John Ferry
02/01/2005
Fred Bisset found a receptive audience when he took the stage at an investment conference in the New York Plaza Hotel’s grand ballroom in October. Bisset, founder and chief executive of the Rowayton, Conn.-based currency management company A.G. Bisset, was there to proclaim the virtues of a strategy called currency overlay, which attempts to shield clients from foreign exchange losses on their overseas investments. His timing was right: The dollar had lost nearly 15 percent of its value against the euro in the previous two years. (A rout in the weeks that followed would shave nearly 10 percentage points more off the greenback’s value.) Those in the audience who had invested in euro-denominated assets had done well; those whose assets were valued in dollars, and who had euro-denominated liabilities, had taken a bath.
| TOP VIEW Investors with assets denominated in a foreign currency run the risk that exchange rates will move against them over the duration of their investments. To lower this risk, some are beginning to turn to currency overlay managers, who use various hedging strategies to manage currency exposures. Though these strategies are sometimes said to be only as good as the predictive powers of the manager, studies show that currency overlay can reduce overseas investment risk. |
Take, for instance, a U.S. investor who has made a 10 percent annual return on his shares in a German company. If, over that period, the value of the dollar falls 15 percent against that of the euro, then he has actually suffered a 5 percent loss in his purchasing power. It is common for currency moves of this nature to wipe out hard-earned gains in foreign equity or bond markets. To avoid this fate, individuals must not only pick high-performance investments, they must beat the currency markets as well.
This requires specific expertise. Indeed, currency overlay gets its name from the fact that it is handled by currency specialists who work separately from the portfolio managers, who pick the underlying investments. The currency strategy lies, figuratively, on top of the investment portfolio. If a U.S. investor owns a $10 million portfolio of Japanese equities, and bears the risk that the yen will depreciate, he can hire a currency overlay manager—separate from the manager of his Japanese equity portfolio—to hedge his $10 million exposure to the yen.
| Overlay managers say their fees are well below those charged by mutual funds or hedge funds. “A typical management fee for an overlay mandate is maybe 25 basis points [one-quarter of 1 percent] a year, and if your manager is good, then he should be earning 2 percent or 3 percent a year in return,” says Gary Klopfenstein. He adds getting started is a relatively simple process. “You don’t have to give your funds to an overlay manager. We simply talk to your custodian bank and get trading authorization.” |
Gary Klopfenstein, a currency overlay specialist at Mesirow Financial in Chicago, says, “If you are a high-net-worth individual and you have 15 percent, 20 percent or more of your assets overseas, then it is going to make sense to look at actively managing the currency piece of your portfolio.”
The globalization of investment markets over the last 20 years has spurred the development of currency overlay. When large financial institutions began placing vast amounts of money overseas, fund managers naturally took note of how currency fluctuations affected their returns. Individual investors who have diversified internationally more recently learned the same lesson.
BESPOKE SOLUTIONS
Currency overlay is not only a defensive strategy; specialists may attempt to generate returns for their clients. They do this by betting that some currencies will decline while others will rise, or by using market-neutral strategies that benefit from large swings in value regardless of their direction. Also, like hedge funds, currencies do not move in lockstep with stock and bond markets, so adding currency plays to a portfolio can dampen its overall volatility, lowering its risk.
In 2003, research firm Russell/Mellon examined the performance of 18 currency overlay managers and found that, over a seven year period, they added an average 1.06 percentage points of return to their clients’ underlying investment portfolios.
The strategies they use to deliver such returns are fairly straightforward, and tend to rely on currency forwards, which are contracts to buy or sell a currency at a predetermined price at a specific date in the future. The firms use these contracts to lock in the value of the investor’s currency. They tailor the amount of the purchase (or sale) to meet the investor’s risk tolerance. Neil Record, chief executive of Record Currency Management, an overlay specialist firm based in Windsor, England, explains: “We establish a hedging program that can either be completely passive, where you choose to hedge blindly a proportion of your assets, or you can have active overlay, where the manager is given the discretion to choose the extent to which any particular currency is hedged or not.”
The best currency overlay managers are effective active managers. (Passive hedging strategies are easy to design and execute.) “You aim to be unhedged when the currency the client is invested in is going up, and hedged when it is going down,” Klopfenstein explains. “Currency overlay consists of three things: knowing when to put a currency hedge in place, knowing when to take it off and knowing by what proportion to hedge,” Bisset adds.
A.G. Bisset carried out a study in which it compared different passive strategies with its own historical record using an active approach. The company claims that from 1998 to 2003 its active hedging and unhedging of currency exposures easily outperformed any passive approach (see graph). However, in certain short time periods, this is not the case.
POOLED PARADIGM
Even if it is better in the long term to actively manage currency risks, predicting when to hedge and when to leave a portfolio exposed is extremely difficult. The real risk of currency overlay is that the strategy is only as good as the manager’s predictive abilities. They freely admit this. “There’s only a handful of us who have the experience to do this,” says Klopfenstein. For this reason, he adds, the handful of companies that specialize in currency overlay are run by people who have decades of experience trading currencies. 
Until recently, only large institutional investors, family offices and extremely wealthy individuals had access to currency overlay managers. Now, companies such as Record Currency Management are creating pooled overlay programs for smaller investors. “We are launching a pool out of Dublin that will offer hedging for minimum account sizes that are relatively small,” says Record. Those with a minimum of around $4 million to $5 million invested in overseas assets can participate.
Investors in the Record pool can choose whether they want to be passively hedged or actively hedged with an additional alpha-generation element. In the context of currency overlay, alpha is the return generated above that which is attributable to the market’s own moves, so it is a measure of the real value a manager adds. (See “Greek Menu.”) “The pool will offer hedging, but there will also be an element that will look quite like a very specialist currency overlay hedge fund,” Record says. “You get almost an identical menu of choices as a pooled investor as you would as a segregated client; you can get pure hedging, pure alpha or a mix.”
John Ferry is an Edinburgh, U.K.-based journalist who specializes in writing about financial markets and investments for, among others, RISK and Worth magazines. john.ferry@blueyonder.co.uk
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