Reducing currency volatility

Volatility in the currency markets, once only a blip, has now reached historic highs and institutional investors are looking for ways to keep their currency exposures from dragging down returns.

As a result, the days when investors could ignore the risk introduced to their equity portfolios through currency fluctuations are over.

Most investors have taken a conservative approach to currency management - hedging out larger portions, or for some, initial portions, of their equity currency exposures, industry watchers said.

Principal Global Investors' managing director and head of currency Mark Farrington said: "With low volatility, people were looking for alpha... Now that the downturn in volatility has reversed, the emphasis on risk reduction has come back."

Volatility was at a steady decline from 2004 right through to June 2007, with the Barclays Capital Trade Weighted 3-Month USD Volatility Index bottoming out at 5.76% on 29 June 2007.

However, by August 2007 implied volatility had topped 10% and continued rising, peaking at over 24% in October 2008 and by early March 2009, it was hovering around 17%.

State Street Global Advisors' head of currency management Collin Crownover said his clients were taking risk off the table. In 2008, gains in SSgA's passive currency business were three times larger than in 2007.

"Where we've seen the spike (in interest from investors) is for passive currency management," he said.

A return to hedging
There's also evidence that pension funds are taking a new look at their hedging capabilities. For example, the US$161.5bn California Public Employees' Retirement System (CalPERS) recently revamped its entire currency hedging programme in a bid to reduce volatility.

In December, trustees at the pension fund voted to hedge 15% of the total foreign equity exposure across all investments, as opposed to the 25% hedge on foreign equities in developed markets that the fund had been using.

The gradual shift towards hedging across the entire portfolio "should reduce risk slightly" but officials at CalPERS were unable to outline by exactly how much, said spokesman Clark McKinley.

CalPERS sees its new hedging strategy as a temporary fix to the currency risk incurred through its ever expanding overseas assets.

When the pension fund began hedging in 1992, the exposure to foreign currency was only 16%. But in the past year, officials at CalPERS have been making a heavy push into international securities across all asset classes, and overseas currency exposure will soon reach 42% of total assets, according to a meeting document.

Instead of a static 15% hedge, staff at the fund will eventually move towards a more dynamic hedge that looks at the appropriate ratio within each individual portfolio and investment program, and then be aggregated to determine the right hedge ratio, said Michael Schlachter, managing director and principal at consulting firm Wilshire Associates, the pension fund's consultant.
By having a static hedge, staff may inadvertently cancel out the intentional currency exposure managers were relying on to generate returns.

"I can think of at least 10 different places where decisions are being made at least partially on currency," said Schlachter.

Many investors already hedge out the currency risk from fixed income investments because the risk of taking a hit from currency fluctuations is much higher than with equities. According to data from CalPERS, currency contributes 20% to the overall risk of an equity portfolio and 90% to the total risk of a fixed income portfolio.

Consulting firm Hewitt Associates' UK-based clients are a case in point.

The firm has started recommending that their clients hedge their foreign equity exposure, while most already hedge out their entire foreign bond exposures, said Hewitt Associates' principal John Belgrove.

"Currency in the long run is a zero sum game, but in the short term, it represents noise," said Belgrove about equity portfolios.

He added: "Following significant sterling weakness in 2008 and beyond, our view has moved to suggest some hedging would now be prudent from a medium-term timing perspective." Belgrove is suggesting a 50% hedge ratio for clients who previously left their currency exposure untouched. "Sterling would have to cheapen further for us to extend that view to recommend a higher hedge ratio."

Less active
Meanwhile, interest in active currency management - exploiting the volatility in the equity markets to reap returns - has been in decline. According to data compiled by Mercer, global searches for active currency managers has decreased since 2006 with 16 searches recorded that year, 11 in 2007 and a mere five in 2008.

The firm has seen "a lot more inquiries" about currency hedging recently, said Mercer principal Diane Miller.

According to preliminary numbers by Mercer, the firm estimates some 33% of UK investors are now using some sort of currency hedging within their portfolios, up from 25% a year ago, said Miller.

An investor can outsource its currency risk to a currency overlay manager and separate the risk management from the security selection and asset allocation decisions.

Managing director at Overlay Asset Management, part of BNP Paribas Investment Partners, Hélie d'Hautefort said about two-thirds of the requests for information the firm has received in the past six months has been for currency protection, with one-third inquiring about alpha generation.

"Prior to that, it was the opposite," he said.

The tides shifted in mid-2007. The subprime credit crisis was the first jolt to the system. "That was the first red flag," he said.

But volatility continued to soar to unprecedented levels towards the end of 2008. d'Hautefort said: "Last fall, especially October and November, were especially hectic."

The currency markets reflected the world-wide financial chaos and the overall lack of liquidity. Implied volatility hovered around 20% through February before dipping slightly down to around 17% in March.

Reducing risk
The downfall of so many large financial institutions has made protecting against currency risk a risky endeavour. Firms like Lehman Brothers and Citibank are often used as counterparties in currency transactions and their declines led to a disruption in the arbitrage system that reduced risk in the currency markets, experts said.

Currency managers said clients have become much more demanding about the due diligence conducted on counterparties.

Principal's Farrington said his clients wanted to ensure the firm didn't have high concentrations with its counterparty banks.

The firm has a 20% limit on the use of any one bank but no counterparty typically rises above 15%, said Farrington. "That was a saving grace for us."

Record Currency Management's chief investment officer Bob Noyen said his clients have also been asking for increased due diligence on counterparties. Clients are looking for increased diversification and proactive ways to mitigate risk.

"On the balance, we try to diversify as much as we can," said Noyen, adding that Record usually uses between six and eight counterparties. Record has also begun using stricter measures to evaluate their banks. "We look at CDS (credit default swaps) and CDS price levels instead of simply relying on ratings," he said.

But he and others said there is also a cash-flow risk involved with hedging.

"If the risk (that you are hedging out) doesn't materialise, or it turns against you, that can be very costly," said Noyen.

Back from the dead
However, despite the uncertainties in the markets, active currency management is not dead. For most, it's just on the backburner.

APG Asset Management, the manager for the Dutch pension fund ABP is one investor that is bucking the trend.

"The violence in the market was incredible," said head of APG's global tactical asset allocation fund Gerlof de Vrij, and this translated into potential for returns.

APG's €3bn (US$3.83bn) GTAA strategy with a target volatility of 15% returned over 5% at the end of 2008. Returns had reached nearly 20% in the beginning of the year, but dipped down again due to market dislocations and liquidity issues, said Vrij.

Putnam Investments' head of currency Parker King, said two of his clients are actually dialling up their tolerance for active currency.

In the years leading up to the credit crisis, passive currency management decisions made little difference because not only was currency market volatility low, but it was low relative to equity market volatility, King said.

"Doing anything with currency didn't make a difference at the plan level because volatility relative to the markets was low," he said.

But now, two of his clients are using currency in an effort to recoup some of the losses from the equity markets. One investor increased their risk budget with the firm and another increased its active currency mandate. King declined to name the investors.

Generally, the unprecedented nature of the economic downturn have made pension funds across the globe reassess the amount of risk they are taking within their overall portfolios.

But managers and consultants alike said there is potential to view currency as an alpha generator in the future, despite the wave of hedging activity currently going on.

"With the institutional investor base, they may currently have bigger solvency-related issues to deal with than currency," said SSgA's Crownover. He added "once the dust settles on the 'emergency' part of the financial process" investors may again look to the currency markets for additional alpha.