As European pension funds stretch out in search of international diversification, they expose themselves to significant foreign currency risk. For example, a 15% depreciation in a typical currency basket with a 10% international allocation means a 1.5% performance hit. This is not uncommon and begs the question, why don’t investors pay more attention to currency management?
As things stand, managed currency portfolios tend to be lumped together with alternative investments. There is a substantial market (daily turnover of $1trn) conducted on the forward foreign exchanges, which are the province of the currency overlay specialists. Separately, there are formal fund structures available providing the ability to manage currency exposure and benefit from currency market opportunities.
Whether an institution is using currency overlay or a more formal managed currency fund, it is important to recognise that these portfolios carry an element of risk not dissimilar to equity or bond portfolios, but with little correlation. A currency fund is not another liquidity fund. Rather, it seeks to profit from currency movement, providing the potential for higher returns than offered by cash deposits and further diversification of equity and bond portfolios. These funds are not as widely used as other asset classes, but do have a genuine role to play for pension fund clients.
With the increase in equity exposure among European institutions and with the advent of the Euro, there is a need for greater diversification. This raises the problem of investors being forced to hold assets in unfamiliar markets and as a result assuming higher levels of risk. Paul Thompson at Goldman Sachs, which offers currency funds based in US dollars and euros, says the attractions of these funds are the low correlation with traditional equity and bond investment: “At any time, these investments can rise or fall in value, but currency funds act much like a hedge fund in that you have the ability to make profits in all market conditions.”
Goldman Sachs runs a team of analysts to assess currency market opportunities. It also uses a market model with clear risk guidelines so that it can tailor portfolios to suit institutional parameters. An institution investing predominantly in euro assets would choose the euro fund and would incur little direct currency risk outside of the assets held by the fund. The essential difference between a managed currency fund and a currency overlay service is that the former tends towards the risk control side of currency management, while the latter can be more opportunistic, attempting to make gains on forecast moves in currency markets.
Harriet Richmond, managing director and head of the currency management team at JP Morgan in London, says: “The reason people have been excited to invest in this way is that if you get some unusually attractive returns.” JP Morgan offers a currency funds service, dollar-based, for investments upwards of $50,000. Richmond says it is most suitable for an investor who wants access to Morgan’s currency expertise but can’t afford a currency overlay programme.
The JP Morgan Managed Currency Fund aims for a return of one-month US dollar Libor plus an alpha of 5–10%, net of fees. So this is no ordinary currency fund; Richmond says it is the first time a JP Morgan fund has used leverage and the first time the funds have levied a performance fee. The reason is simple: to market this fund effectively, you need to have a target return and playing the currency markets you are not going to generate the sort of returns promised by this fund. As a result the manager has the ability to go overweight or underweight by 300%. The 20% performance fee is charged on any outperformance above the target net of fees. This fund is not available in the UK.
Currency management is becoming a more important consideration for pension funds as they increase their holding of overseas assets. The question is still to what extent they understand the significant currency risk they have adopted. Unfortunately, the majority of long equity fund managers seem to care little about the intricacies of currency management, in view of the consequences of making bad decisions on the currency side.
There is also a school of thought that the impact of currencies is small and tends to cancel itself out over the longer term. This has a ring of truth to it at times of dollar weakness such as we saw from 1985–95, the so-called “free lunch” period where the currency contribution to international equity returns was 114%. But this trend has since been reversed. In the last six months, enquiries from institutions and consultants have increased, according to Gartmore’s senior investment manager James Binny: “Many of the consultants do not possess key data on this area. They are now coming to ask for it. It hasn’t yet generated many extra mandates, but certainly the momentum for change is there.”
Pension plans in the US will usually employ a specialist to manage their currency risk. In Europe, Dutch pension funds use currency overlay quite extensively. Why don’t institutions use currency overlay more?
Certainly if you have more than 10% invested in overseas assets, the diversification, relatively speaking, is not worth the risk, so overlay is desirable.
Foreign players investing in euro assets this year have been heavily exposed to the depreciation of the currency, losing 15% in the process.
Binny comments, “If we go back to Markowitz and portfolio theory, there’s no justification for accepting short-term volatility for the sake of long-term gain.”
Currency overlay as an industry has been running for 10 years without capturing the imagination of investors. Until recently there was no conclusive proof that it added any value. But in 1998, currency trading analyst Brian Strange, now with Key Fund Management, showed that the average currency overlay manager added 1.6% a year of alpha, relative to a given benchmark. So not only had the strategy eliminated currency risk, but also added something positive to the top line return. Even taking into account that fees will come into the equation, there is still justification for using a currency overlay of some description.
So for investors the choice is either a pooled currency fund or a full overlay service, adopting maybe a fully hedged strategy, or perhaps a 50% hedge approach, allowing the manager to play both sides of the benchmark for additional alpha.
Richard Newell is a director of Forsyth Partners