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“The argument for currency overlay from the UK perspective is just as strong, just as valid, and just as logical as from the US or any base currency perspective,” says Adrian Lee, founder of Dublin-based Lee Overlay Partners, an active manager that positions itself primarily as a value-enhancer, as well as a risk mitigator. “I am at a loss as to why it hasn’t taken off. It is only a matter of time.” Describing currency overlay as “a necessary speciality who’s time has come,” Lee says trustees face three major choices on currency risk which should be made explicitly, or they will be made implicitly through inaction. “Not making these choices explicitly is, in itself, a risky option,” he warns. First is to decide how much strategic currency exposure is desirable. “If you have 30 per cent international exposure, you start with 30 per cent currency risk. You have to take it as part of the deal, but currency overlay unwraps the risk,” he says. The second decision is on active versus passive management of that risk – which may not be clear-cut. “Regardless of the preference, active management is taking place when a portfolio manager decides to underweight the US. That is a dollar bet as much as any other.” The third question is: who makes currency decisions? The equity or asset manager, or a specialist? “If you allow an equity manager to make currency decisions, you may receive sub-optimal outcomes,” Mr Lee suggests. Neil Record, chairman and chief executive of Record Treasury Management, attempts to distil the reasons for why currency overlay has not taken off as quickly in the UK as it has elsewhere. “A combination of factors has held it back, led by peer group benchmarking, which obscures currency risk,” he says. “Trustees tend to have the view that you take a risk by diverging from the peer group. Unfortunately that opinion ignores the fact that the peer group lost a lot of money in the late 1990s as a result of the strength of the pound.” In recent months index-driven funds moved into the majority, exposing currency risk, but Bill Muysken, head of global manager research at WM Mercer Investment Consulting, says it could be a lingering factor. “Up until ten years ago, a typical UK pension fund was benchmarked against a peer group, and everybody assumed currency exposure was unhedged. That has been changing, and the number of large plans benchmarked against a peer group must be in the minority now. But even funds with their own specific benchmarks still give some thought to peer group benchmarks.” Mercer cites two reasons for adopting a currency overlay strategy, which it says is suitable for funds with at least £30m invested internationally. “On a strategic level, we think it makes sense to have a partially hedged benchmark for international equities, because it is less risky than an unhedged benchmark,” Mr Muysken says. “The second reason is that we think active currency management has good prospects for adding value. If a pension fund is going to pursue active management in any way, shape or form, we think active currency management is a type they ought to consider.” Record says the benefits of currency management are overwhelming. “If measured against what most funds are doing now with currency – leaving it unhedged – we can reduce the volatility and increase the return. It is the only asset allocation change that can do that.” Any way you cut the analyses, he claims, currency managers’ aggregate performance record shows that trustees will reduce risk against sterling-denominated liabilities by hedging their currency risk, and his own firm, an active manager, has produced added value across its 18-year history. “We do it by exploiting the well-known inefficiency known as trends,” he explains. Others use different approaches. “We have a reactive, non-forecasting, model-based approach which we expect to outperform fundamental approaches over time,” says Kevin Bailey, co-managing director, of BNY Overlay Associates, part of the Bank of New York. “It is not so much about managing risk – you do that incidentally. We are of the camp that believes running a currency overlay programme can add significant value.” Bob Collie, director of consulting at Frank Russell, says his company’s work has found that currency managers, as a group, have performed “reasonably well in most active manager situations,” and praises the skills of the incumbents. “A lot of participants in the currency markets have different objectives than them, so it is easy to see why they can do well.” However, unlike Mercer, Frank Russell is not suggesting that all sizeable UK funds pursue a currency hedging strategy, at least not yet. “Is this performance something that is just interesting, or is it something that funds should actually start to exploit?” he asks. “That is what we are looking into now. We are discussing currency overlay with some of the largest, most sophisticated funds, but we are a long way from recommending that all funds should start currency overlay.” Frank Russell took a more bullish stance a year ago, when, along with Mercer, Bacon & Woodrow, and Watson Wyatt on the consulting side, and Lee Overlay, Record Treasury, and Pareto Partners from the managers side found consensus during a round table discussion of currency issues for UK pension funds. All
seven agreed that: However, the bigger barrier, it seems, is more insidious. “Part of it is just inertia. It takes a long time to change old habits,” he adds. Frank Russell’s Collie says there are all sorts of barriers to implementing a currency overlay programme – he cites possible distortion of the overall strategy, cash flow implications, the need to ensure multiple managers’ decisions are aligned, and the simple reality of having another manager to deal with – but he says these are probably surmountable challenges. The greater blockages are inertia and fashion, he agrees. “What funds ought to do, based on sound investment strategy and what funds actually do, varies wildly,” says Collie. “There is a large element of fashion and flavour-of-the-month in the decisions they make. Even if our conclusion is that currency overlay is good and that they should do it, there is no guarantee that all funds will.” BACK
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