Paying heed to currency
The rationale for pension funds to manage currency comes from the mismatch between pensions assets and liabilities versus a base currency, Gumersindo Oliveros, director, pensions investments at the World Bank in Washington DC, pointed out.
As first to take the stand at IPE's e-symposium on the theme of currency, he said that while the risk created was clear, the rationale for pension funds to intervene was less clear.
This was because pension plans are supposed to take the long-term view, and the idea was that currency effects ought to wash out in the long term. "The reality, however, is different… pension boards can rarely afford to take 15-year plus views on risk," he said, adding that short-term effects of curve movements on portfolio performance could be quite substantial.
There are many ways a pension plan can implement currency management, he said. "Irrespective of whether currency should be seen as an asset class, currency risk… can be avoided and as such should be managed," he said.
"Hedge ratios can be fixed or dynamic… fixed when (the currency) moves against the manager and left open when it moves in his favour," he said, adding that plan sponsors should use more qualitative judgements to determine the hedge ratio.
"Each plan needs to consider a whole range of factors to reach a decision that is optimal in their case." The World Bank Pension Plan was one of the first pension plans to implement currency hedging in the late 1980s, said Oliveros. In 1996 it started adding the alpha component and since 2003, hedging and alpha mandates have been separate.
Five or six years ago, the question of whether currency was even a persistent source of alpha was very much a topic for debate, said Alexander de Giorgio, client portfolio manager at JP Morgan Asset Management.
"It's only been over the last two to three years that we've really seen a proliferation of managers offering stand-alone alpha products," and this because investors had become increasingly aware of the need to diversify, he said.
Traditionally, currency has been seen as a zero-sum game. But despite liquidity, forex markets demonstrate persistent inefficiencies which can be modelled, said de Giorgio. The three fundamental inefficiencies were higher volatility, forward rates and the fact the currency markets could trend over a long period.
Currency has a viable future in portfolios, he said. "What we've seen is that currency markets are expanding… they're evolving as they're deepening," he said.
What light can economic theory shed on currency and portfolio management? Asking the question, currency expert Bruno Solnik of HEP in Paris said there were many variables that influenced currency levels at any one time.
"But the basic result is that short-term changes in exchange rates are extremely hard to predict," he said. However, the major empirical findings on the topic of currency were that changes were quite volatile, that risk could be hedged cheaply, and that while risk was small in a well-diversified equities portfolio, it was significant in bond portfolios.
Also, currency changes showed virtually no correlation with equity or bond returns, and hedging did not materially change the correlation of domestic and foreign stocks, but increased the correlation of domestic and foreign bonds.
Portfolio investors might have accepted that international diversification brings benefits, but currency hedging is a sensitive decision, he said. "For an American investor, selling short the US dollar is emotional," he said.
Because of this, we need to look at the contribution of behavioural finance, said Solnik. He outlined ‘prospect theory' whereby disappointment/loss aversion leads to even more hedging - because investors hate losses even more than they love gains. Secondly, ‘regret theory' was a strong factor behind hedging decisions.
Regret is stronger than mere disappointment, said Solnik, and it was experienced relative to the best outcome of alternative choices that could have been made.
"Currency hedging is a dimension where regret applies," he said. Although a 50/50 currency hedge ratio was the one that was always going to be wrong, it was the one that minimised regret, he said.
The roundtable chaired by Andrea Canavesio, partner at MangustaRisk, looked at how pension funds implement currency management strategies.
Jean-Pierre Steiner, pension director of corporate pensions and risk services at Nestec/Nestlé in Switzerland, is responsible for SFR20bn (e12.7bn Swiss francs in pensions assets, administered as 240 pension plans and with close to 100 pension funds.
"IAS19 has an influence on the way we manage the fund and the currencies in particular," he said, because of its influence on the company balance sheet.
For practical reasons, it is difficult to go as far as a 100% currency hedge, he said. In Nestlé's case, the base currency was Swiss francs but a large proportion of investments were in euro. However, historically, volatility between these two units had been very low compared to Swiss franc/dollar, or even sterling or yen, he said. "The risk against the euro is so low we tend to ignore it."
