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Is It Time To Hedge Pension Assets?

In the 1980s, many pension fund managers saw the dollar rise substantially against most world currencies, and took to hedging programs to offset the potential loss of value in foreign equity holdings. Many of those same funds dropped their hedging programs during the long period of dollar weakness that followed. The result? If the dollar rises substantially in the next few months, many of pension funds will be left unprotected.

How would a 10 percent rise in the dollar effect U.S. pension portfolios? What is the best way to hedge against a rise in the dollar? Should hedging be implemented by money managers or globally by an overlay manager of the pension plan itself? Is this the moment to implement a currency hedging program? Answers from our contributors are all over the map. Most, however, agree that the hedging decision presents a difficult problem-and that market timing is not the answer.

Matthew Jensen
director, international research, RogersCasey

Have plan sponsors been aban-doning the concept of currency hedging over the past couple of years? No. Rather, many have not directly addressed it, and in several cases for good reason-the average plan sponsor does not have a large enough allocation to international assets to justify most types of dedicated currency hedging strategies. In a survey of large public and corporate pension plans by RogersCasey and Goldman Sachs released in 1996, the median respondent to the survey had 15.4 percent allocated to international assets. Most industry participants and RogersCasey's own research has shown that at allocation levels below 10 percent the risk reduction benefit from currency hedging is small and somewhat offset by the cost. At somewhere between a 10 percent and 30 percent allocation to international equity holdings, with some consensus around 20 percent, the cost/benefit relationship reverses and some form of currency hedging makes sense. RogersCasey's own experience is that international allocations are increasing, and this has caused plan sponsors to address more actively the issue of currencies.

For those plan sponsors that have a significant amount of international assets, they typically do not have the time or resources to implement selected tactical hedging strategies based on the current position of the dollar. However, plan sponsors do make important longer-term decisions related to the currencies in their plan.

All plan sponsors have a currency hedging policy either de-facto by the type of benchmark they have selected or through some form of analytic framework. For example, the plan sponsor that has selected MSCI EAFE unhedged has selected its neutral position on currencies as unhedged. In the RogersCasey-Goldman Sachs survey nearly 60 percent of corporate and 77 percent of public plans have an unhedged policy, though more are moving toward some type of partially hedged approach. All sponsors also have, again sometimes by default if not by process, selected an implementation method of their currency policy. The implementation can be simply allowing an active EAFE manager to hedge defensively based on fundamental and technical factors, or employing any number of active or passive overlay strategies.

Our position is that the currency policy and implementation strategy are long-term decisions and should not be driven by the current state of the dollar-that is a tactical decision that should be handled by the portfolio or currency managers. Rather, policy and implementation result from the specific attributes of the plan, the sponsor's attitude toward risk, a long-term evaluation of the behavior of currencies and current market conditions.

For plan sponsors that have not gone through an evaluation process for determining their currency policy, now, and in fact anytime is the right time to do so. Given the current dollar strength, however, now may not be a good time to implement that currency policy.

Janet Becker-Wold
vice president, international consultant, Callan Associates

American pension plans began investing in international equities in the mid-1980s. From that time on, the dollar has mostly depreciated against the major currencies of the world. In only a couple of years has the dollar appreciated enough to cause U.S. plan sponsors to sit up and take notice? Compared with the dramatic moves the dollar had in the 1980s, both up and down, the changes in the late 1980s and 1990s look relatively docile in comparison. Just to put things in the proper perspective, the dollar appreciated versus the German mark 40 percent from 1980 to February 1985 and then depreciated by 109 percent from early 1985 to 1987. Since 1990, many currencies have traded in a much tighter range to the dollar.

The answer to whether or not U.S.-based investors should hedge their non-dollar exposures has been thoroughly debated in the academic arena. Consultants, asset managers and specialist currency overlay managers have taken on the mission of educating their clients on the various pros and cons of hedging. Ideally, hedging is a policy-level decision made at the time of the allocation to the non-dollar asset class. In this context the risk, return and correlation that currencies contribute to the asset class and the total fund are considered explicitly in the asset allocation decision. A policy on hedging should also incorporate an assessment of the risk profile of the fund in light of the funded status, which takes into consideration the nature of the liabilities. That is, how much risk (in absolute or relative terms) the plan can comfortably bear. There is never a better time than the present to consider these issues and to formulate and document a currency policy.

