It is not certain whether the currency risk of an equity portfolio can be hedged effectively. Martin Steward assesses this and pension funds' changing approaches to currency risk

No one buys a foreign currency bond (except local currency emerging market issues) without also buying a currency hedge. Because bonds exhibit quite low volatility, the extra volatility of foreign exchange (FX) movements on top are enough to swamp the active decision to buy those bonds. Pension funds have generally not had to worry about that because their fixed income managers have FX specialists dedicated to managing that exogenous risk. The same cannot be said for most equity mandates, where it has largely been assumed that higher inherent volatility renders the problem of FX volatility less urgent.

But as institutional portfolios have become more international, investors have scrutinised that assumption more closely. FX volatility levels out at about 10% annualised, so a fund with 40% overseas exposure could see a one standard deviation event wipe out 4% of overall return - easily enough to destroy every alpha decision in the portfolio. And last year's turmoil has concentrated minds further: even given the exceptional volatility of equity markets, the equally storm-tossed FX markets meant that, for example, US institutions saw a strengthening dollar double their losses on UK and Australian equities.
"For most base currencies there is no material penalty on the return for hedging, and a material reduction in volatility," says Neil Record, CEO of $30bn (€22bn) FX specialist Record Currency Management, the man who literally wrote the book on currency overlay in 2003.

This was the "free lunch" described in a well-thumbed 1988 paper by André Perold and Evan Schulman, that underpins a widely-held view in the pensions community: currency risk is unrewarded, so it makes no sense to let it chew up chunks of your risk budget that could be profitably spent elsewhere. But is that strictly true? Perold and Schulman identified long-term market inefficiencies that argue for currency risk premia - such as investors being unable to diversify their FX risk, for example - and others since have observed that purchasing power parity exchange rates often deviate from market rates in the shorter term. Furthermore, recent empirical research from MSCI Barra finds that excess returns from inefficiencies such as these are usually accompanied by greater risk - suggesting that hedging is not necessarily a free lunch and that maintaining FX risk exposure could sometimes be beneficial.

More specifically, MSCI Barra found that, from the perspective of simply reducing risk, Japanese yen (JPY)-based investors have benefited from hedging across all time horizons and all other foreign markets, while all investors into US dollar (USD) markets have benefited, regardless of their base currency. But those were the only clear-cut results - cost and benefit everywhere else has varied according to the investor's base currency, the currency into which they've bought, and the time horizon considered. The USD-based investor buying a global basket has benefited from hedging for one or three months, but not for six or 12 months. On a three-month horizon, USD- and euro (EUR)-based investors have benefited from hedging but Australian dollar (AUD)-based investors have not. And we are talking about big effects here: the JPY-based buyer of USD equities got 32% risk reduction from hedging, while the AUD-based buyer of Japanese equities saw risk increase by 15%. Clearly, the decision whether or not to hedge at all needs to take account of how these three variables - base currency, asset currency, time horizon - aggregate across an investor's international portfolio.

The research also looks at the risk-adjusted nature of the excess return generated by FX exposure by comparing information ratios (IRs) across the same three variables. The results were clearer and clustered around base currencies. JPY-based investors got negative IRs across all markets and hedging horizons, while EUR- and AUD-based investors enjoyed IRs that were positive across all horizons and all markets except sterling (GBP) equities. USD-based investors only got positive IRs when they were hedging their JPY exposures. Again, the IRs were significant, even though the experiment was conducted exclusively with passive hedges.

The cases of (anti-cyclical) JPY-based and (pro-cyclical) AUD-based investors in particular demonstrate how different the hedging decision might be, depending on whether you are concerned solely with reducing risk, or are equally concerned with how that might also reduce your equity-allocation returns. This is obvious to anyone starting from the standard CAPM framework - but if you approach the problem assuming you get that free lunch, the question might not even get asked.

Even if you hedge passively, you have more choice than just hedging 100% of your exposure or 0%, of course - and the factors already discussed should play a role in defining your optimal hedge ratio.

"If you're measuring risk relative to sterling liabilities you could argue that you should be hedged 100%," says John Hastings a partner with Hymans Robertson. "But in terms of portfolio efficiency you are probably best-off leaving the first 15% of your equity positions unhedged - because after all you get a bit of diversification from playing USD as well as just US equities. That's why most people say that a 75% to 100% hedge is the way to go."

