CalPERS charting new waters on currency hedge extension

CalPERS officials have proposed extending their currency hedge to include all asset classes instead of just international equities in a move that is considered very unusual.

In doing so, they propose putting in place a 15% hedge across the total fund, replacing the 25% applied just to international equity exposure.

Brad Pacheco, a CalPERS spokesman, said relatively few U.S public funds have currency overlay programs and even fewer use the strategy across multiple asset classes. He said it's possible CalPERS is the only pension fund to include all asset classes.

As of Oct. 31, CalPERS' international equity portfolio totaled $35.9 billion. Two external managers, Pareto Investment Management, London, and State Street Global Advisors, Boston, ran currency overlays of $2.5 billion and $2.3 billion, respectively, as of the same date. The remaining overlays are managed internally. CalPERS has a total of $7.5 billion in overlays.

Officials at Pareto and SSgA did not return calls seeking comment on CalPERS' proposal.

Last week, CalPERS' investment committee adopted the proposal on a temporary basis until mid-2009, when fund officials expect to complete a “mini” asset allocation study necessitated by the continuing market turmoil. Meanwhile, CalPERS' staff and its consultant, Wilshire Associates Inc., Santa Monica, Calif., will try to resolve a contentious debate over how the hedge should actually be structured.

Nobody at CalPERS or Wilshire is arguing that extending the hedge isn't a smart play. What they are debating is how to place their bets when it comes to calculating the hedge ratios themselves — and the dilemma boils down to a fundamental dispute over whether to retain the static ratio supported by CalPERS staff or replace that with a dynamic approach championed by Wilshire.

In approving the new policy, CalPERS brushed away 16 years of tradition limiting its hedging solely to developed-market equity exposures.

Fund officials substantially increased the target unhedged foreign currency exposure to 42% from 26% with the asset mix adopted in late 2007, upping non-U.S. allocations in public equities, real estate, private equity and inflation-linked bonds.

The new policy will result in more accurate management of the program and better measurement of results, permitting more comprehensive reporting of both hedged and un-hedged risk and return on the entire fund, according to a staff memo to the investment committee.

According to the memo, staff has proposed a “top-down” method of linking the new ratio to the entire fund and not just its international equity exposure. The result would be a hedge ratio of 15% exposure on the total fund. By implementing a single approach to calculate the hedge ratio, CalPERS believes it can minimize the volatility of the total fund.

Under this plan, the staff estimates that when it projects the new approach against its $77.7 billion in hedge program assets, the dollar equivalent would be $13.7 billion; annual transaction costs would be around $17.8 million plus 13 basis points; and the dollar settlement charges would be in the neighborhood of $1.37 billion if the dollar should decline by 10%.

By using a bottom-up approach, the CalPERS' staff concluded its exposure would be in the neighborhood of 41%.

In a Dec. 1 letter to CalPERS' Interim Chief Investment Officer Anne Stausboll (who was named the fund's CEO Dec. 17), Michael C. Schlachter, managing director and principal at Wilshire in Denver, outlined the consultant's objections to the staff proposal.

“Staff has proposed a new currency hedging methodology and hedge ratio, which seeks to minimize the volatility in the performance of the total fund from the standpoint of a mean-variance optimization exercise,” Mr. Schlachter wrote. “While we readily admit that this is the simplest and cleanest way of picking a hedge ratio, we believe this approach is not the current state of the art and does not take into account the true nature of all of CalPERS' underlying positions.”

Mr. Schlachter also cautioned that picking a hedge ratio designed to minimize past return variations “likely will not fit the structure of CalPERS' investments in the future.”

By calculating the ratio in this manner, he said both staff and the investment committee would need to continually revise the 15% hedge ratio to compensate for change in the portfolio composition, but these revisions would always be based on “a backward-looking calculation.”

He also implied the staff's use of annual returns in calculating the hedge ratio instead of monthly returns was designed to produce the result staff wanted.

In addition, Mr. Schlachter wrote that currency is “an intended source of return” for some investment programs, such as CalPERS' hedge fund portfolio. “It seems rather wasteful to us have the (hedge fund) team hire a U.S./non-U.S. arbitrage hedge fund for a fee of 2% base and 20% of the value-added, for example, and then have a blanket program of hedging 15% of that manager's exposure automatically,” he said.

Mr. Schlachter took a different tack. Although the consultant supports extending hedging to the entire fund and agreed with the temporary 15% total fund hedge ratio, he proposed treating currency as just one element in a much more comprehensive system of supervising and regulating the currency risk facing the pension fund's entire portfolio.

He wrote that his proposal would not rely on historical performance. but instead be more dynamic in nature — by establishing a ratio that was calculated for each asset class, and potentially for each underlying portfolio within a particular class, and aggregating those results to produce the best overall fund-wide ratio.

This approach, he argued, would better reflect current market conditions and be more realistic than the CalPERS staff proposal. Although Mr. Schlachter conceded that developing an optimal hedge ratio will be more complicated, the consultant believes over the long term, it will more accurately reflect fund performance and reduce costs.

(When the investment committee approved the temporary policy, Wilshire had not yet submitted its estimates of hedge dollar equivalents or transaction costs.)

Although CalPERS has released one letter from Wilshire that was mildly critical of its staff currency overlay proposal, just how acrimonious the debate really is can't be accurately gauged because much of the arguing has occurred behind closed doors.