'A guide to currency overlay management'
Deutsche Bank Global Markets Research has published a 70-page report titled ‘A Guide to Currency Overlay Management’. The report concludes that “investors and plan sponsors should consider increasing their focus on both the risk of, and the potential returns from FX” since “historical performance data suggest that active management of FX risk can significantly increase alpha”.
The report has 11 independent ‘articles’. Two are by pension consultants, InterSec Research Corp and William M Mercer Investment Consulting, which outline their findings, followed by the views of eight currency overlay specialists. They discuss the issues a plan sponsor needs to consider when a currency overlay program is implemented. Hoogovens Pension Fund then describes how it selected its team of overlay managers.
Pension funds began to focus on their currency risk in the late 1980s. That is when currency overlay was born. As Carol Parker of InterSec highlights in the report, InterSec forecasts “that the world’s pension funds will control cross-border assets totalling well over US$3trn by 2005.” It means one in five dollars in pension assets will be subject to currency risk. Hence, it is imperative that investors address how that risk is managed.
Sponsors like General Motors and Shell, in the Netherlands, which have been path-breakers in implementing overlay programmes, have found that equity managers did not have any skill in managing currencies effectively. David Knott of Deutsche Bank reports that InterSec has found that in its EAFE Plus performance universe of “over 100 representative manager portfolios”, no manager in that universe had “added implicit or total currency value to their portfolio performance” over the past 10 years.
InterSec’s study confirms that currency exposures must be managed independently by currency specialists. Harriet Richmond, head of currency management at JPMorgan Fleming Asset Management, points out that “there is little reason to believe that investors who excel at stock picking will also excel at currency management”. Bill Muysken, head manager of global research at William M Mercer, concurs, “Active currency management is worthy of serious consideration”.
The inability of EAFE managers to manage currencies effectively stands in stark contrast to the added returns currency managers have achieved in the past 10 years. Michael Collins of Deutsche Asset Management reports that “successful active currency management not only produces alpha, but tends to be uncorrelated with underlying portfolio returns”. And, he adds, “Active currency specialist managers have produced some impressive risk-adjusted returns. No other asset class has a median manager with an information ratio of 0.5.”
The returns overlay managers have produced are impressive. David Knott, editor of the report, points out that Watson Wyatt Worldwide, a leading pension consultant, has measured the results of over 200 currency overlay accounts from 20 leading overlay firms. As he put it, “Across all accounts they found that the average cumulative gain since inception was 1.5% (per year), and that Watson Wyatt had concluded, ‘active currency management can increase portfolio returns.”
Watson Wyatt has published its findings in IPE. In February 2001, Brian Hersey and Kurtay Ogunc described how to create currency overlay teams to reduce single manager risk and to boost the returns an overlay can provide.
Although overlay managers have different decision styles and disagree on whether the currency market is efficient or inefficient, they agree that investors need to appoint more than one manager. Alfred Bisset of our firm discussed why in the September 2000 issue of IPE. Since the dollar/euro tends to be the dominant cross-border currency risk, it is not prudent to have only one manager. Because any manager can underperform from time to time, a plan sponsor is not as protected against adverse currency movements as when the risk is spread across a team of managers.
It was to eliminate the single manager risk that Joost van der Kolk, of Hoogovens Pension Fund, created a search process that included comparing how pairs of overlay managers produced return and risk profiles that were suitable to Hoogovens’s particular risk preference.
The articles in the Deutsche Bank report by Record Currency Management, JP Morgan Fleming Asset Management, State Street Global Advisors, Deutsche Bank Asset Management, Lee Overlay Partners, Pareto Partners, FX Concepts and Bridgewater Associates provide important information on currency overlay programmes. However, a plan sponsor need not bother too much with strategic exposures or if currencies have a long-term return or not. In the past 30 years, the DM (now the euro) has changed in value against the dollar by more than 10%, up or down, in 60% of those years. Managing exposures with a team can reduce that risk while it can boost the return on cross-border investments with an average of 100 basis points or more, per year, over time.
The aim of Deutsche Bank’s report is to inform investors of the need to manage their currency risk and that overlay managers can do that effectively. Unfortunately, it did not list the 20 overlay managers who now report performance to consultants like Frank Russell on an ongoing basis. A plan sponsor may wish to also examine the records of our firm, Appleton Capital Management, Barclays Global Investors, BNY Overlay Associates, BT Fund Management, Credit Suisse Asset Management, First Quadrant, Gartmore Investment Management, Goldman Sachs Asset Management, Overlay Asset Management, Putnam Investments and SS Windham Capital for a complete view of the overlay industry.
Last, but not least, Deutsche Bank Asset Management will hopefully submit its overlay records to consultants to permit plan sponsors to measure how the bank’s performance compares with those of the leading firms in the currency overlay industry.
Ulf Lindahl is chief investment officer at A G Bisset & Co, based in Rowayton, CT