Pooled funds have been an attractive proposition for wealthy individuals and smaller institutional investors for many years, due to their lower management fees and custodial costs when compared with separately managed accounts. Pooled funds are also available in a huge variety of investment strategies, including international investments. However, pooled fund investors have largely missed out on an important aspect of international investment – currency risk management.
From its birth in 1989, currency overlay management grew substantially as an international investment strategy throughout the 1990s. The main users have been large institutional investors, and separately managed accounts have been the rule. By contrast, very few mutual or pooled funds have employed such strategies, preferring instead to manage investments against unhedged currency benchmarks. There are several good reasons for this. First and foremost, most advisers manage against an unhedged benchmark because everyone else does. In the performance derby, managers cannot stray far from the pack for fear that they’ll substantially underperform the competition. Secondly, most managers’ investment processes neglect currencies and concentrate on their acumen for choosing stocks and bonds.
Of course, pooled fund managers could hire the expertise of currency overlay managers, subcontracting the decision on when to hedge currency risk. However, currency-hedging positions may pose several problems to both managers and investors. They may represent a walk away from the unhedged benchmark, which the manager may fear to take, lest they lose out to competitors. They may also represent an unwanted strategy to the investor who chooses an unhedged currency allocation. Thus, in a single fund, a manager cannot satisfy all parties.
An alternative might be for a fund manager to set up two classes of funds for each investment strategy – one unhedged, and the other with currency managed. The graphic illustrates the point for six investment strategies. Six new funds need to be created and administered; and these would only be for active management. What about investors desiring passive management? Another class of passively hedged funds would need to be launched.
Most fund managers have considerably more than six international investment strategies, and the global ones have clients from many currency bases. Imagine the complexity, then, if fund managers had to create passive and active currency managed funds for each of their international strategies and each of their investor bases. At a minimum it would triple or quadruple the number of their international offerings. No wonder that mutual and pooled fund managers have avoided the issue!
Is there an alternative? Perhaps. Rather than replicate all of their international offerings with currency managed versions for several currency bases, fund managers could set up currency risk pools to which investors, desiring currency management, could subscribe. They would appoint a currency overlay manager (COM) as a sub-adviser to the pools.
Let’s go back to our euro-based investor who chooses to allocate into six offerings – both small and large cap equities, plus bonds, in the US as well as Japan. In our first example, six extra funds for the currency managed strategy would need to be created. However, using currency risk pools for each currency pair would reduce the number to two.
The euro-based investor is concerned if the $ or the yen falls against their base currency. they could subscribe to the US$ vs Euro Managed Currency Risk Pool in an amount of their investments in the US funds, and to the Yen vs Euro Managed Currency Risk Pool for the amount in Japanese funds. As investment values change and funds flow in and out, the fund manager could automatically adjust the amounts assigned to the pools.
No additional funding would be necessary, since the pools are managed using forward contracts. However, the contracts need to be settled at maturity. If the COM sold the dollar forward and it fell in value, the hedging contract would generate funds in an amount sufficient to offset the now lower value of the US investments. The proceeds could be used to re-invest in the various US funds, taking them back to their original value. If the dollar went the other way, then the US investments would be worth more, and a portion could be sold to meet the losses on the forward contracts in the currency risk pool. In either case, the investor is back to the net starting position. Of course, the challenge for the COM is to hedge when currencies fall and not hedge when they rise. If successful, cumulative contract gains will exceed contract losses, and the investor will do better than being unhedged. The pools would be compared against an unhedged benchmark.
It could get slightly more complicated, but not impossible, if investors wanted passive currency management or had divergent hedging benchmarks. Suppose Euro Investor A invests $10m in the US small cap fund and wants an 80% hedged position against a euro currency benchmark. Euro Investor B invests an equal amount and selects 40% as the benchmark hedge ratio. How could each be accommodated?
Three pools could meet each investor’s goal. First, a passively hedged $ vs euro currency risk pool would be established. Investor A, with an 80% hedged policy position, would subscribe for $8m, while Investor B signs up for $4m to reflect the neutral 40% hedged choice. Each achieves his passive position by subscribing for a fractional amount of his investment equal to his benchmark choice.
But each investor has also opted for active currency management. Investor A wants to be completely hedged when the COM feels strongly that the dollar is falling, and unhedged when the COM believes it will rise. The COM can vary the hedges of the active $ vs euro risk pool between 0% and 100%, based upon the strength of their assessment that the $ is moving favourably or adversely against the Euro. If the COM is very confident that the $ is falling, they will hedge 100%. Investor A already has $8m hedged back into euros, and gets 100% hedged by subscribing for an additional $2m in the active pool.
On the other hand, when the COM is convinced the $ is rising, Investor A wants to be completely unhedged. By subscribing to a reciprocal euro vs. $ risk pool, in an amount equal to the passive pool, Investor A gets to a net unhedged position. With the $ rising and the euro falling, the COM hedges 0% of the $ vs euro pool and 100% of the euro vs $ pool. Investor A’s net position is: (see table)
q Pool Amount Action Passive $ vs € $8m short sold $, bought €
q Active $ vs € $0 no positions
q Active € vs $ $8m long sold €, bought $
q Net position $0 unhedged
The equal subscriptions in the passive and reciprocal active pools offset one another.
Investor B would achieve his goals by taking up similar subscriptions, but in different amounts to match his passive benchmark choice.
Further variations on currency hedging mandates could also be structured. For instance, if investors chose passive hedging, they’d select an amount equalling their entire investment. Also, cross-hedging and total return are popular diversification strategies employed by many COM’s which take positions not entirely related to underlying investments. A separate pool could be established for investors wishing such an approach. Managed currency funds are ideal in this respect, since they provide returns independent of underlying assets. The combination of an allocation to a passive pool and to a managed currency pool would provide results very similar to a sophisticated, separate-account, currency overlay mandate with a partially hedged benchmark, and cross-hedging and net long or net short positions permitted.

Credit Risk
Forward contracts entail a delivery risk and each counterparty to a contract must be satisfied with the other’s credit standing and ability to deliver the countervalue. If the currency risk pool were the counterparty, the trading banks would surely express some reservations about the credit risk as the risk pools would have no assets. Respective participants in the risk pools could pledge shares in the underlying investment funds to satisfy counterparties, but this might prove administratively complicated.
It may be easier for the pooled fund manager to extend a guarantee and/or pledge shares in the underlying liquid investment funds in a sufficient amount. In concept, this is a parallel structure existing in asset-backed securities and collateralised mortgage obligations. Fund investors would then indemnify the fund manager by pledging their shares in the investment funds, and would provide the right of automatic offset, placing the fund management firm in a relatively risk-free position when offering a guarantee, as it would have control of the collateral.
Why bother with all this? Shouldn’t the investor just approach a COM and set up an overlay programme for all international investments? Certainly, if exposed assets aggregate to an amount large enough to make a separate account cost-effective. However, the truth is that there are many smaller institutional and high net-worth investors for whom this is not the case, and it is this class of investor, which has been unable to embrace the best practices employed by their larger, first-class brethren. They have suffered higher risk and lower returns by not managing their currency risk. Pooled fund operators have provided them with first-class capability for managing their underlying investments. With imaginative arrangements they can afford the same first-class treatment for enhancing currency returns and mitigating currency risk.
Brian Strange is vice president at JP Morgan Fleming Asset Management in London brian.b.strange@jpmorganfleming.com

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