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CalPERS will abandon passive currency hedging

Eric Baggesen said with passive hedging, net returns increased by only two basis points from the start of the program in June 1992 through June 2013.

22-year-old program contributed nothing to fund's bottom line

CalPERS is axing its 22-year-old passive currency hedging program because it has had almost no effect on the returns or volatility of the $282.5 billion pension fund.

In its place, the California Public Employees' Retirement System, Sacramento, will do active currency hedging, but has not set a start date.

The decision by officials of the nation's largest defined benefit plan to change course is contained in the fine print of a new asset allocation plan approved by CalPERS' board on Feb. 18.

That plan reduces global equity and private equity allocations, while it increases fixed-income and real estate allocations. But it also means CalPERS no longer will take a unilateral bet to protect currency fluctuations from hurting overseas investments.

The 15% passive hedge position placed on all non-U.S. investments — which make up 44% of the pension fund's total assets — will be lifted as part of the new asset allocation that is effective July 1.

Eric Baggesen, senior investment officer for asset allocation and risk management, said in an interview that under the passive currency hedging program, net returns increased by an annualized two basis points from inception in June 1992 through June 30, 2013. Return volatility was reduced by nine basis points during the same period.

Mr. Baggesen called the results ”statistically insignificant.”

The 15% hedge was adopted in December 2008. Before then, CalPERS had a 25% passive hedge but only on its foreign equity portfolio. The data provided by CalPERS covered both periods.

“What it really tells us is that we went through all this motion for over 20 years and basically ended up in the same place we started from,” Mr. Baggesen said. “When you're a very long-term investor, what's the point?”

Mr. Baggesen said that prior to 2008, the U.S. dollar had been declining relative to key foreign currencies, so the hedge wasn't paying off. Since 2008, he said, the dollar had been strengthening and the optimal hedge rate was growing larger and larger.

He said the passive hedge didn't make sense because the fund was hedging some currencies that were part of the total fund benchmark even though the fund had no actual exposure to them. In another example, CalPERS was hedging against the yen because it was part of the system's private equity benchmark, even though the private equity portfolio had no exposure to the yen.

Another reason the passive hedge is being eliminated is that CalPERS needs to maintain cash reserves for settlements of hedges, known as forwards, at a time when the pension fund faces cash shortfalls.

Even if CalPERS achieves it 7.5% assumed rate of return every year, the pension fund is projected to need $2 billion more to pay benefits beginning July 1, 2015, than its cash on hand is expected be. That shortfall is expected to grow to $17.9 billion by the 2039-2040 fiscal year, the retirement system's statistics show.

“Our ability to absorb cash flow volatility is rapidly diminishing,” a review of the currency program by CalPERS investment staff states. That review was presented to board members last September. Charts prepared for the investment board show the forward settlements ebb and flow, with money coming in and out, but the potential for a large payout in a particular month to settle forward contracts can occur.

The most CalPERS paid to settle forwards was $483 million in November 2009. Mr. Baggesen said the settlements even out over time, but CalPERs still needs to keep cash on hand for the potential of a settlement.

Not without controversy

The plan to end the passive hedge is not without controversy. CalPERS' general consultant Wilshire Associates recommended against it until an active hedging program can be put in place.

“The currency hedge has reduced risk slightly for CalPERS without decreasing returns,“ said Wilshire consultant Michael Schlachter in a Feb. 7 letter to the CalPERS board.

He said CalPERS is also managing its cash flow better even with a projected cash shortfall.

“Given the proven reduction in risk to CalPERS with no impact on return and a decreasing cash flow management program going forward, we believe that this program should be given more consideration for continuation,” he wrote.

Mr. Schlachter and Wilshire have been longtime advocates of an active hedging program for CalPERS. In 2008, when the CalPERS board implemented the 15% passive benchmark, Mr. Schlachter called for an active program that would be more dynamic in nature than CalPERS' staff's recommendation.

Mr. Baggesen supports active currency management, but said an implementation plan still needs to be decided by staff and then presented to the board for discussion over the next few months.

Mr. Baggesen said active currency management will force CalPERS' investment staff to take a position on whether it thinks the dollar will strengthen or weaken against foreign currencies.

“Then we will live or die with how well we do with our forecast,” he said. n

This article originally appeared in the March 3, 2014 print issue as, "CalPERS will abandon passive currency hedging".