FX Grows Up

After Brian Pellegrino took over the investment office at United Parcel Service in 2005, he found that the pension fund’s custodian was hedging developed-markets foreign currency in the international equity portfolio. The 50 percent hedge was doing the intended job of reducing the volatility of the portfolio return stream — but the high cost outweighed the benefits, says Pellegrino, who, a decade later, still oversees the pension fund, now valued at $30 billion.

The international equity portfolio, at only one third of the total equity allocation, was at the time relatively small. In addition, the more easily hedged, major currencies like the yen, British pound, and euro represented only 6 percent of the total pension fund — another consideration. As a result, immediately before the global financial crisis that struck in 2008, the Atlanta-based CIO terminated the program, believing, “If you can live with the volatility, you’re better off not hedging.” It adds no value, he concluded, and the fees are a drag on performance. “You won some and you lost some, but at the end of the day it was a net zero game,” he explains.

Not that long ago “a lot of investors in foreign equities were prepared for the rough and smooth of currency-delivered returns,” says Roger Urwin, global head of investment content for advisory firm Willis Towers Watson in the U.K. and a consultant to global pension funds. Increasingly, however, that is seen as inappropriate. In the last few years, more asset owners have been managing the risk and return exposures of currency with more finely calibrated strategies and more precision than they had in the past, he says. Urwin adds, only half in jest, “A lot of people say currency is a return-free risk.”

In the early 1990s, as increasing numbers of U.S. pension funds took on non-U.S. investments, some began to hedge the foreign exchange exposure. The California State Teachers’ Retirement System (CalSTRS), for example, began an international investing program in 1992. Three years later the pension fund started hedging its currency risk internally. It used no set ratio of assets to be hedged and was just “to play defense,” says CIO Christopher Ailman, speaking of a time before his arrival in 2000.

That strategy was about to change. After commissioning a study on its foreign exchange risk, in 2006 CalSTRS officials began to look at currency as a source of alpha, or return, taking a comprehensive view of all the exposures, including real estate and private equity, and managing it from that standpoint. “Currency isn’t just a risk; it’s an opportunity,” says Ailman. “CalSTRS made the decision that, as currency is influenced by central banks, it would be managed on the fixed income desk.” Glenn Hosokawa, who heads the desk, agrees with his boss: “Currency is a factor in our investments. It has an impact on everything.”

In keeping with CalSTRS’s philosophy of diversifying managers, the now-$192 billion fund’s three external managers hedge up to 40 distinct currencies within 20 percent of the total portfolio, including, in a somewhat rare move for their peer group, those from the emerging markets. “These are the first managers I visit when I’m in London because they have their finger on the pulse of the whole world,” says Ailman, speaking of Millennium Global and Adrian Lee & Partners. The third currency manager, FDO Partners, is in Cambridge, Massachusetts. An internal team of two hedges the other 75 to 80 percent in six major currencies that include the Australian and Canadian dollars, the euro, the British pound, and the yen.

Currency hedging is not without its own risks. It can bring pain when the home currency is rising or gain when it is falling, say foreign exchange experts. Richard Bernstein, CEO and CIO of his eponymous, New York–based macro-style investment firm, says the period from December 21, 2001, through December 31, 2007, “was an extraordinarily easy period of time when the dollar was falling. Most equity managers didn’t hedge then because it hurt performance.” At that time, when the Standard & Poor’s 500 Index produced an annualized 6.1 percent return, if one invested outside the U.S., in dollar terms, without hedging, it resulted in a 10.9 percent gain — or the total return of the MSCI All Country World Index (ACWI).

The effect was then reversed from December 31, 2007, through September 30, 2016, when the ACWI in dollar terms was only up 2.6 percent. “Now you start losing 100 basis points per year because of currency,” continues Bernstein. “In an environment of low returns, it can make a big difference.”

The total foreign exchange market is the largest asset market in the world. Trading includes spot delivery of physical currency swaps and forwards, turning over $5 trillion a day, as of April 2016, or 20 percent of total currency, including tourists’ overseas spending, says Javier Corominas, director and head of economic research and FX strategy at U.K.-based Record Currency Management. Typically between 20 and 40 percent of the average defined benefit fund’s assets are invested overseas, so currency is going to be one of the biggest risk factors, says Corominas. Hedge ratios can vary anywhere from unhedged to a full 100 percent of total assets, depending on the desired volatility reduction, at the total portfolio level, he says. Corominas explains that currency can be hedged at a set ratio as a passive benchmark, or more actively by varying the hedge ratio to allow a manager to add value and/or generate a lower cash-flow volatility profile relative to a passive benchmark.

Asset owners outside the U.S. have their own currency management decisions to make. Mark Fennell, general manager of portfolio completion of the capital markets team at the NZ$31 billion ($21.8 billion) New Zealand Super Fund, reports 100 percent of its developed-market foreign assets are hedged; emerging-markets currencies are hedged at a lower level. In 2010 fund officials brought currency management in-house to enable them to hedge in real time, rather than with their former Paris-based overlay manager. “We get a pick-up from hedging back to New Zealand, a persistent risk premia relative to developed-markets currency,” says Fennell, pointing to the country’s narrow export base and relatively high debt level. So while hedging does reduce volatility, because New Zealand dollars are slightly riskier to own than the U.S. dollar, “we’re also looking to capture that risk premia,” says Fennell.

APG Asset Management in Amsterdam, the €444 billion ($472 billion) manager of giant Dutch pension fund APB and several smaller funds, hedges between 70 and 80 percent of its clients’ assets in an overlay approach across all investment pools. Klaas Reedijk, head of allocation and overlay, says the country’s pension-funding ratio of 110 percent makes it important to mitigate volatility. “We’ve seen years where the hedge made us a couple million [euros] and years where we lost a couple of million,” says Reedijk. “If we make a profit in the overlay, there’s a loss in the asset class, and vice versa. It is a stabilizing mechanism.”

Not too far from Reedijk, Kasper Lorenzen — CIO of Danish pension fund ATP — says that for more than a decade, the internal fixed income, currency, and commodities team has hedged all of its currency exposure back to the euro and, in some cases, the Danish krone. “We’re completely hedged away so there is no hidden FX beta,” says Lorenzen.

Meanwhile, back in Atlanta, the UPS currency picture began to change significantly as the international equity holdings increased under Pellegrino’s watch, now representing half of the total equity portfolio. “It has a much larger impact on the portfolio and we needed to address it,” says the CIO, who has taken what he describes as a longer-than-usual time to select a currency manager and a broad hedge bogey. The future goal is to actively hedge between 10 and 50 percent of the major currency exposure in equities, and only where UPS thinks it’s prudent. Pellegrino plans a slow, three- to six-month rollout of this process to “check the pipes” and see if it’s working before turning it on full force. Next up: one-off hedging of assets in the private markets program. •