Dollar's rise makes case for currency hedging … or not

As the American dollar's strength eats into U.S. institutional investors' overseas returns this year, those looking at currency hedging will search in vain for consensus on the merits of doing so.

Depending on the scale of non-U.S. exposure in a portfolio, some investment consultants — including Russell Investments and Rogerscasey Inc. — contend there's a strong argument to be made for hedging.

Others, such as Ennis Knupp & Associates Inc. and Hewitt Associates LLC, see as much potential for harm as for gain.

The only point of agreement is that currency volatility is prompting a growing number of U.S. institutional investors to study the topic — again.

Interest in currency management always tracks volatility, and the euro's tumble from $1.514 last November to $1.2644 midday July 9 has helped move the hedging discussion from the bottom of U.S. investors' crowded “to-do” list “back to the top,” said Laurie O'Donoghue, chairman and president of currency manager Pareto New York LLC.

The dollar's gain of more than 15% is enough to shave three percentage points of return from a U.S. institutional portfolio with 20% or more of non-U.S. exposure, noted Ms. O'Donoghue.

Collin Crownover, State Street Global Advisors' London-based managing director and head of currency management, agreed, saying the number of currency discussions SSgA is having with U.S. investors is double to triple the rate of a year ago.

Some U.S. institutional investors are doing more than talking.

The head of defined benefit investments for one Fortune 100 company, who declined to be named, said his staff adopted a 50% hedge of its non-U.S. exposure earlier this year in an effort to “take down the volatility within the plan” — effectively reducing its currency exposure to 10% of the portfolio from 20%.

The expected reduction in volatility, while marginal, would still “move the needle,” said the executive, calling it one of several moves his staff has made since the Pension Protection Act in 2006 left them “with less ability to ride the volatility than you used to have.”

Karyn Williams, a Los Angeles-based managing director with consultant Wilshire Associates Inc., said currency is one of a wide variety of topics her clients are studying amid a “heightened sensitivity” to anything in their portfolios that could cause substantial swings in value. This year, some have implemented hedging programs for the first time, she noted, while declining to identify them.

But for the most part, currency managers say it remains a case of more talk than action. And pointing to past bouts of dollar strength, some managers say by the time institutional clients are ready to move, the currency often has strengthened enough to limit significant near-term benefits.

That might not be the case this time around, according to a research paper last month from Russell Investments, which predicted financial tremors in Europe could send the euro tumbling to parity with the dollar in the coming months.

Officials at Russell Investments, Tacoma, Wash., have long urged U.S. clients with significant non-dollar investments to consider hedging 50% of that exposure, and heightened uncertainties now make this a good time to “take some of that risk off the table,” Kevin Turner, director of consulting, Americas, said in a recent interview.

Ian Toner, global head of currency implementation at Russell, said a “trifecta” of rising non-U.S. exposures, heightened currency volatility and growing correlations between the movements of the dollar and equity markets are prompting more investors to ask about hedging.

The currency issue is “vastly different” for a client with 45% of its portfolio in non-U.S. assets than when the total overseas investment was only 10%, agreed Cynthia Steer, managing director, chief research strategist and head of the beta research group with Rogerscasey, Darien, Conn.

With emerging markets increasingly taking the central role in the global economy that developed markets have played, and developed economies struggling with issues once identified with the developing world, currency today is “probably the most mismanaged issue around,” Ms. Steer said.

Mr. Toner said an increasing number of U.S. clients are moving to put programs in place; he declined to identify them. Mr. Turner noted that about 25% of Russell's U.S. clients now hedge and predicted the proportion could rise.

Ms. Steer said 30% to 40% of Rogerscasey's corporate clients probably hedge some of their non-U.S. exposure today, declining to identify them.

Erik Knutzen, chief investment officer with Cambridge, Mass.-based investment consultant NEPC LLC, said his firm's research suggests that for U.S. clients with between a quarter and a third of portfolio exposure to non-U.S. currencies, that exposure provides diversification benefits that hedging may reduce.

If they have greater non-dollar exposure, they might want to consider some hedging, but for now that's a relatively small number of the firm's clients, he said.

Other firms see fewer clear benefits from hedging.

In an e-mailed response to questions, Ian Peart, a senior consultant and head of currency in London with Hewitt Associates, said hedging is important for low-volatility assets such as bonds, but for a U.S. investor, the reduction in risk from hedging non-U.S. equities is “marginal.”

And should the currency move against a hedge, investors could face “substantial” cash-flow requirements to maintain that hedge. “Therefore, the decision to hedge currency exposure for overseas equities is not just about the reduction in volatility, but also the implementation and cash flow management,” Mr. Peart said.

While the expectation is that hedging will reduce total portfolio risk, there have been periods where doing so has resulted in higher portfolio volatility, noted Shane Shurter, a consultant with Chicago-based Ennis Knupp. Considering the liquidity-cash flow risks that accompany hedging, the circumstances of the vast majority of clients probably don't call for doing so, he said.

A hedge can be very costly if it moves against you, agreed William Vincent, the London-based managing director and head of currency policy with Cambridge Associates LLC, who said diversifying equity allocations across regions is his firm's preferred means of dealing with currency-related risks.

Talking about “non-U.S. exposure” as if that represented one bucket is too simple, said Mr. Vincent, who noted that exposure to the euro creates a different set of risks from exposure to emerging market currencies in Asia.

In an interview, Luis M. Viceira, a professor at Harvard Business School, Boston, said a paper he wrote earlier this year with John Y. Campbell and Karine Serfaty-de Medeiros, reached a similar conclusion. (Mr. Campbell is a professor and chair of the department of economics at Harvard University; Ms. Serfaty-de Medeiros is a consultant with OC&C Strategy Consultants.) A look at data for the 30 years through 2005 suggests a negative correlation between reserve currencies — such as the euro and the U.S. dollar — and global stock market returns, which argues against hedging.

Commodities-influenced currencies, meanwhile, such as the Australian or Canadian dollars, and other major non-reserve currencies, including the British pound and the Japanese yen, are positively correlated, and should be fully hedged.