36 | Professional Pensions | 31 March 2011

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Sponsored Currency PANEL

Current currency
In our annual currency panel, the panellists discuss how to manage currency exposure to reduce risk
and enhance scheme performance plus likely major currency trends for the rest of the year
Ashley Shaw, head of distribution, Macro Currency
Group, Principal Global Investors

Bob Noyen, chief investment officer,

Record Currency Managment

Jay Moore, managing director, State Street

Global Markets

Ashley Shaw is head of distribution for the

Macro Currency Group. He is responsible
for leading the development of the
Groups business and communicating
the Groups investment strategy to clients
and prospective clients (through the
institutional, wholesale and fund of hedge
fund channels). Shaw is also responsible
for developing the Groups product range.
Shaw joined the firm in 2008. He received
an MSc in International Business & Finance from the UMIST
School of Management and has a BA(Hons) in History from
the University of Manchester.

Bob Noyen joined Record in 1999 as

director responsible for investment and
research. He is now chief investment
officer responsible for research, portfolio
design, trading operations, and a
member of the executive team. Noyen
joined from Minorco (part of Anglo
American plc), where he was assistant
treasurer in Luxembourg since 1989.

How can schemes do more to manage currency

exposure within their existing portfolios? Is
currency overlay one option open to schemes
looking to reduce risk and, if so, how would this
help schemes?

Bob Noyen: Investments made in foreign

assets contain inherent currency risk.
Investors can minimise this risk, thus reducing
overall portfolio volatility, by hedging their
currency exposure. This can be done either
passively or dynamically. Passive hedging
works by investing in currency forwards or
other instruments that offset some or all of an
investors foreign currency exposure.
By contrast, dynamic hedging can be
thought of as an insurance policy. It works
by allowing investors to profit from foreign
currency appreciation by leaving the underlying asset unhedged or reducing the hedged
proportion, while protecting investors
against foreign currency weakness through
increasing the proportion hedged. Thus,
dynamic hedging maintains the volatility
reduction benefits of a passive hedge, while
adding value on the returns side.
For investors who have exposure to
emerging market currencies, we would not
generally recommend hedging these exposures as we believe these currencies have a
strong potential for appreciation, making the
hedging programme loss-making. However,
investors wanting to reduce their exposure to
certain (overrepresented) emerging markets
currencies could achieve a more balanced
currency exposure through recalibration .

Ashley Shaw: Where a scheme has significant overseas exposure, it is inevitably exposed
to currency risk. Accepting that this risk exists,
and understanding that simply ignoring it is
in itself an active decision, is the first step to
dealing more effectively with their currency
exposures. Allocating adequate resources to
manage this exposure is the second step.
Once a scheme has made the decision to
actively manage their currency risk, it makes
sense to engage a specialist manager as they
have the expertise to effectively manage the
currency risk by providing a range of useful
benefits to scheme portfolios, such as:
Management of currency risk in the
overseas portfolio, particularly reduction
of the drawdowns associated with equity
returns;
The preservation of principal generated
by the traditional portions of the portfolio
by providing protection from return
degradation caused by adverse currency
movements against the schemes home
currency;
Expression of tactical or strategic views on
the direction of the home currency;
Generation of additional returns.
Currency overlay has a very specific function in a globalised portfolio and should be
considered of primary importance, rather
than a fringe or alternative asset. There can
be a decision to run a passive fully hedged
overlay or a dynamic partial hedge, but this
should be understood as an active decision,
albeit one with a low turnover, made within a
given investment framework.

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Jay Moore is managing director of

currency management at State Street
Global Markets, the trading and research
arm of State Street Bank & Trust. He
currently oversees all functions related to
the firms currency management business.
Moore has a bachelors degree in finance
from the University of Connecticut and
earned the chartered financial analyst designation. He
frequently writes and speaks about currency management
issues and trends.

Jay Moore: Ideally, decisions regarding

currency exposure should be taken at the time
of asset allocation. Investors often design their
asset allocations with assumptions about international asset class returns in either the local
returns (fully hedged) or unhedged returns
to their base currency. The resulting asset
allocation implies a view on the diversification
benefits of currency exposure that should be
consistent with the final decision to hedge or
not hedge.

For example an allocation to global equities decided upon returns denominated in

GBP (unhedged) implicitly includes both
the equity and currency components. This
suggests that inclusion of both foreign equities and currencies is optimal to meet the
risk return objectives of the scheme as determined by the asset allocation study. Hedging
away the currencies in this example may
materially change the risk profile of the asset
allocation, if the currency component was
identified beforehand as a source of diversification alongside the other portfolio assets.
Exposure to currencies should be a proactive
part of the asset allocation decision, if only as
a risk factor to help diversify the portfolio.