Michel Tomas, investment director of PensPlan in Italy, said the plan used a system of manager of managers. "We believe in the objective of keeping a big part of our assets in euro because we will pay in euro," he said. About a third of the portfolio was non-euro, and this would be hedged when appropriate, he said.
A big part of the non-euro assets was in US dollars, and this currency was the major worry. "Only when we think the dollar will decline do we sell it forward," he said. Rothschild handles a currency overlay programme for the pension plan, he said. At KEVA, Finland's local government pensions institution, on the active side, the benchmark is fully hedged, said Karri Makitalo, senior portfolio manager.
Whether the mandate was active or passive, and whether it was managed internally or externally, there were definitely some benefits compared to the situation where nothing had been done, he said. "I believe that over a long period of time there should be some kind of value-added," he said.
Steiner commented that his fellow panellists seemed very confident in their market-timing skills - knowing when to hedge and when not to hedge.
"We have to watch the markets very carefully," Tomas responded. "But our results show us it's working." With diversified and quantitative approaches, KEVA used the data rather than trying to beat the market, said Makitalo. "But timing is the key to our success at the end of the day," he said.
Kicking off a series of overviews, looking at how major pension funds in various countries approached currency management, Edward Jögli of Wassum Investment Consulting said foreign currency exposure was a growing element within the equity investment of Swedish pension funds.
Swedish funds were decreasing the home bias and taking on more foreign currency exposure, he said. "Given that investors have foreign currency exposure in the equity portfolio, they tend to hedge it to a relative low extent," he said.
Investment in foreign fixed income was likely to increase in future, said Jögli. New legislation implemented this year meant pension funds would have to match their liabilities with assets. "Therefore they will have to look for longer-dated bonds than (exist) in the Swedish market," he said.
Average currency hedge ratios for fixed income among Swedish institutional investors were 100%, according to a recent survey, he said. For equities, the average hedge ratio was 18%, with national pension funds having the highest ratios. Only 10% of the survey's respondents used active currency management.
Before 2004 in Germany, under the Capital Investment Companies Act (KAGG), currency management using derivatives was only allowed for hedging currency exposure, explained Bernd Haferstock, partner and head of investment consulting at Buck Heissmann.
"Currency itself was seen more as a risk factor than an asset class with the likelihood of obtaining additional alpha," he said.
This changed with the Investment Modernisation Act, and there had been specialised currency mandates in Germany for some time now. Within the pensions environment, it was CTAs (Contractual Trust Arrangements) and support funds that benefited most from the new legislation, he said. "Nevertheless, Germany is still a ‘developing country' with regard to currency management," he said.
In the UK, pension funds still have a lot of equities, despite talk in the media about a shift towards bonds, said Anthony Ashton of consultants Hewitt Associates. "However, what we have seen is a significant shift out of UK equities and into… overseas equities," he said. With that shift, currency had become a much bigger risk to deal with.
Illustrating by using rolling 10-year volatilities of the MSCI World Index in sterling terms, hedged and unhedged, Ashton showed that hedging did reduce volatility. "But sometimes it is preferable to be unhedged," he pointed out.
The rationale for UK investors was that there were strong theoretical arguments for hedging. However hedging could give rise to a considerable level of cashflow disruption and there were transaction costs associated with that, he said.
Among UK pension funds, currency hedging benchmarks were typically set between 30% and 70%, he said.
Many Swiss pension funds use passive currency overlay, said Adrian Gautschi of consultants Complementa. As for active currency overlay, this was mainly used by large portfolios of SFR 500m
Swiss pension funds managed currencies in several different ways depending on what it was they were aiming to achieve and their motivation, he said. Currency management that treated currency as a new asset class was becoming of more interest to Swiss funds, and had recently gained widespread acceptance, he said.
