U.S. pension funds, which have been focusing on currency as a new source of alpha, could find a growing appetite this year for active hedging programs as well, especially if the long-suffering dollar finds its feet.
A number of plans in the U.S. are actively looking at hedging as the growth in their overseas allocations boosts the impact of currency fluctuations on overall portfolio returns, said Laurie ODonoghue, president of the U.S. arm of London-based Pareto Investment Management Ltd.
In recent years, hedging mandates have been few and far between, as the dollars steady decline in currency markets produced windfall gains for U.S. investors translating their holdings denominated in euros or pounds back into depreciated dollars.
In midday Jan. 4 trading, the euro was buying 1.4785 U.S. dollars, up 12% from $1.3165 at the start of 2007; the Canadian dollar, meanwhile, was trading at $1.0010, up roughly 15% from $0.8532 a year ago.
The dollars decline accounted for more than 75% of the 10.5% gain U.S. investors would have enjoyed on a passive Morgan Stanley Capital International Europe Australasia Far East portfolio for the year through Nov. 30, noted Ulf J. Lindahl, senior vice president and chief investment officer with Rowayton, Conn.-based A.G. Bissetop A.G. Bisset & Co.
After being a positive factor for U.S. investors in recent years, currency will be more problematic in 2008 and 2009, said Rodger Smith, a senior consultant with Greenwich Associates, Greenwich, Conn. Its unclear exactly when the dollars decline will reverse, but when it does theres going to be a lot of pain, he predicted.
From a behavioral finance perspective, the currency gains of the past few years can make investors less and less concerned about currency risk, when the opposite should be true, said Mr. Lindahl, whose firm sees the dollar potentially strengthening next year.
In a Dec. 19 conference call, Jeffrey Gundlach, chief investment officer with Los Angeles-based TCW Group, likewise predicted the dollar will strengthen in 2008.
Short end of the stick
Overseas investors have gotten the short end of the currency stick in recent years, and currency managers say non-U.S. clients have accounted for a far greater number of hedging-related mandates, both active and passive.
A U.K. pension fund with about a third of its money in U.S. capital markets basically got no return on its investment in 2006, when the pound rallied vis-à-vis the dollar, noted Mr. Lindahl. A.G. Bissets business in that market it opened a London office in 2006 has been growing strongly, he said.
Currency managers say demand among investors in Canada and Australia, whose currencies appreciated against the dollar by between 10% and 20% over the past year, has also been picking up, even if putting a hedging program in place after the dollar has fallen so far might prove somewhat like locking the barn door after the horse has bolted.
People respond better to pain than to opportunity, noted Max Darnell, chief investment officer of First Quadrant LP in Pasadena, Calif., whose firm focuses on alpha-related currency mandates.
Pension consultants and executives with firms that manage currency either to hedge the risks resulting from exposure to overseas currencies or as a separate investment to bolster returns say while less than a quarter of U.S. institutional investors actively manage their exposure, their ranks are likely to grow.
The issue wasnt critical when pension funds only had 10% to 15% of their assets overseas, but as more push toward a global asset allocation weighting, where U.S. equities can account for less than half of the total, the impact from currency fluctuations is becoming more substantial, said Timothy R. Barron, president and chief executive officer of Darien, Conn.-based pension consultant Rogerscasey.
That growth in overseas allocations is leaving the industry on the cusp of a pretty dramatic transition, with heightened awareness of currency exposures setting the stage for an enormous growth of business over the coming three to five years, said John M. Balder, a vice president and senior member on the currency investment team at State Street Global Advisors, Boston.
Paretos Ms. ODonoghue said her firm where active hedging accounts for $58 billion of $62 billion in institutional currency assets under management is seeing more U.S. pension funds moving to put hedging programs in place, even as the falling dollar has continued to pay unhedged dividends. As one new client said late last year, weve had a windfall profit from the weakening dollar, but trees dont grow to the sky, she said, declining to identify the client.
After bringing trustees and investment committees up to speed during the past 12 to 18 months, a growing number of U.S. funds might put hedging programs in place during the first half of 2008, she said.
Still, theres no consensus among sophisticated pension funds on the necessity of hedging currency exposure, whether actively or passively.
Michael Travaglini, executive director of the $54.2 billion Massachusetts Pension Reserves Investment Management board, Boston, said the board is comfortable with its decision to shut down its hedging program with Pareto last year. PRIM executives are still mulling using currency as an alpha source, but its unclear whether active hedging over the course of an economic cycle can really add value, he said.
By contrast, in December, the board of the $248.2 billion California Public Employees Retirement System, Sacramento, voted to rehire Pareto and SSgA for another year to hedge together as much as 25% of the systems $56 billion international equity exposure. With the dollars weakness during 2007 arguing in favor of reducing hedges rather than adding them, the two money managers were hedging only 16.5% of CalPERS international equity exposure as of Sept. 30, according to a Dec. 17 CalPERS document.
At this point, many currency managers see the continued dearth of mandates more as a tactical or timing decision than a strategic rejection of the need to hedge. A growing number of U.S. pension executives are concluding that hedging should be a part of their program, but so many people remain bearish on the dollar that its tough for them to move ahead just now, said Carter Lyons, a principal and client relations officer in Barclays Global Investors Americas Institutional business.
Mr. Lindahl said his firm sees growing U.S. pension fund interest in active hedging programs this year, especially if a strengthening dollar results in a drag on performance for the non-U.S. chunk of those funds portfolios. A.G. Bissets $3.3 billion in client currency mandates mostly involve hedging, although roughly $600 million are in alpha components included in the hedging strategy, he said.
In Europe, where some pension funds had adopted a passive hedge combined with a currency-focused hedge fund strategy to add alpha, A.G. Bisset has persuaded some clients to replace the passive hedge with an active strategy, Mr. Lindahl said.