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| Risk & Reward: Strategy |
World Beaters
John Ferry
02/01/2005
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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. |
“Nothing is more powerful than an idea whose time has come,” Bisset told his audience, echoing Victor Hugo’s remark about the French Revolution. Bisset chose his quote carefully: He believes the process of managing the currency risk in an international investment portfolio is nothing short of revolutionary, and that it can help affluent investors avoid substantial losses. “The wealthy individual with international investments has just as much risk in his currency as a pension fund that has taken 10 percent or 20 percent of its assets and diversified into other countries,” he says.
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.” |
The dollar’s strength in the 1990s and the first years of this decade made many sanguine about their exposure to currency fluctuations, but the losses investors have suffered from more recent turmoil has made it a pressing issue. “I think that the excessive volatility that we have seen in currency markets during 2002 and 2003 has made international investors realize they are holding a risky asset that doesn’t give them any return,” Marco Bozzolan, CEO of Geneva-based Perréard Partners Investment, says, referring to their currency exposure. “Investors have decided that it is time to do something about it and are coming around to the idea of hedging that risk.” 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.
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