In fact, hardly anyone hedges at their true optimal ratio. Most cluster around either 50% or 75% and waste little time with intricate regression analyses. Setting the hedge ratio "is not strictly scientific", says Rashid Hoosenally, global head of FX structuring at Deutsche Bank; "50% is, I think, shorthand for something between 0% and 100%," says Constantine Ponticos of currency manager Pareto Partners. Any hedge involves significant cash flows: if your equity allocation profits from an FX move your hedge obviously makes a proportionate loss, which then has to be funded from elsewhere in the portfolio, introducing transaction costs. The higher the hedge ratio, the more volatile these cash flows.

"Some investors have come back and said they don't think it makes much difference, and once you get into discussing the cash flow issues you do start to question whether it's all worth it," Hastings says.

"The intangibles like hiring a manager, paying a manager, dealing with the cash flows and coping with the problem of the instability of your optimal hedge ratio - it could turn to be a disaster over a short period of two or three years, and many boards don't have the stomach to deal with those heavy cash flows when things go against them," agrees Putnam Investments' head of currency Parker King. "Generally people have been erring on the side of less hedging rather than more."

This makes perfect sense because the relationship between the hedge ratio and risk-reduction is non-linear: almost 70% of the available risk-reduction can be achieved by hedging at 50%.

"Even taking into account only marginal costs, that's efficient enough," says Record. "Like a lot of things in life it's better to be approximately right than exactly wrong."

There is no reason why you should stick rigorously to your chosen hedge ratio, and given the "instability" King refers to - the correlation of your equity with its equivalent FX pair - it might seem foolish to do so.

"We at Pareto say that there is a benefit to hedging actively," says Ponticos. "We advocate retaining the risk-reducing negative-correlation effect of a hedging programme while trying to introduce some asymmetry into the cash flows - to be as hedged as possible into the base currency when it is strong and to try to get out of the way when it is weak by taking off the hedges."

That feels obvious. Sometimes it makes sense to bet against your home currency. As Elizabeth Para, currency strategist with Overlay Asset Management, puts it: "Why blindly hedge sterling at 50% if you have a strong view on sterling?" The London Borough of Islington Pension Fund found this out when a ‘systems error' at Goldman Sachs Asset Management meant that the forward contracts hedging 50% of the FX risk on £200m worth of equities were not rolled for Q3 2008: the plummeting pound netted the fund £6m. Most sterling investors have not had to gamble with Murphy's Law to learn the lesson: many put passive hedges on in 2006, after global equity returns of 11% were all but wiped out by FX moves, only to see sterling weakness eat away at those hedging positions in 2008.

Most overlay providers, like Pareto, offer some variant of active hedging. Record sees a lot of interest from its USD-based clients in "the tactical element" (the MSCI Barra research indicates why); Deutsche Bank is readying a kind of semi-passive product with a "split hedge ratio", set at the higher or lower level, depending on which way clients' exposures are moving; and State Street Global Advisors is about to bring its "dynamic strategic hedging programme", which it has been developing with a large public pension plan user since 2006, to the wider market.

"It tries to quantify how undervalued the base currency is against the portfolio basket," explains senior currency product engineer Monica Fan. "And if sterling is extremely misvalued against the yen, for example, you'd have a different hedge ratio than you'd have on, say, GBP/USD. They'd be adjusted depending on how far away from fair valuation the model thinks each pair is, and it also takes into account overshooting - the further you are away from fair value the faster you are likely to revert - and it therefore also generates alpha."

But is that alpha really desirable? If MSCI Barra's research is correct, an investor is already taking an active decision to hedge (or not) in the first place; by making that hedge dynamic, another active layer gets added and the hedge is taken further away from the original object of negative correlation with the underlying equities' FX exposures. Of course you could look at it from the other side - if there are currency risk premia, then why focus on hedging? Surely energy should be spent harvesting those premia on the one hand and managing them to generate alpha on the other? And if that is the object, constraining your manager to a currency benchmark just because it matches your equity exposures starts to look very odd. What other reason could there be for making him sell every other currency against just one - the base currency? Does it make sense for a EUR-based investor to allow active management of EUR/USD and EUR/GBP positions, but not GBP/USD? Currencies like AUD, NOK and SGD can present pretty racy opportunities, both long and short, but probably represent tiny proportions of investors' equity allocations.

"If you want someone to generate alpha in currencies, it doesn't make sense to ask them to do it 60% of the time in dollars and 30% of the time in euros," says Para.

