Each year, our firm, a currency overlay manager, undertake a survey of US pension plans to establish their views on international investing and currency risk. We have now carried out four of these surveys, and so are getting a clear view on how US pension plans' concerns and plans are changing over time, and can contrast this with the situation existing on this side of the Atlantic. In doing so we can perhaps foresee some of the issues that may arise as European plans consider the currency risks which they face.
Today the US pension plan market is responsible for over $7trn in assets. Of this total about 10% is invested internationally. The growth in international investment can be seen especially clearly when you consider that the allocation was close to zero in 1980. This is confirmed in our survey, which reveals that nearly 38% of the respondents have more than 20% invested outside the US. However, we may have gone past the peak flow of investments moving out from the US as there is clear evidence from the survey that fewer funds expect to increase their international allocations in the coming year as compared with last year (18% as against 58%). Indeed individual funds that we have talked to have actually reduced their overseas holdings figuring that they can get their international exposure through their US stocks.
So why have US funds invested abroad? The primary reason is to diversify their portfolios. Nearly half cite this whilst less than a quarter are looking for additional return. This coming from funds in a country with nearly 50% of the world's stockmarket capitalisation. From a European perspective where our stock markets are a fraction of the size, range and depth of the US, this must surely put international diversification close to the top of our funds' objectives. Reducing risk also features for Americans, whereas I wonder how many European funds would include it as a major concern.
The US view of currency risk is one which is likely to have many sympathisers on this side of the pond. Over 60% of the respondents believed that currency risk was unimportant in the long run, with neithera major positive or negative impact - a form of the 'zero sum game' line of argument. Less than 20% viewed it as an unacceptable risk to be managed. This view of currency risk is probably heavily linked to the benchmark that most US plans espouse for their international programmes. In our survey over 80% of plans use an unhedged benchmark for measuring the performance of their international equity portfolios. Using an unhedged benchmark removes the need for measuring currency variations over each reporting period, which just adds unnecessary complexity if your underlying belief is that currency movements balance out over time. Even more interesting is that more funds are using unhedged benchmarks now than a year ago, according to the survey results.
Despite this, about 80% of the funds' managers (both equity and fixed income) implement currency hedges - which is somewhat surprising given the views expressed earlier - although there is a growth in the restrictions on their activities. It is even more surprising when you consider that studies show no systematic positive contribution being made in currency decisions taken by equity managers.
Another surprising result is that the US seem to have become less interested in currency overlay despite rising international exposures and a strong dollar depressing international investment returns. This can perhaps be traced back to the benchmark issue and the view of currency as zero sum.
What can we learn from the US experience? Coming through all of the results is an element of contradiction about how currencies affect fund performance and how they should be managed. This is the area in which I think that European funds would be well advised to concentrate. At its heart is the analysis of currency effects and the choice of benchmark for international investment programmes.
Given the currency volatility that we have seen over the past few years (and which continues as I am writing this) and the way that it can obscure other performance issues, I feel that currency attribution is a critical part of the overall process. This then leads to benchmark choice. Given the higher international exposures seen in Europe, a move towards hedged benchmarks would seem to be more appropriate. This then would focus minds on currency activity as you need a passive hedge just to match the benchmark. From here an informed evaluation of currency overlay strategies is only a small step.
Les Halpin is chief executive, Record Treasury Management in Windsor