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Currency hedging expected to rise

Date: Monday, February 9, 2009
Author: Drew Carter, Pensions & Investments.com

Global volatility strengthens case for investors to offset foreign exchange risk.

Global institutional investors are poised to hedge their currency risk in the face of dramatically increased volatility in the foreign-exchange market, experts say.

“What we have been seeing more recently is people asking about hedging,” said Diane Miller, principal at Mercer LLC's London office. “We're getting quite a lot of queries.”

Consultants said they have recommended currency hedging for years, but today's environment has heightened investors' concerns about their foreign exchange exposure.

For the year ended Dec. 31, volatility doubled among the Group of Seven currencies, according to the JPMorgan G7 Volatility index. Similarly, a Bloomberg analysis of the G10 currencies shows volatility in the quarter ended Dec. 31 was more than double from a year ago. The pound was hit particularly hard, losing 36% and 30% to the dollar and euro, respectively.

“At the present time, (the interest in currency risk) has probably pegged up one or two notches,” said Matthew Roberts, a London-based investment consultant at Watson Wyatt Worldwide. “A number of our clients have shown an interest in their currency risk in recent months” because of the increased volatility.

Said Joachim Alpen, global head of currency at merchant bank SEB AB, Stockholm: “The massive increase in volatility has certainly made people more aware of currency risk.”

“It's very hard for anyone to neglect (hedging),” Mr. Alpen said.

A recent survey of corporate treasurers by JPMorgan Asset Management indicated that 43% of respondents said foreign exchange risk was a key concern in cash management for 2008, up from just 6% a year earlier. Currency risk was the top concern, edging out the credit crisis.

“This is clearly a reflection of the dramatic currency movements witnessed in recent months and also the extreme uncertainty over global interest rates seen in the summer of 2008, when central banks seemed to be treading the finest of paths between the devil of higher inflation on one side and the deep blue sea of slowing growth on the other,” Kathleen Hughes, head of global liquidity for Europe, the Middle East and Africa at JPMorgan Asset Management, said in a news release accompanying the survey results.

Mr. Alpen said global equity investors used to be able to justify not hedging their portfolios because performance in local currency terms would often make up for any foreign currency moves. “That argument is very hard to make today, when you have large and erratic movements in all asset classes, including FX (foreign exchange),” he said.

A large Swiss public pension fund is moving to hedge all of its foreign currency investments, which created a $1 billion net inflow for passive hedging strategies to Record PLC, London, in the fourth quarter. “The funded public schemes (in Europe) are taking risk reduction very seriously,” said Neil Record, chairman and CEO of the eponymous currency management company. He would not identify the Swiss fund.

Record also has been selected by two U.S. public pension fund clients for active currency hedging mandates worth a combined $5 billion, pending contract completion. Active hedging varies risk reduction on currencies to allow the investor to gain from beneficial foreign exchange movements and adds approximately 100 basis points to returns, Mr. Record said.

The $11.5 billion Kentucky Retirement Systems, Frankfort, is one of Record's new clients, said Adam Tosh, the fund's chief investment officer. The move was made as part of a “modernization” of the fund and as a response to heightened volatility, Mr. Tosh said.

“We had been naked to currency for a long time,” he said. “We didn't want to be in a situation where (international equity managers were doing well) and lose that to currency.”

Making money work

But the system's investment committee also didn't just want a static hedge. With an “abyssmal” funding status, “We have to make the money work as hard as it can for us,” Mr. Tosh said.

International equity constitutes 20% of total assets and “will continue to rise,” he said.

The C$5.2 billion (US$4.2 billion) University of Toronto Asset Management Corp. decided in December to change its passive 100% hedge of foreign exchange exposure to an active 50% hedge, said William W. Moriarty, UTAM president and chief executive officer. He wouldn't disclose the amount of foreign exchange exposure.

UTAM, which manages pension, endowment and other funds for the university, will begin a private search “shortly” for a currency manager to run the active piece; Pareto Investment Management Ltd. will continue to run the passive portion and can bid for the active job, Mr. Moriarty said.

Interest also is growing among other investors, said Simon Chinnery, vice president of JPMorgan Asset Management's U.K. institutional business in London. JPMorgan's Life Global Dynamic fund in the U.K., with £250 million ($360 million) in assets, offers a hedged share class that is suddenly attracting attention of smaller pension funds with £100 million to £200 million in total assets, Mr. Chinnery said.

“We (created the hedged share) because one or two clients asked us for it. We're getting quite a lot of interest now,” he said, declining to name clients.

Virginia Reynolds Parker, founder and managing member at Parker Global Strategies LLC, Stamford, Conn., said she's seeing increased currency hedging interest from both institutional investors and global corporations with exposures outside their base currencies. Parker provides advisory services and manages about $800 million, including $180 million in currency strategies.

The trend toward adding currency hedges has been growing the past five years or so, consultants say. In part, it has been fueled by the increasing diversification of equities away from a home-country bias: As overseas equity assets mount, so does currency risk.

That diversification will continue in 2009, according to two estimates that place global or international investments at or near the top of new mandates expected. The annual Consultant Search Forecast survey of Casey, Quirk & Associates LLC identifies international/global equity as the No. 1 asset class for expected search activity, while a survey by Eager, Davis & Holmes found global mandates were expected to see the second highest increased demand, behind liability-driven investing strategies.

“On the margins, as cross-border investments increase, currency hedging is likely to increase, but not at the same pace,” said Yariv Itah, partner at Darien, Conn.-based Casey Quirk, in an e-mail response to questions. “For the most part, institutions do not hedge away all of the currency exposure gained through foreign equity and bond investments. Much of the diversified currency exposure is intentional or at least tolerated by the investors.”

Currency volatility is one reason for “an awful lot more examination of the currency risks and the fact that it is two-sided,” said Graham Wood, senior consultant at WM Performance Services, Edinburgh, an independent consultant to pension funds.

Mr. Wood said that in the U.K., approximately half of all pension funds use some currency hedging, although the scope varies.

Mercer's Ms. Miller said about 25% of its U.K. clients use passive hedging. Consultants recommend hedging about 60% to 75% of an overseas equity portfolio's assets.

She expects passive hedging to grow in 2009: “The case of hedging for individual pension funds has to be seen in relation to their total assets and overall risk profile. Even so, we expect that the proportion hedging their overseas equities is likely to be greater than 25%.”

Contact Drew Carter at dcarter@pionline.com