problem is to implement an active currency overlay programme; it can reduced losses when currencies decline and permit participation in gains when currencies rise, producing return, risk and cash-flow profiles that are superior to those of passive hedging strategies.
Equally clear is the fact that the currency exposure in most portfolios is concentrated in three of the four major currencies (dollar, euro, sterling and yen) depending on an investor’s base currency.
The concentration is usually 70% to 80% and is not diversified and the risk cannot be practically diversified by hedging into other currencies. Appointing a single currency manager for portfolios with 20% to 30% invested across borders is therefore risky. To mitigate the single manager risk it has become common practice to appoint at least two currency specialists.
This also improves the probability of reaping an excess return similar or higher than the annualised 1% reported for the average manager.
A 2006 survey by Hymans Robertson, a UK consultant, of the 20 largest institutional currency managers found they had £280bn (€425bn) in assets under management.
Some 40% (£112bn or €169bn) was in active overlay programmes designed to reduce currency losses while also adding some return, or alpha.
That is still a relatively small percentage of total pension assets invested across borders, but assets under management will no doubt grow as evidenced by last year’s high number of UK pension plans seeking to appoint currency specialists.
The awareness that currencies can provide returns that are largely uncorrelated with those of equities and fixed income has led to a surge of assets moving into currency funds (pooled vehicles), as well as into segregated currency alpha programmes implemented as overlays.
A study by Amy Middleton, vice president, Portfolio and Risk Strategy at Bank of America, found that 40% of the 100+ pure currency programmes tracked by Barclay Trading Group were launched in the last three years. Assets under management surged from $2bn to $15bn. Middleton also found that 82% of the managers employed trend-following strategies.
The Barclay Currency Index tracks the performance of those currency programmes. Each programme is equally weighted in the index at the start of each year and returns are computed net of fees and unadjusted for different levels of leverage applied.
As shown in the graph below, the average currency manager has had two difficult years; the index moved sideways in 2005-2006 - not unlike the period of 1993-1994, which was followed by several years of strong returns.
The rapid growth and increased interest in currency management have led to some confusion as to what strategies investors should adopt.
First and foremost, the considerable currency risk that is associated with cross-border investments needs to be address and managed.
However, since overlays add most value in periods when currencies decline and they are hedged, the excess returns overlays achieve are periodic.
In years when currencies trend higher, an overlay manager will be largely unhedged. Although a portfolio will benefit from currencies rising, there is usually little, if any, excess return added at that time.
As a result, investors increasingly seek to have overlay programmes that can generate alpha in both up and down currency markets employing managers who can implement cross-hedging strategies, etc that can also generate added value when currencies rise.
Enhanced currency overlay programmes should not be confused with currency alpha programmes, which are usually included as an investment in the alternative asset space.
Here, investors seek to benefit from the uncorrelated returns currencies can provide with allocations that tend to be a fraction of the currency exposures they have associated with their international investments.
It is important to recognise that currency alpha programmes do not substitute for currency overlays designed to reduce the risk of pre-existing currency exposures. Investors can benefit and can have both. Another distinction is between currency funds and currency alpha programmes implemented as an overlay. When an investor buys into a currency fund, or fund of fund, structured as a hedge fund or pooled vehicle, the expected return needs to be higher than that of the assets sold to invest in the fund if the aim is to enhance a portfolio’s total return.
However, when an alpha programme is implemented as an overlay, but with no regard to any pre-existing currency exposure, the expected return need not be higher than those of assets currently included in a portfolio. Why? In overlays it is usually not necessary to invest any money up front since positions are established using currency forward contracts through FX trading lines set up at financial institutions.
To illustrate: assuming the expected return for a portfolio is 8%, then a 5% allocation to a currency fund must provide a return of more than 8% to increase the total return.
If the fund return is 10%, the incremental return for the total portfolio is 0.1%. However, if a 5% allocation is made to a segregated alpha programme implemented as an overlay, which returns 5%, that return is added on top of the other returns, and this strategy, although having a return half of that of the currency fund, enhances the portfolio’s total return by 0.25%. The overlay approach to seeking currency alpha may not be the first one that comes to investors’ minds, but it may be one that is preferable in terms of the actual return enhancement achieved over time.
Finally, although IPE has followed the growth of the currency management industry and currency management has become as accepted as investing internationally, the goal-post has not been reached.
Investors and their consultants need to accept the inevitable logic: when searching for international equity managers, those searches need to be coupled with simultaneous searches for currency specialists to ensure that the currency risk is managed professionally as soon as the international investments are funded.
Ulf Lindahl is chief investment officer at AG Bisset & Co, Rowayton CT