Unlike defensive hedging of foreign exchange exposures linked to an underlying pool of assets, active currency management is not necessarily constrained to existing assets and seeks to add alpha through market inefficiencies. Although interest has been global, U.K. pension funds are at the forefront of the push into currency as an alternative source of alpha, investment consultants and managers say.
The reasons: U.K. pension funds have been forced to find better ways of controlling volatility by diversifying risks, largely as a result of mark-to-market accounting; plus, international equities and foreign exchange exposure swelled as U.K. pension funds diversified away from domestic stocks.
The U.K. has been on fire, said Robert Stewart, vice president and head of currency management at JPMorgan Asset Management, London, which managed $87.2 billion in notional active and passive currency assets as of Dec. 31, an increase of 31% from the previous year.
Of 17 searches for active currency-only managers in which Mercer assisted last year, the U.K. accounted for 11, said Mercers Ms. Miller. In 2005, 10 of 13 active currency searches originated in the U.K.
The £2 billion ($3.9 billion) Leicestershire County (England) Council Pension Fund has two £340 million active currency portfolios managed by Millennium Global Investments Ltd., London, and Mellon Capital Management Corp., San Francisco.
Millennium, Mellon and Record Currency Management Ltd., Windsor, England, manage a £150 million active currency portfolio each for the £8.9 billion Strathclyde Pension Fund, Glasgow, Scotland. The £2.4 billion Lothian Pension Fund, Edinburgh, has $800 million in an active currency strategy managed by JPMorgan, Record and A.G. Bisset & Co., Rowayton, Conn. A spokeswoman for Lothian wouldnt say how much each manager runs.
Mr. Stewart and others say interest in active currency has spread to larger institutional investors in the Netherlands, Scandinavia, Germany, Australia and Asia. Some of the largest North American pension funds also are pursing active currency management, but often wrapping it into a global tactical asset allocation strategy, rather than a stand-alone one, said Brian Zeiler, investment consultant at San Francisco-based Callan Associates Inc. who specializes in global manager research.
Traditional currency management originated in the United States, although historically, the average U.S. pension fund had less than 20% of its portfolio exposed to foreign exchange vs. more than 30% for U.K. funds.
Over the long term as international and, therefore, currency exposure goes up, I think it will be more common for (U.S.) investors to come around to the thinking that this is not only a risk to be managed, but also a source of alpha to reap, Mr. Zeiler said. But I dont think were there yet.
Still, some big U.S. pension funds are taking the plunge. The $158 billion California State Teachers Retirement System, Sacramento, plans to name its first external managers to run active currency-only mandates later this year, said Michelle Cunningham, director of fixed income. The externally managed portion would comprise about 20% of the funds $33 billion foreign currency exposure.
We looked at all areas for opportunities in alpha, and there are opportunities to make money in the currency area, Ms. Cunningham said. Having seen that, we decided to design a program to take advantage of those opportunities.
The opportunities for alpha and diversification are the main advantages for investing in active currency, according to consultants, managers and pension fund executives.
Currency has low to zero correlation with other asset classes such as equities and bonds, consultants and managers said. ABN AMROs Mr. Binny, who researched the level of correlation of currency with equities, bonds, real estate and other asset classes in a paper published in 2005, said the correlation appears to oscillate around zero in simulations analyzing returns of various asset classes from 1978 to 2005.
That correlation is considerably lower than that provided by a fund of hedge funds, Mr. Binny said.
With active currency management, institutional investors expect anywhere from 50 basis points to 500 basis points. Strathclyde, for example, is seeking 100 to 150 basis points net of fees.
Officials at New York-based Goldman Sachs Asset Management say their global currency portfolio fund should produce an annualized excess return of 300 to 350 basis points with a tracking error of 400 basis points.
Currency also presents advantages in terms of capacity, liquidity and transparency. Its efficient use of leverage means assets can be stretched further. As such, it also has been dubbed by investment experts as one of the purest forms of alpha around.
It has taken quite some years for institutional investors to be convinced, but they are being convinced in a big way, said Ian Battye, director of currency implementation at Russell Investment Group, Tacoma, Wash.
Demand has been so strong that at least two top managers Barclays Global Investors and Bridgewater Associates have closed active currency-only strategies to new investors.
As soon as they (money managers) get any capacity, it gets eaten up in a few hours, said one consultant, who requested anonymity.
BGI officials declined to comment on capacity questions about its active currency strategies.
Raymond T. Dalio, Bridgewaters founder, president and co-chief investment officer, said the firm hasnt accepted new currency-only clients in at least a year. Some currency markets are very liquid and others arent. If we were to grow, we would have to grow disproportionately in the liquid markets, which would reduce our diversification and hurt the risk-adjusted returns for our clients.
Bridgewater, Westport, Conn., manages $70 billion in notional assets within active currency-only portfolios. Currency bets also feature prominently in the firms pure alpha and optimal beta strategies, which have $55 billion and $13 billion in notional assets respectively.