The legal status for pension funds, however, was not yet clear. But if they declared it as an alternative investment, there would be no problem, he said. In the Netherlands, pension funds are focusing more sharply on financial risk management due to the country's ageing population, low solvency ratios and upcoming regulations, said Rik Ghejsels of Cardano Risk Management.
Currency hedging seemed efficient to the funds, but the question was, which hedge ratio should they adopt? Right now, 30% of Dutch funds hedged 100%, 50% opted for a 50% hedge and 20% had no hedge at all. Large funds, said Ghejsels, were hedging 100% whereas small funds tended to do nothing.
"Almost all large to medium-sized Dutch funds use strategic currency hedges," he said, "And we expect an increase in the number of Dutch funds using currency management."
The new FTK regime would define a buffer on every risk taken, and this included currency risk. "This definition gives more focus to the risk you are taking," he said.
Tackling the crucial question of whether currency overlay managers add value, Nick Rogers, technical consultant at Mellon Analytical
Solutions, began by giving some historical data. Active currency overlay accounts had risen to 680 in December from 241 in June 1999, however the average gain had declined to 83 basis points from 106.
The falls, though, reflected the very bad year that currency managers had in 2005, he explained.
Looking at why currency risk has been ignored by pension funds, Rogers said trustees had been reluctant to touch currency, which was seen as an unregulated, highly-leveraged and highly volatile market.
In the past, he said, there had been no uniform way of measuring performance, however Mellon Analytical Solutions has used three approaches to get around issues of performance - each, though, with a number of limitations that needed to be overcome.
The three approaches were excess returns, composite analysis of total returns and universe analysis. "We have to make sure we're making simple like-for-like comparisons," he said.
Mercer has seen a lot of client interest in currency overlay recently, said Bill Muysken, global head of research at Mercer Investment Consulting. In three years to the end of 2005, the consultancy had carried out 44 currency manager selections, accounting for $15.1bn (e11.7bn) of assets.
There are 117 currency managers listed in the Mercer Global Investment Manager database, he said. "But the universe of potential currency managers is so large, it wouldn't be cost effective to try to research all of them in depth," he said.
The firm's four-factor manager evaluation framework covered the four things it believed a manager needed to be able to do in order to outperform reasonably consistently over time. These were: idea generation, portfolio construction, implementation and business management, he said.
Passing on tips for conducting due diligence meetings with managers, Muysken said it was important to prepare well beforehand and know something about the manager rather than starting from scratch. "Try not to be too threatening," he advised. "If there's a really difficult question you've got to ask, leave it to the end so it doesn't spoil the meeting."
The global currency markets are huge, Eric Busay, currency overlay and international fixed income portfolio manager at CalPERS, pointed out, with trading volume of around $1.9trn per day. And players within the markets had different objectives - they were either ‘price takers' or ‘price anticipators'.
Price takers needed to transact and assumed that the market is efficient, while price anticipators believed the forward price of a currency was not what would actually be realised. On the question of whether there was potential return from active currency, Busay pointed to studies by Russell Mellon and Watson Wyatt which have indicated that currency managers are able to extract value from the market.
There were, however, a number of points investors needed to consider with currency hedging and management, including the time horizon and whether a multi-asset hedge or a single asset hedge was needed. Also, should there be diversification over time or style?
"Then you have the active/passive decision, and you must realise that inactivity in itself is a decision," he warned. "You end up having a currency position if you take on international investment." Changing a hedge ratio was an active decision, and it was important to realise that, he said.
In response to a question, Busay said that CalPERS had changed the way it looked at currency and now saw it as a source of alpha as well as merely a risk-reduction measure.
Emerging market currencies may offer extra opportunities for currency managers to extract alpha, according to Paolo Pasquariello, assistant professor of finance at Ross School of Business at the University of Michigan.
"Emerging currencies are special because of their much greater likelihood to experience a crisis," he told the e-symposium. When planning a global forex portfolio, currency crises and stress events should be defined in an objective and conceptually meaningful way, and effort should be made to explain and predict such events, he said.