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The Actuary The magazine of the Institute & Faculty of Actuaries

Managing foreign investments

Pension funds hold a specific set of assets to match their liabilities. Almost all pension liabilities are defined in local currency terms. Investment in cross-border assets represents a mismatch between the assets and the liabilities (benchmark) of a pension fund.

Global asset allocation
Pension funds around the world have traditionally invested high percentages of their assets in global investment portfolios. The two countries with the largest funded pension sectors are the United States and the United Kingdom. The US has a historical allocation to international investments of around 9%, and the UK 26% (based on average holdings over the last ten years, see figure 1). Of this allocation to international assets, 90% or more is invested in global equities.
The strategic decision to allocate such a high percentage of the portfolio to international assets is not based on the view of pension funds that the local currency will appreciate or depreciate against other currencies. The main reasons for this decision are:
– diversification of the investment portfolio or risk reduction; and
– pursuit of higher returns than those available in the local economies.

Currency risk is real and needs to be managed
Whenever investors purchase a foreign asset they have to purchase or borrow the foreign currency to pay for those assets. This exposure to foreign currency comes with some significant risk and no expected long-term return. The evidence from historical data suggests that the correlation between foreign equity markets and the relevant currency required to invest in those markets is low to zero. This implies that any exposure to currency in a global portfolio will increase the volatility of that portfolio if the relative currency pair exhibits significant volatility. Table 1 shows the comparison of the volatilities of some of the major currency pairs that investors could be exposed to in a global portfolio context.
We can see from table 1 that investors are exposed to high currency volatility through investing in foreign markets. Most institutional investors have a specific risk budget for their investments. If the volatility from currencies can be removed, the risk budget can be allocated to those asset classes that fall under the core competency of fund managers.

Currency overlay
Fund managers are chosen for their proven expertise in equity or fixed-income markets, not their currency management skills. Currency overlay is essentially removing from the portfolio the management of fluctuating foreign exposure that arises from investing outside one’s home country. The concept of currency overlay has been around since the late 1980s, when specialists began to provide disciplined currency management services to fund managers with international investment portfolios. At one end of the spectrum, currency overlay means that currency risk is simply fully hedged, while at the other end it means that currency is viewed as a separate asset class and positions are taken to maximise potential gains in the underlying currencies.
In practice, a currency overlay programme is typically implemented through hiring an independent manager who will manage the fluctuations in currency exposure that arise from foreign investments. This currency exposure will be managed separately from the other assets through the use of derivative instruments, mainly forward contracts. A mandate is agreed with the currency overlay manager in which the investor specifies the instruments that can be used, the tracking error against a specific benchmark, the hedge ratio (ie the proportion of currency exposure to be hedged), the hedge frequency, the approach (active or passive), and the constraints on the size of the positions that may be entered into.
Although currency overlay has become increasingly accepted and utilised over recent years, the vast majority of pension funds with cross-border investments have yet to improve their risk/return profile by initiating a currency overlay programme. Surveys by various international investment consultants (eg Russell Mellon) show that roughly 10% of funded pension plans hedge the currency exposure in their global investment portfolios.
The dollar’s 30% drop against the euro since it peaked in 2000, and the increase in volatility of all major currency pairs in the last few years, strengthen the case for currency management. Mercer Investment Consulting reported in a recent survey of UK pension funds that it expects active currency management to be implemented in 15% of plans, rising from 5% currently, over the course of 2004.

Pros and cons
The arguments in favour of currency overlay are as follows.
– Currency has a substantial impact on risk and return in global investment portfolios and this should be managed.
– Currencies exhibit low historical correlation with traditional asset classes, providing diversification benefits.
– Currency overlay can be used to alter the risk profile of a international investment portfolio, allocating a higher risk budget to more profitable asset classes.
The arguments against are:
– Currency trading is a zero-sum game.
– Currency movements represent a random walk and are unpredictable.
– There are no opportunities from investing in an efficient, liquid foreign exchange market.
As stated above, investing in a portfolio of global assets comes with some significant risk and no expected long-term return. The ‘no expected long-term return’ supports the zero-sum game theory, but comes with a big caveat. It theoretically implies that currencies should follow purchasing power parity over time. This is the case, but only over the very long term. Empirical evidence suggests that it might take 1015 years for currencies to return to equilibrium levels. In the short term, currencies can and do fluctuate a lot from this equilibrium. Few managers can wait for ten years or more when their investors have a much shorter time horizon. This point is illustrated by looking at the movement in the e$ exchange rate since the euro’s inception on 1 January 1999 (see figure 2). Although the cumulative return is close to zero, there are clearly periods of high volatility that would have had severe effect on reported portfolio returns.

Choosing a strategy
Once a decision has been made to manage currency exposure, the next step is to decide on the approach to currency management. This is the process through which the currency allocation is changed in order to reduce the risk or increase the return from the underlying global investments. The foreign exposure can be managed through passive hedging or active currency management.

Passive hedging
Institutional investors that are most concerned with the additional volatility from currencies within a portfolio would use this approach. The investor typically chooses a constant hedge ratio based on ex post data and a specific view of the future. The currency hedge is then implemented by purchasing forward contracts, selling the foreign exposure forward at an agreed rate for a specific date. The date of the forward contract is determined by the hedge frequency the investor wants to use typical contract terms are one or three months. Longer-term contracts are typically more expensive and expose the funds to greater moves in the underlying currencies. Hedging using forward contracts can remove most, if not all, of the currency risk within the portfolio, depending on the hedge ratio and hedge frequency chosen.
This risk reduction through using forward contracts does come with cashflow implications for the portfolio which might be a reason that a lot of pension funds do not hedge currency investments. The forward contract would be in favour of the investor if the local currency depreciates with respect to the foreign currency, and vice versa if it appreciates. If there is a negative cashflow effect from the forward contract, underlying investments might have to be sold or extra cash paid to settle losses. However, an outflow of cash is merely the response to an unrealised currency gain in the portfolio.

Active currency management
Investors that believe currency movements can be predicted over time might opt for a more active approach to managing currency exposure. The aim of this active approach is to enhance returns while reducing risk. Investors would typically hire a currency overlay manager to implement these active views on currencies. These managers have a specific approach and view when it comes to investing within the currency markets.
Various approaches and quantitative models based on historical data and future expectations are used by different managers to determine ex ante currency moves. The most common inputs into these models are fundamental economic views, technical analysis signals, and volatility information from the options market. The manager takes a view on the future appreciation or depreciation of the base currency against the foreign currencies invested in. Instead of having a fixed hedge ratio, the manager would then underweight or overweight the exposure to foreign currencies depending on market conditions and their approach.

Regardless of one’s approach to foreign investment, in today’s transparent investment environment the perception of a fund can be favourably enhanced only if the currency risks of the fund are well understood. It is even more important that the currency risk within a portfolio is communicated clearly to plan sponsors and trustees. o

Figure 1 UK pensions fund global asset allocator

Figure 1 UK pensions fund global asset allocator

Figure 1 UK pensions fund global asset allocator

Eben Karsten works at UBS in currency management services, giving advice on currency management issues ranging from hedging foreign investments to corporate transaction flows, as well as managing currency portfolios