By definition, however, overlays serve primarily to hedge an existing portfolio's exposure. Futures tend to be more efficient than cash or even over-the-counter forwards, and don't pack much alpha. And futures are what corporate treasurers typically use to hedge a company's own currency exposure. But, says Tom Hazuka, chief investment officer at Mellon Capital Management, plan sponsors incorrectly conclude from this that alpha-oriented currency managers will therefore fail to generate returns large enough to justify their fees. Instead, says Hazuka, plan sponsors should base their judgments on the cash or forwards markets, which more openly reflect the inefficiencies that produce alpha.
GM again is a case in point, as it uses an overlay despite its interest in alpha. It manages that trick by hiring managers to run the overlay on an active basis, using forward contracts or cash to produce higher returns while hedging international assets. "Even if you want to be hedged, you want to add value," says Holstein. Of course, some sponsors go further. "Some people are trying to go only for alpha," notes Holstein. But given the risk involved, GM prefers the middle ground. "We're trying to work our assets harder," he says.
In the cash and over-the-counter markets, however, factors affecting price movements are harder to pinpoint, and sophisticated macroeconomic models are needed to exploit market opportunities—along with managers expert in using the models. While Hazuka asserts that a "properly structured approach provides superior performance," he adds that "the investment must be handled vigilantly."
Even sophisticated plan sponsors such as the California State Teachers' Retirement System (CalSTRS) concede as much. Granted, its $128 billion (in assets) portfolio enjoyed outsized returns during the past two years with an overlay exposing about $25 billion—or almost 10 percent of its portfolio—to currencies other than the dollar. "The weak dollar has helped our portfolio a great deal," says Christopher Ailman, CalSTRS's chief investment officer. Ailman says the experience now has him considering adding a currency overlay for the entire portfolio. "We feel that having a position in other currency adds diversification and return."
But he doesn't expect to continue to get alpha returns without paying alphalike fees. He says CalSTRS's current approach to currency "is really a risk-mitigation policy," and that notwithstanding its success betting against the dollar, "we found that it is difficult to add lots of alpha" on its own. So the pension plan is working with a consultant to determine if a currency manager would be worth hiring. As go CalSTRS and GM, so go other plans? That's what happened with other types of alternative pension investments.
Marie Leone is a senior editor for CFO.com.
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