GLOBAL - During a time of fluctuating markets and when returns are all, Gartmore's James Binny asks whether pension funds can really afford to ignore currency risk any longer?
Currency overlay strategies are typically non evasive strategies that look to control risk on foreign currency exposure in the first instance.
But in recent times, when pension funds are desperately scratching around to enhance returns, firms such as Gartmore Investment Management have also turned their attention to generating alpha on existing currency exposure.
Binny, a senior investment manager with Gartmore, explains how, unlike conventionally crowded markets such as stocks and bonds, managers have room to manoeuvre amid “incredibly liquid” currency markets where not every player is there to outperform.
“With currency it’s quite a different game. The total volume going through currency markets is US$1.3trn each day, according to the Bank of International Settlements, [but] the total volume of assets under management in currency is considerably less,“ he says.
“[This is] because of all of the other players who are not trying to make money, such as central banks, corporates, or traditional managers transferring equities. This leaves money on the table for professional currency managers which means that the average manager can add value.”
So how does it all work? Managers of large sums of money such as pension- or mutual funds frequently hedge against currency risk by buying or selling futures or options contracts. For example, a pension fund manager with a large position in Eurozone stocks, who thinks the euro is about to slide in value against the US dollar, may buy futures or options on the euro to offset any projected loss.
The practice really started to take hold in the 1980s - Gartmore first entered the market in 1988 - and is now used by pension funds worldwide, particularly in smaller markets where overseas exposure tends to be higher. Some estimates put the number of large pension funds using currency overlay by mid-2000 between 200-300.
Despite this uptake, however, UK pension funds are still lacking converts. Certainly, in the bullish 1990s, few cared about what was perceived as nominal currency volatility. Many also considered Sterling to be weak and believed that currency markets were a purely speculative game.
But the affects of controversial accounting standard FRS17, as well the growing shift from balanced to specialised portfolios in the UK, are forcing schemes to examine the whole issue of risk more closely, adds Binny.
“When a pension fund invests overseas, there are two aspects - one is the return on the asset, the other is the return on the currency. Typically, overseas managers get hired [as stockpickers], but the currency gets left unmanaged and unhedged.”
Some estimates have put global crossborder transactions at US$3trn by 2005, meaning a potentially greater impact on returns, he points out.
For example, the use of a currency overlay strategy on a 30% overseas exposure could mean additional returns of between 1-2%, or an extra 60 bps.
But why look to currency as an uncorrelated source of return and not, for example, hedge funds?
“With hedge funds you must sell assets in order to by the hedge fund, and potentially you are selling at an unattractive price. But with currency overlay you already have that exposure. Its just a matter of managing it. In a way it’s a return that has not been exploited.”
Binny is the first to admit that the technical language surrounding currency can often “frighten” pension funds and agrees that simpler education is needed in order to stop schemes accepting unnecessary risk and realising untapped currency gains.
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