Currency overlay managers last year came to the aid of many non-U.S. equities investors - including the pension funds of Mobil Oil and American Airlines - as the dollar's climb sheared international returns.
The approximately $2.5 billion pension fund of Mobil Oil Co., Fairfax, Va., fared well with currency overlay protection. With currency overlay, Mobil's international equity portfolio gained between four and five percentage points above the unhedged return of about 11% to 12%, said Donald Hellyer, manager, benefits finance.
Mobil has 20% to 25% of its pension assets in international equities, an unusually high allocation. The fund uses London-based Pareto Partners for currency overlay.
And it uses an unhedged currency benchmark to measure the performance of its non-U.S. equities.
"Pareto has done a good job for us," Mr. Hellyer said.
During the first 11 months of 1997, currency overlay added 2.7 percentage points in return to the approximately $200 million in hedged international equities in two American Airlines pension funds. (The two pension funds have a combined $8.1 billion in assets.)
Late in the year, Dallas-Fort Worth-based American doubled to four its number of currency overlay managers. It also expanded the percent of equities with currency overlay coverage to about 60% of its $1.2 billion in international equities in the plans.
Currency overlay management's returns "have been above our expectations," said Nancy Eckl, vice president of AMR Investment Services, which oversees the pension funds. She acknowledged AMR's use of an unhedged currency benchmark and the rising dollar created "an ideal environment to produce above-average returns."
Still, astute currency management proved critical last year to the overall showing of non-U.S. stocks.
Overall, non-U.S. equity returns were weak, and the rising dollar further trimmed performance. In this environment, currency hedging provided a reprieve.
As Jack Burlbaugh, president of Currency Management Inc., Rockville, Md., summed up, investors "needed their currency manager this past year to protect non-U.S. investments with a good overlay program. A lot of investors are saying, 'This was a really good year for my currency overlay guys' - when in reality it may or may not have been better than other years."
Of course, portfolios with the highest hedging ratios would have been best served last year. Returns of the Morgan Stanley Capital International Europe Australasia Far East index underscore the point. In 1997, the hedged EAFE index without dividends rose 13.7%, vs. 0.2% for the unhedged EAFE index. In '96, the hedged EAFE rose 11.77%; the unhedged, 4.4%.
But in 1994 - when the dollar declined - the unhedged EAFE returned 6.24%, compared with -3.06% for the hedged EAFE barometer.
Last year, individual currency overlay managers turned in some impressive showings. However, comparisons among them are difficult because managers present their returns in different fashions.
State Street Global Advisors outperformed, especially for clients that do not impose risk constraints on its strategy, said John Serhant, principal and chairman of the Boston-based firm's investment committee. He offered one currency overlay account as an example: a non-U.S. stock benchmark - in which the currency exposure is about one-third hedged - that gained 750 basis points of return above that of the underlying equities. He said 400 basis points are attributable to the one-third hedged policy position and another 350 to hedging above that policy position.
Pareto Partners' currency overlay management averaged four percentage points of outperformance for U.S. dollar clients that had unhedged benchmarks. (For American clients with fully hedged benchmarks, the average was -1.99 percentage points.)
Record Treasury Management, Windsor, England, measured its returns against an EAFE benchmark (not specific client returns). Its overlay management produced a gain of 8.21 percentage points above the return of the unhedged EAFE last year. (When compared with the fully hedged EAFE benchmark, its return was -3.02 percentage points.)
J.P. Morgan Investment Management Inc., New York, annually targets its currency overlay management to produce at least 200 basis points of return above that of the currency benchmark of a typical client. The firm surpassed the target during the past one-, three- and five-year periods for clients with unhedged and partially hedged benchmarks. In 1996 and 1997, the currency return was "significantly" above that 200 basis point target, said Adrian Lee, managing director.
Currency Management breaks down its overlay victories by currency. For example, by selective hedging back to dollars, it posted a net gain of 16% against the Swiss franc, 3.85% against the deutsche mark and 18.12% against the yen.
Overall, currency overlay returns "have generally been better in the last couple of years," said Brian Strange, principal of Currency Performance Analytics, Cleveland, a consulting firm. He has studied quarterly currency overlay returns between March 1988 and June 1997.
On an annualized basis, these returns over the entire period averaged 1.68 percentage points above the benchmark assigned by a client. But returns improved in more recent time periods. For example, the annualized average outperformance for the five-year period ended June 30 was 1.48 percentage points; for the comparable three years, it was 1.6 percentage points; for two years, it jumped to 2.44 percentage points. And for the year ended June 30, respondents averaged 2.04 percentage points above their assigned benchmarks.
Of course, the amount of value added to non-U.S. investment returns from currency overlay depends on several factors. Among them: the amount of hedging flexibility or restrictions put on currency overlay mandates; benchmark used; and the dollar's path.
When the dollar is rising, investors with unhedged benchmarks could be the biggest winners: The more they hedge their foreign currency exposure, the greater their outperformance. Conversely, as the dollar falls, those with fully hedged benchmarks that do not hedge will look like the biggest heroes when compared with their benchmark.