CLEVELAND -- Currency overlay managers boosted money managers' international investments by an average 1.9% a year, according to a new report by Brian Strange.
In an interview, Mr. Strange said the report is the first of its kind.
"No one has previously put together all the data on how much value is added to performance through these strategies," he said.
The study was done by Mr. Strange's firm, Currency Performance Analytics, Cleveland, which has since closed. (He has been appointed to the post of director of client services at Key Asset Management, Cleveland.) A few years ago he conducted a study of currency overlay managers on simulated portfolios, but the latest study is the first he's done using actual client portfolios.
Mr. Strange analyzed data from 14 currency managers with more than $1 billion in currency overlay risk under management. Eleven provided data on a total of 152 individual accounts, representing $40 billion; three provided information on five composite accounts, representing another $20 billion.
"The goal was to gather this data to see if this (currency overlay) works," Mr. Strange said.
He concluded the strategy added nearly 2% a year, but the value added varied depending upon the benchmarks. It was a difficult task because each currency manager used a different set of currency exposures and benchmarks. (For full details of the study and its results, see Portfolio Management on page 26.)
Symmetrical mandates, which allow managers to increase or reduce their hedging activities, added more consistent value than mandates that were more limited.
"If a manager has an unhedged benchmark, for example, he will get best results by hedging when currency is falling, and doing nothing when it's rising," Mr. Strange said.
On average, 80% of the accounts he analyzed outperformed their benchmarks, with an annualized average value added of 2.4%. Those that underperformed their benchmarks did so by an annualized average 1.3%. The standard deviation of the average value added was 3.5%.
Accounts managed against benchmarks that weren't hedged at all, or were completely hedged, showed a 1.6% higher standard deviation of excess return than those hedged somewhere in between (with 50% hedged being the most common).
Mandates that were less constrained resulted in more consistent outperformance. In general, managers have been adding value more consistently in recent years, because the U.S. dollar has strengthened since 1995 and the majority of overlay accounts are dollar-based. In addition, the increased popularity of 50% hedged benchmarks has allowed managers to add value to dollar-based accounts as the dollar rose, and currencies fell.
Mr. Strange said he tried to group managers according to style, but it was difficult because few stayed with a single style.
Ronald Layard-Liesching, director of research at Pareto Partners, London, which manages $23.7 billion of currency overlay and participated in Mr. Strange's study, praised it for "probably being the most thorough evaluation of currency overlay value added to date."
However, there are caveats, Mr. Layard-Liesching said, notably "survival bias. Firms that performed poorly or were terminated may not have been included, which skews the results. Since Brian doesn't know if they were included, the findings could show a false upward bias, particularly because there was no third party checking on the data."
Mr. Strange said this concern is not material, because the number of mandates and managers represents the majority. "Some mandates that were shut down would have had positive value added if they were continued and included in this survey."
There also are questions about the lengths of time the accounts used the strategies. That varied from one to the next, Mr. Strange said.
"I looked at them from the time they began. Most started after 1992, but the first one dates back to 1988 or 1989," he said.
Mr. Layard-Liesching said the currency bases and styles also differed, making it hard to draw comparisons.
"It's not really meaningful to pool risk controlling styles with forecast-based currency market timing, for example," he said. "Nevertheless, the conclusion is clear -- currency overlay has added value, and it's particularly reflected in the global growth in this area."
Large pension funds that do a lot of sophisticated international investing are the primary users of currency overlay, Mr. Layard-Liesching said.
"Most of them also do their own analysis. You can't really compare one set of performance numbers with another because of the differences in benchmarks, exposure and style, unless they are using the same mandate and the same currency base," he said.
Pareto's average currency overlay account has 22% of its assets invested internationally in developing markets and another 3% or 4% in emerging markets.
"Pension funds are increasing their currency overlay to make their international investments safe, and it's working," Mr. Layard-Liesching said.
