Perfect for harder times
In this tough environment for pension funds, Robert Meijer finds there is increasing interest in the area where he offers his specialist advice – that of currency management, at both the strategic and tactical allocation level.
Whether you are talking the Netherlands, where he is based, or elsewhere, many funds are under-funded or close to it and there is a strong appetite for “risk-free returns”, says this former treasurer of the Shell Pension Fund, who was responsible for introducing its successful approach to currency management in the 1990s.
“At the strategic level, currency hedging is a perfect risk-reduction tool at times of pension funds deficits. It takes away risk in portfolios, enabling funds to take risks elsewhere.” But this decision that has to be taken at the strategic level and not at the portfolio manager level, which makes it ultimately a board decision he maintains. “Nor should it be a decision that is left over to the currency overlay manager themselves.” Generally, they favour an internal benchmark of 50% hedging, as here they can add value in most regimes, he observes.
But in recent dollar euro conditions, this was difficult. Here, the answer can be cross hedging and taking long and short positions. “Such ‘over hedging’ enable excess performance against the benchmark, since, for example, you can hedge up to 200%.”
Rather than changing the benchmark, he prefers a free hedging approach. “It is better to allow for net longs and net shorts. You achieve the same as you would in terms of excess performance with a 50/50 hedge, but the protection you receive from a free hedge benchmark is obviously much higher.” Meijer describes ‘net longs and net shorts’ as being “half way to an alpha product. You still use a fully hedged benchmark, but you allow for more than the underlying”.
“Currency alpha products are perfect instruments for pension funds to use, being negative with equities and having a low but positive correlation with bonds,” he says. “The new currency alpha products will enhance the growth of the overlay market.”
There is a significant difference between strategic hedging at the ALM level and active currency overlay, which is a tactical approach to making returns out of currency. While there is greater acceptance of hedging techniques at the strategic level among pension funds, there is only a small number using currency overlay as an active tool.
He thinks that people are caught up in the belief that currencies are a zero sum game long run. “While I subscribe to this, at the same time active management can add value in the short term. A positive information ratio of 0.5 is the normal return expectation.”
But hedging strategies and currency management techniques do have their costs too, he points out. “While the cost of a forward is minimal, just a few basis points, what normally concerns investors is the fee of the currency overlay manager.” But there is a big difference between these fees and those of a traditional asset manager, or hedge fund mangers. “The fee is normally between 15 and 25 basis points for a currency overlay manager and for an alpha product it will be higher, but much lower than a hedge fund manager, though it uses similar approaches.”
So whether the decision to do the currency management in-house or externally, Meijer points to the need to have services like those a prime broker provides to the hedge fund industry.
“There is no need for larger funds to do it in-house. It is better to make use of the services in the marketplace, which are ideal for currency overlay,” he maintains. “It makes much of the implementation easier, as you can leave many of the governance issues to the service provider.” The risk monitoring in particular can be left to the prime broker, provided they are made accountable.
The aim is to make the whole back office processes of risk monitoring much more transparent. Meijer believes that one of the biggest problems in gaining acceptance for currency management with plan sponsors is convincing them that the back office is off the premises and fully outsourced.
When implementing a currency programme, more attention needs to be paid to the management structures. “Going through a test period first, with the external accountant to look at the local control structure before starting,” he says. Pension fund trustees and boards need to be sure that everything is under control.
“Educating the board is probably the most important aspect of implementation. This is underestimated by the market, in particular the time it takes to get aboard and to understand the full consequences of the currency overlay concept and the appropriate benchmark decision,” says Meijer.