To what extent can an active currency portfolio

help improve scheme performance?
Ashley Shaw: Currency markets have
proved that, regardless of the global economic
climate, they remain highly liquid relative to
other asset classes and responsive to changes
in underlying fundamentals. Engaging an
active currency manager, therefore, has the
propensity to improve scheme performance on
both sides of the equation: by generating additional returns while reducing the risk of the
total portfolio, thereby improving the schemes
sharpe ratio.
By selecting the right currency investment style, schemes are able to access alpha
managers that can generate returns that are
uncorrelated with traditional holdings in the
portfolio; the more lowly or negatively correlated, the greater the diversification benefits
of the investment and so triggering a riskreduction effect. While the focus here is on
alpha generation, risk-reduction is a welcome
secondary effect.
Base currency hedging can also be

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Sponsored Currency PANEL

utilised to improve a schemes performance,
particularly if an active approach is adopted.
By shifting the schemes hedge ratio on a
dynamic basis, a dynamic hedging strategy
is able to not only reduce non-base currency
risks but position the clients currency
exposures to benefit from the appreciation
or depreciation of their home currency on a
strategic basis. While the focus here is riskreduction, alpha generation is a welcome
secondary effect.
Bob Noyen: As well as being a viable way
of reducing risk in international portfolios,
currency strategies can also be a source of
uncorrelated value-added for institutional
investors. Currency movements are not
random, nor is the currency market efficient.
It is possible, therefore, to observe trends and
mean-reversion patterns over different horizons, as well as take advantage of certain risk
premia. This allows managers to add value to
their portfolios by adopting an active approach.
As an active approach to currency overlay
we recommend that investors maintain exposure to a diversified range of currency investment styles (such as carry, trend-following,
deviation from fair-value) and allocate risk
dynamically between the strands. This allows
investors to improve scheme performance
under different market conditions and diversify away from more traditional asset classes.
Jay Moore: Active hedging of international
portfolios can be a daunting and expensive
task. This is particularly true of non-US portfolios in which the most meaningful exposure
and hedging decisions are focused on the
US dollar. In a sense, investors that forego
complex cross-hedging or currency alpha
programs are effectively hiring their managers
to make portfolio calls on the US dollar. For
this reason, pairing the right passive hedging
strategy with a separately managed currency
alpha program offers the best balance of risk
management and return generation.
Active exposure to currencies as an asset
class can provide a unique source of diversification for a portfolio. As with any asset
class, active currency managers depend on a
breadth of investment choices to maximise
the likelihood of consistent performance.
Currency alpha programs decouple the
investment universe from implicit portfolio
exposures, providing an opportunity to take
both short and long positions as well as to
expand to less efficient emerging market
currencies.

to generate alpha while potentially easing

the cash-flow requirements of a passive
hedge. As mentioned above, while the focus
of base currency hedging is risk-reduction,
alpha generation and portfolio efficiency are
welcome secondary effects of adopting a
dynamic approach.
Bob Noyen: As the eurozone struggles on in
its efforts to ensure macroeconomic stability,
there are tough times ahead for the Euro.
While the political resolve of Eurozone leaders
is still so strong that we regard an outright
departure from the Euro relatively unlikely in
the near term, we believe that the full range of
possible outcomes is not adequately priced in
by the markets.
A lot of investors we speak to are
concerned with the prospect of developed
currency debasement. This, we believe, is
a reasonable concern, with most developed
country governments finding themselves
politically incentivised to debase, given the
debt-laden households and high stock of
public debt. One can capitalise on this uncertainty by investing in harder currencies
currencies that, due to strong economic
fundamentals, a preference for low inflation
or resource wealth, are likely to maintain
their purchasing power going forward.
Emerging market currencies also offer an
opportunity for institutional investors. Our
research shows that over time about 40%
of EM equity returns can be accounted for

by currency (for GBP investors). With EM

growth several percentage points above
developed market levels and EM currencies
still undervalued, we expect to see further
currency appreciation going forward.
Jay Moore: In the wake of the global financial
crisis, asset owners and investment managers
alike have become far more aware of the
importance of currency risk in preserving
performance. Asset owners are faced with the
decision to hedge or not hedge. Investment
managers are forced to decide whether or not
currencies should be included as core to their
investment philosophy.
Fixed income managers have long considered foreign exchange to be a critical part
of their investment philosophy. But equity
managers have traditionally been less
engaged, considering FX risk to be a relatively
benign component of total performance.
While some equity managers are now
adopting hedging processes that preserve
the local returns of their foreign investments,
most have chosen to offer both hedged and
unhedged portfolios in response to client
demands for one or the other strategy. This
trend of asset manager currency risk management provides many asset owners with
investment products that meet their strategic
hedging objectives. But it may not deliver
optimal value to larger schemes that can afford
to deploy centralised hedging strategies that
can be more cost effective and transparent.

What do you believe are the major currency

trends for the remainder of 2011 and what
are the opportunities that schemes can take
advantage of?
Ashley Shaw: One of the major trends in the
currency world this year is the definition and
capturing of the markets beta, itself an iteration of the broader alpha/beta separation trend
experienced in the aftermath of the financial
crisis. Currency market beta strategies provide
schemes with the opportunity of accessing a
highly liquid asset class while in the process
introducing an additional dimension of portfolio diversification.
There is also growing interest in the
concept of dynamic base currency hedging.
Like its passive counterpart, the aim of
dynamic hedging is to reduce a schemes
exposure to non-domestic currencies thereby
reducing currency derived volatility across
the portfolio. Where the approaches differ is
that dynamic strategies also have the ability

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