Given a view of a rising dollar, what can plan sponsors do to protect the dollar-based returns of their non-dollar assets? If you believe, on a dollar basis, that the total return from non-dollar assets will underperform dollar-based assets, tactically shift the portfolio toward dollar-denominated assets. The second, and more common solution, is to hedge. Given an acceptable policy in place, this option requires no change to the existing strategy. Implementing a hedge can be done through the asset managers, an external currency specialist or an in-house hedging program. There are pros and cons to each implementation strategy. Central to analyzing the merits of each are issues of accountability, skill, resources and an assessment of whether active currency management can really add value over the long run.

Bond managers have recently employed a type of hedging strategy that is related to European Economic and Monetary Union. Some managers have taken positions in the higher-yielding peripheral European markets, as opposed to the G7 markets, because the currencies have been moving in line with the dollar. While this phenomenon exists today, historical correlations between a rising dollar and appreciation of higher-yielding currencies do not hold over all time frames.

Most plan sponsors historically have allowed their asset managers to, at a minimum, defensively hedge their non-dollar portfolios. A significant rise in the dollar may precipitate a renewed interest in partially or fully hedged benchmarks and the use of active hedging strategies.

Adrian Lee
currency manager, JP Morgan

A 10 percent rise in the dollar against most currencies would reduce the value of foreign-currency-denominated portfolios by 10 percent. Most pension plans have about 10 percent or more overseas, which translates into a 1 percent loss of pension fund value.

There are several ways to hedge against this, and essentially the issue is how much the sponsor takes responsibility (strategic hedge) versus a manager (tactical hedge). Forward contracts and/or options can be used. The hedging should be implemented by an overlay manager for a host of specialist advantages they bring to the table, including knowledge of currency markets; diversified use of counterparties, ensuring management of credit risk and best execution of currency hedges; coordinated cash flows with the custodian; lack of distractions and disturbances of the asset manager; and separate performance measurement.

All plan sponsors should use a currency overlay manager, whether the outlook for the dollar is strong or not. Funds should be aware of the amount of currency risk in their portfolios and understand the strategic (long run) nature of this. They should manage their risk strategically-that is, using a fixed hedge of the same amount, say, above a certain percentage exposure-and they should delegate the management on a tactical basis to an overlay manager. It is unrealistic and naïve for plan sponsors to put in place a tactical hedge just while the dollar is strong.

A strong dollar should be hedged using forward exchange contracts and not by an implicit asset strategy. Pension funds that hold derivatives are having a difficult time keeping track of what their money managers are doing. Now some leading custodial banks are gearing up to give them what they want. But other plan sponsors question whether more intense scrutiny is really necessary.

Timothy O'Grady
partner, Evaluation Associates

A rise in the value of the U.S. dollar has already taken a bite out of international equity returns during the first quarter of 1997, and, as a result, many plan sponsors are now pursuing a currency hedging program to help protect their overseas investments.

Currency adds both diversification and volatility to an investment portfolio. The trick is to find the amount of currency exposure that optimally balances these two effects.

Academic studies based on historical returns, correlations and volatilities have suggested that plans with an international equity allocation below 15 percent should leave the exposure unhedged as the diversification benefits of currency outweigh the risks. This suggestion is valid only if the portfolio's domestic assets are negatively correlated with currencies. As international exposure increases, the necessary positive correlation between foreign assets and currencies becomes more dominant, thereby increasing the optimal amount of currency exposure to hedge. The relationship between currencies and equities is important because equities are the largest portfolio allocation (usually between 50 percent and 70 percent). Large-cap equities have a higher correlation with currencies and serve to increase the hedge ration. Conversely, small-cap equities have a low correlation with currencies and, therefore, currency exposure would add diversification to the small cap of a portfolio. Historically, the currency component of a plan's international bond exposure has helped diversify its domestic small-cap equity allocation. Given the strong U.S. dollar and recent progress toward European Economic and Monetary Union, these diversification benefits may diminish.

Unfortunately, the variables used in determining the optimal hedge ration are constantly changing and, therefore, require active currency management. Currency can be divorced from international equity management and should be handled by an overlay manager. International equity managers typically focus on bottom-up issue selection and not on forecasting short-term interest rates. An overlay manager (similar to an international bond manager) focuses on the macrofundamental factors that affect currency movements. There are four main styles of currency overlay management-fundamental, technical, structured and option replication. Consultants have combined different styles in an attempt to diversify manager and style risk.

Until recently, not having a currency policy-that is, being unhedged-has enhanced international asset returns as the U.S. dollar has systematically declined against most major currencies. Currencies will continue to be volatile and plan sponsors should have a currency policy as part of their overall investment policy.