Currency turmoil a conundrum for investors

The strengthening U.S. dollar, diverging central bank policy and a continued search for returns have pension fund executives grappling with both sides of the coin when it comes to currency.

On one side, U.S. pension plans are losing out when they convert overseas investment returns, given the strength of the dollar.

On the flip side, pension plans across the globe are questioning whether they should be taking advantage of the alpha opportunity presented by volatile currency markets as central banks in the U.S., U.K., Japan, Europe and China move down diverging policy paths.

“Many plan sponsors are not comfortable simply passively hedging all of their currency exposure,” said Sean Ealy, director of investment manager research, principal, at RVK Inc. in Portland, Ore. “We see more interest in dynamic hedging and alpha strategies as a complement to a passive hedging program. Performance of the primary holding certainly is the key driver of performance, but the currency decision has an impact, particularly in the short term.”

Data from eVestment LLC show currency overlay managers have been popular in 2015. Net inflows were $3.6 billion in 2015 through June 30, vs. full-year 2014 net outflows of $682.2 million.

Last month, Kansas Public Employees Retirement System, Topeka, launched a search for a currency overlay manager to cover about $1.8 billion in international developed markets currency exposure. The new manager will complement the $16 billion pension fund's existing currency manager, Insight Pareto, whose overlay program will increase to about $1.8 billion, from $1 billion.

In April, the $45.8 billion Teachers' Retirement System of the State of Illinois, Springfield, issued an RFP for managers to provide currency management, and potentially to “identify opportunities to generate alpha through currency exposure,” the RFP said.

The Florida State Board of Administration, Tallahassee, which oversees $181.3 billion of assets, hired Record Currency Management to run $500 million in currency management in April.

Others are grappling with the resurgence in volatility within currency markets, and the strong dollar. A spokesman for the Ohio Police & Fire Pension Fund, Columbus, which has $14.8 billion in assets, said in an e-mail that the pension fund has no currency hedge in place, but executives there are “considering” it. Executives are debating whether currency could be used to generate alpha, but are “leaning toward the view that currency risk should be our focus,” the spokesman wrote.

Not everyone shares the view that currency hedging is necessary, for U.S. clients at least. In a recent white paper, investment consultant Rocaton Investment Advisors of Norwalk, Conn., questioned whether currency hedging made a real difference to U.S. client portfolios.

“For the vast majority, hedging currency does not actually reduce overall risk by that much,” said Matt Maleri, partner, asset allocation, in an interview. “Where they get currency risk is primarily non-U.S. equity portfolios, and there is not a lot of benefit from hedging out the currency, as most of our clients have between 20% and 30% in non-U.S. markets. That currency hedge doesn't move the needle too much,” he said.

Generating alpha from currency moves also has moved onto investors' radars. The BarclayHedge Currency Traders index returned 7.4% over the year ended June 30. That compares with a five-year annualized return of 2.3%, and 1.99% for the 10-year annualized return.

“Broader active returns had been very poor up until about a year and a half ago,” said Roger Hallam, chief investment officer for currency management at J.P. Morgan Asset Management, in London. The yen/dollar depreciation became a euro/dollar story, which “helped enormously with investors' returns. Quite a large number of active manager searches have come out of the woodwork,” he said.

Moves over the past few weeks by the Chinese government to devalue the currency, the European Central Bank and Central Bank of Japan's fiscal loosening, and the expected, imminent interest rate hikes by the U.S. and the U.K. point to “significant volatility in the FX space,” and a potential source of alpha, said Russel Matthews, London-based portfolio manager in BlueBay Asset Management LLP's investment-grade team.

Then, investors will look at what else is on offer, said Paul Lambert, London-based head of currency at Insight Investment. “Expected returns from bonds and equity holdings are not as attractive as they have been, and (pension funds) have liabilities and commitments that (they) need to reach. They need to generate some alpha.”

Added Mr. Matthews: “Where are you going to find returns for your clients? That is when the option is FX — you find when you have this kind of environment, there is a rich source of alpha to be generated.”

Interest has been piqued across the globe, both from institutional investors and from their advisers said Mark Astley, London-based CEO at Millennium Global Investments. Consultants, he said, have been in contact on the topic of currency alpha generation, and interest in currency — from risk and alpha perspectives — “is the highest it has been anytime in the last 10 years.” Millennium Global manages currency overlay and absolute-return strategies, and has assets under management of about $14 billion.

And in a world where it is feared that liquidity is scarce, currency markets look like a better option than other asset classes. “Liquidity in asset classes is deteriorating to some extent,” said Andreas Konig, Dublin-based head of FX Europe at Pioneer Investments. “FX is still the most liquid market — it has deteriorated as well, but is still (liquid.) Transaction costs are low ... this has brought more attention” to the opportunity.

But risk also is climbing up the agenda. In the past, plan sponsors opted for the “path of least resistance,” a 50% currency hedge, Mr. Hallam said. “They don't want the absolute currency volatility that comes with (having a) completely unhedged portfolio.”

A lot of interest in increasing hedge ratios has come from U.S. pension plans, amid concerns surrounding the dollar cycle, particularly as an expected rate hike by the Federal Reserve later this year could see the currency appreciate further, he said.

London-based currency manager Adrian Lee & Partners also is seeing increased business for hedging strategies, said Adrian Lee, president and chief investment officer. “We've seen an extraordinary surge in interest over the last few months, particularly from U.S. investors as the rising dollar started to erode their profits.” The firm has received more inquiries in the past three months than in the last three years. Adrian Lee manages more than $6 billion of assets.

The strength of the dollar has also been of concern to sovereign wealth funds, Mr. Astley said. “We are seeing explicit interest from sovereign wealth funds in the Middle East. Given they are dollar-based, big dollar moves on any unhedged currency is making them take notice.”

But it's not just the dollar that managers are keeping an eye on.

Colin Harte, London-based portfolio manager and strategist within the multiasset solutions team at BNP Paribas Investment Partners, said his team is starting to consider the euro.

“Our clients, themselves being predominantly European, have been happy at the moment to ride out the weaker euro. But we are starting to think, and talk to clients, about currency overlay and hedges,” he said. “There has been a great run with the euro, but it is starting to look quite cheap in real exchange-rate terms. There is a possibility it will get to parity, and possibly go through it.”