"When managers come in to manage currency risk against a benchmark, the questions are: ‘Are we allowed to go net short; and are we allowed to hold currencies that are not in the benchmark?'" notes Thanos Papasavvas, head of currency management with Investec Asset Management. "If the answer to both of those is ‘yes', in the name of efficient portfolios, then why not clean the whole thing up and allocate risk to a separate funded alpha solution?"

Torquil Wheatley, head of currency solutions for pension funds and insurers at Deutsche Bank, observes that the traditional, constrained way of doing overlay is being seen less and less: "People have realised that it's highly inefficient to limit the opportunity set for alpha generation."

His colleague, Hoosenally, agrees that setting an FX hedge ratio and deciding whether or not FX might be a worthwhile way to spend some risk budget are two separate and distinct processes: "The only thing they have in common is that they both have the word ‘FX'," he says.

The sceptic might say that this suits a bank very well - split the two decisions up and the bank can use its access to liquidity to keep the costs of the mechanical passive hedging down (while foisting wider bid/ask spreads onto currency managers); and, in the case of Deutsche Bank, use its FX-Select active currency fund platform to generate revenue from the client's alpha demand. But it does reflect a broader industry trend for greater emphasis on funded, alpha-generating mandates which do not reference the underlying portfolio. Often, these stand alone and where there is a separate hedging mandate it is now usually of the passive-50% variety.

"Hedging merged into absolute return, and now they've divided again," says Record. "In the UK we had probably 20 clients who hired us for absolute return and then added: ‘Oh, by the way, the consultant said that we should hedge our internationals, too'. And that has generally gone back to something very straightforward - the base currency which is always long in the forwards and the invested currencies which are always short in the forwards. Whatever the merits of that, it has been good for us in that those who have terminated the absolute return have generally retained the hedging."

Record, whose firm's carry-trade tilt has given some clients pause over the past year, is in the minority when he expresses relief that he retains the hedging revenues. By contrast, the growing legion of currency alpha specialists who want to see pension funds look beyond the institutions that do their hedging when they come to select for alpha have an interest in this division of labour.

"In my opinion, hedging and absolute return should be completely separate," says Bob Arends, Henderson Global Investors' new head of currency management, whose alpha-focused team was tempted away from Fortis Bank in the teeth of other offers from the hedge fund world. As a member of the investment strategy team at the Shell Pension Fund, Arends went through the process of putting on a passive hedge and then smarting at the losses when foreign currencies strengthened; but at Fortis he was among those who pioneered the turn away from active overlay, replacing it with the bipartite, passive hedge plus alpha structure described by Record. "As soon as you move away from passive overlay you are into alpha territory, in my opinion, and the best model for overlay can be very different from the best model for alpha."

Splitting the alpha section off makes obvious sense. But why has that been accompanied by a return to passive hedging? It feels like a default setting for investors neglected by managers who are no longer interested in active mandates with any kind of constraints (which hedging mandates necessarily impose). As Arends puts it, the best models for hedging can be very different from the best models for alpha-generation. He is right in all the best academic senses, but he is also right in the commercial sense - successful alpha models pull in much more revenue than hedging models. That's fine, but now that the FX industry has convinced the pensions community to take a spin in its Ferrari, it is important not to neglect the maintenance of the Volvo in the garage.

It is certainly dangerous if investors start to think that a currency alpha mandate will do the job of hedging its underlying FX exposures. Only one person IPE spoke to - Ponticos at Pareto Partners - warned that an active risk that is unrelated to pre-existing risk threatens to "confuse the objectives", and that "in some circumstances" an active hedging programme could be more beneficial than a passive hedge plus alpha programme, simply because a profitable bet on, say, the New Zealand dollar, might do nothing to offset the negative cash flow associated with being hedged passively into the base currency.

The MSCI Barra research confirms most people's suspicion that passive hedging was never a free lunch. It implies that for some investors, going to market unhedged may be the best solution; that for most, some kind of dynamic hedge ratio would be best; and that the increasingly popular passive hedge is optimal for no-one (not even the perennially anti-cyclical Japanese). It may be that dynamic hedging products from banks (like Deutsche) or institutional managers sitting next to large custodians (like SSgA) offer the best solution in this area where specialist managers no longer want to be constrained. But one thing is for sure: more work needs to be done to ensure that pension funds are getting this more prosaic part of the currency-management solution right.