WITH INSTITUTIONAL ASSET MANAGERS INCREASINGLY looking worldwide for sources of return, it seems like a no-brainer that they would pay more attention to currency risks. But most U.S. firms still leave their portfolios unhedged. “In the United States we have found that very few institutional investors have currency hedging programs in place,” says Michael DuCharme, senior currency strategist at Seattle-based investment adviser Russell Investments, which provides such programs. “We find that people in the United Kingdom, Europe, Asia and Australia are much more aware of these currency effects.”
Many U.S. asset managers have looked at the dollar’s movements over the past decade and concluded that “there is no point in hedging because over time it’s kind of a wash,” says Alan Kosan, head of alpha investment research at Darien, Connecticut–based advisory shop Segal Rogerscasey. Kosan’s firm and other specialists in currency risk don’t share that view.
James Wood-Collins, CEO of U.K.–based Record Currency Management, says that just five years ago U.S. pension funds would have had a strong bias toward U.S. equities and used the Standard & Poor’s 500 Index as their primary benchmark. But more recently, many U.S. asset managers have substantially increased the level of global stocks in their portfolios, so their currency exposure is far higher. Jay Love, Atlanta-based partner at investment advisory firm Mercer, says his company’s surveys of U.S. institutional investors clearly show that “there is a significant movement away from U.S.-centric investments toward more-globalized portfolios.”
According to Wood-Collins, whose firm has $32.5 billion under management: “We generally find that an international equity manager’s job is to be expert at equities. They all have different models, but relatively few equity managers would claim to be currency experts.”
Firms like Russell and Record offer two basic currency management programs to institutional investors. One is passive hedging aimed at reducing the currency exposure risk of a particular portfolio. If a fund manager is heavily invested in Europe, for example, the currency manager would sell euro forwards to reduce the risk. The second option is investing in currencies themselves as a separate source of excess return. For many years there’s been a debate about whether foreign currency constitutes a separate asset class. But even if that argument never gets settled, buying a basket of foreign currencies is now like investing in equities and bonds.
Wood-Collins estimates that 80 percent of his firm’s business is in passive hedging, but he says U.S. asset managers are showing more interest in active management, which Record calls dynamic hedging. A successful passive hedging program can reduce volatility in a portfolio by about 2 percent and add an average of 1 percent a year in returns over the long term, Wood-Collins explains.
Once a month or so, Record looks at its clients’ portfolios to see whether their currency exposure has changed and then buys currency forwards to cover that exposure. Wood-Collins says monthly analysis is probably best because more-frequent hedging runs up transaction costs.
Ian Toner, head of currency implementation at $159.1 billion-in-assets Russell, contends that active currency management makes more sense than passive hedging. Asset managers generally don’t choose what bonds to buy based on the equities they hold in their portfolios; similarly, they shouldn’t choose currencies based on what’s in their equity portfolio. For example, an asset manager with a portfolio that is 30 percent in European equities would hedge that position by selling euro forwards for 30 percent of the portfolio’s value, Toner says. But that’s wrongheaded, he asserts, because it doesn’t represent a neutral bet on currencies.
Instead, Toner urges clients to adopt what he calls a conscious currency program that buys forwards based on existing global foreign exchange benchmarks such as Deutsche Bank’s DB Currency Return Index. “You should decide whether you are overweight or underweight not relative to the equity markets but relative to the currency benchmark,” he says. “You can either replicate the market or do better than the market.”
Wood-Collins says his firm’s dynamic hedging program works differently, only going long the client’s base currency and never shorting more than 100 percent of currency exposure. It uses a proprietary trend-following model to purchase hedges day-to-day based on the client’s actual assets, not a benchmark. The trend-following model tries to predict where currencies are heading, so it sometimes leaves portfolios unhedged when it expects the base currency to appreciate.
“The bottom line is that investors should recognize the impact that currencies have on their portfolios,” says Segal Rogerscasey’s Kosan. “Managing currency through a strategic hedging policy or an active management program has the benefit of reducing volatility and preserves diversification.”
