Most pension funds with active currency overlays on their international equity portfolios have added value through the hedging strategy, according to two new studies.
Of 241 historical mandates included in "Capturing Alpha Through Active Currency Overlay" from Frank Russell Co., Tacoma, Wash., currency overlays added value over the life of 75% of the accounts studied; and over three- and five-year periods for 81% of the accounts with track records that long.
U.S. dollar investors were most successful, with more than 82% adding value through currency overlays for all account lengths. The strengthening U.S. dollar during much of the study period helped these accounts. The average excess return of all accounts was 1.06 percentage points per year and the average tracking error was 2.25 percentage points. Accounts still in existence as of June 30, 1999, the last date in the six months during which data were collected, with a minimum of three years of trailing data, added 1.17 percentage points per year on average; those with five years of data as of that date added 1.39 percentage points on average.
A Watson Wyatt Investment Consulting study of more than 300 accounts also shows currency managers can add alpha to a portfolio.
Across all accounts in the study, the value added since inception averages 1.34 percentage points per portfolio as of year-end 1999, while dollar and non-dollar accounts generated an average of 1.37 percentage points and 0.67 percentage points in excess returns, respectively.
Most accounts studied were 3 to 7 years old, said Brian Hersey, director of investment consulting, Watson Wyatt, Atlanta.
Both studies show how active currency managers were able to add value across three benchmark categories -- 100% hedged, 50% hedged and unhedged.
Easy time
Meanwhile, since the dollar was going up during most of the period the Russell report covers, it was easy for currency overlay managers to add value.
"If the dollar is going up, the currency manager can add value by investing back in U.S. dollars," said Brian Meath, head of global equity research for Russell and one of the authors of the report.
The greatest tool active managers possess, according to the Watson Wyatt study, is their ability to adjust absolute portfolio hedge levels, or, in the case of many overlay strategies, foreign currency exposure in relation to underlying asset allocations.
The benchmark decisions are very important, Mr. Hersey said, because most currency managers "stay very tightly around the benchmark."
Considering the effect of currencies within a fund's asset/liability framework helps determine what the exposure should be, he said.
It is "the inefficiencies of the currency markets that are exploitable by skillful managers," he said.
J.P. Morgan Investment Management Inc., London, where the firm's currency overlay operation is based, handles more than $26 billion in currency overlay mandates for 40 accounts for which the firm does not manage the underlying assets. More than 75% of those assets are for pension funds.
Of the 241 accounts analyzed in the Russell study, 48 came from J.P. Morgan, said Harriett Richmond, managing director at J.P. Morgan, who heads the operation. Morgan's accounts added 1.42 percentage points, more value than the 1.06 percentage point average in the Russell study, with a tracking error of 1.79% for Morgan and 2.25% for the Russell universe.
Morgan's strategy involves combining fundamental research with a technical component to determine its currency bets.
The fundamental factors the firm looks at include interest rates, inflation rates, bond yields and trade balances. From a technical side, it looks "to see if there are any repeating patterns in past historical prices" of currencies, Ms. Richmond said.
State Street Global Advisors Inc., Boston, also uses a combination of fundamental and technical analysis in the currency overlay programs. Officials also look at inflation and interest rates, which they use "to determine if a currency is cheap or expensive," said Paul Duncombe, the London-based head of currency management.
In its technical analysis, the firm looks at what currency prices have done in the recent past and looks for price trends, he said.
"If prices have been rising for the last two weeks, we assume the trend will continue and buy the currency. If prices have been falling, we sell it," he said.
The firm runs $25 billion in overlay strategies for 140 outside clients.
Mr. Duncombe said that for its longest running account, managed for a large U.S. pension fund for the past five years, SSgA has added 250 basis points per year of alpha with the currency overlay strategy.
Sponsors' experience
American Airlines Inc., Fort Worth, Texas, has been using a currency strategy for the 20% of its $5.2 billion defined benefit plan that is invested internationally for five years. William F. Quinn, president of AMR Investment Services Inc., which oversees the $11.2 billion American Airlines pension plan, said, "We're looking to add value to an unhedged portfolio."
The strategy has added an average of 2.2 percentage points of alpha annually over the five-year period.
At the $91 billion General Motors Investment Management Corp., Frank Delvecchio, head of currency management, said that since the currency overlay program's inception in 1989, it has added alpha of 1 percentage point per year with a risk level of 2.8% per year. GMIMCO uses a 50% hedge ratio on its $15 billion of international equity exposure.
