Investors' lament: Where does the buck stop?

Currency managers say U.S. institutional investors that hedge some or all of their non-U.S. equity exposure remain a decided minority, but with bearishness on the dollar's outlook giving way to more mixed views, a growing number are revisiting their options.

With the dollar generally declining in value against other major currencies over the past decade, not hedging has been a winning bet for U.S. investors. But increasing overseas allocations and potential gains by the U.S. dollar are prompting some soul searching, observers say.

Currency is the biggest unmanaged risk U.S. investors are taking today, said Max Darnell, chief investment officer of First Quadrant LP, Pasadena, Calif. Currency adds 8% to the volatility of the non-U.S. portion of a plan's portfolio, or roughly half the total volatility, with no expected return, agreed Laurie O'Donoghue, chairman and president of currency manager Pareto New York LLC.

Following the wake-up call in 2008, when safe-haven buying caused the euro to plunge from $1.60 to $1.25 between July and October and more recent dollar strength, State Street Global Advisors' currency strategies “are definitely seeing more interest now” as institutional investors revisit the rationale for hedging, said Alistair Lowe, executive vice president and CIO for SSgA's multiasset class solutions and currency strategies.

The past decade's consensus that the dollar was going to be weak forever has been battered recently, leading to a growing number of “sober” conversations about the place hedging has as a risk management tool in institutional portfolios, Ms. O'Donoghue said.

Even so, demand from U.S. investors remains a fraction of what Pareto is seeing in markets such as Australia, where the firm's business “is going through the roof,” she said. Pareto has garnered two sizable currency hedging mandates from U.S. institutional investors since the start of 2009, with one more yet to be funded — a fairly normal pace of new business, Ms. O'Donoghue said. For the same period, Pareto won 10 new assignments from Australian institutional investors, with another five awaiting final approval or funding, she said. She wouldn't identify the clients.

Pensions & Investments' latest survey of top U.S. pension funds, conducted during the fourth quarter of 2009, showed only 36 of the 200 biggest funds had currency programs. And, many of the 36 were using currency as a source of alpha or absolute returns, rather than for hedging.

While there's been more talk than action to speak of thus far, some big U.S. institutional clients have pulled the trigger over the past year.

For example, the $32 billion Maryland State Retirement & Pension System, Baltimore, hired Windsor, England-based Record Currency Management in early 2009 to oversee a disciplined, “protective currency strategy,” designed to provide little or no hedging when the dollar is in a downtrend while offering protection when the currency is trending higher, said CIO Mansco Perry III. Maryland had 27.4% of its portfolio invested in international stocks as of Sept. 30, according to data provided to P&I.

In a telephone interview, Neil Record, chairman and CEO of Record Currency, said Maryland was one of three U.S. mandates his firm has won since 2008, while another dozen or so potential clients are talking with the firm. That's the biggest flurry of U.S.-based activity the U.K.-focused firm has seen since 1995, a time when the dollar had fallen to historic lows against currencies such as the yen, he noted.

The firm he launched 25 years ago hasn't focused on U.S. client demand over the past decade, but that's changing now, as the continued internationalization of U.S. pension portfolios promises to make currency risk a major issue for a growing number of pension executives, said Mr. Record.

U.S. investment consultants say the currency question is one clients have to explicitly examine, but many believe the case for putting a hedging program in place remains open to question.

“We feel that for the vast majority of our clients, it doesn't make sense to hedge” when weighing the potential benefits and costs, said Shane Schurter, consultant with Ennis Knupp & Associates, Chicago. “We have not seen much (if any) push from clients to hedge currency.”

Several — including heavyweights such as Towers Watson & Co. and Mercer LLC — while noting that case-by-case considerations may lead some clients to consider hedging, say their firms aren't urging them to do so.

Russell Investments, Tacoma, Wash., doesn't have a stock answer on whether or not to hedge because the scale and types of non-U.S. exposure vary by client, noted Robert Collie, director of investment strategy.

Others view hedging more favorably. In the past, domestic holdings far outweighed non-U.S. allocations, but a growing number of investors are on track to have $2.50 invested outside the country for every $2 invested inside, noted Neil Rue, a Portland, Ore.-based consultant with Pension Consulting Alliance. At that scale, it's imperative to talk with clients about how they want to attack the currency hedging question, and PCA's bias is for some sort of active hedging program, he said.

Consulting veterans such as Michael Beasley, chairman and CEO of San Francisco-based Strategic Investment Solutions, and Alan D. Biller, president of Menlo Park, Calif.-based Alan D. Biller & Associates Inc., recommend that clients use unhedged benchmarks for their non-U.S. equity exposure, leaving the question of whether or not to hedge in the hands of the money managers overseeing those assets.

Churchill Franklin, director of marketing, sales and client service with Acadian Asset Management LLC, Boston,said whether to hedge is a “check-list item” with separate-account clients, and with a greater balance between dollar bulls and bears recently, “more talk about currency hedging is starting to come up, he said.

The range of opinions among institutional investors about hedging remains diverse.

David Kushner, deputy director of investments at the $13.2 billion San Francisco City & County Employees' Retirement System, said his board eliminated the hedging component for its non-U.S. equity exposure in the second half of 2009, while leaving an alpha component in place. The effort San Francisco was expending identifying its underlying currency exposure and hedging back to the plan's benchmark proved more costly than it was worth, in part because deviations from that benchmark have been relatively small, noted Mr. Kushner. The Pennsylvania Public School Employees Retirement System, Harrisburg, has had a dynamic hedging program in place since mid-2006, with the ability to hedge up to 30% of the $46 billion fund's non-U.S. equity exposure, said James Grossman, director-external public markets, risk and compliance. He said the program, which was hedged at that 30% limit after the dollar spiked higher in September and October 2008, has since been reduced to zero.

Tim Walsh, CIO of the $7.9 billion Indiana State Teachers' Retirement Fund — and a currency trader for more than a decade earlier in his career — said his portfolio's non-U.S. equity exposure is largely unhedged, but the issue is moving now from “the backburner to the mid-burner.” He said devoting more resources to managing currency exposures could well add value, but other matters have had priority during the first 22 volatile months of his tenure.