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Gaining Currency?

Currency is being billed as a source of higher returns for corporate pension plans. But sponsors remain skeptical.
Marie Leone, CFO Magazine
April 1, 2005

Want to be like Warren Buffett? Don't pitch softball in Omaha; bet against the dollar in the global currency markets. The chairman of Berkshire Hathaway, who says he is hard pressed to find something better to do with the money, has almost half of Berkshire's cash hoard of $43 billion in 12 other currencies. Of Berkshire's $3.5 billion in investment gains last year, more than half came from foreign-exchange contracts.

True, currency investing doesn't appeal to some finance executives. Says Mark Buthman, CFO of paper-and hygiene-products maker Kimberly-Clark: "We view [currencies] more as a source of volatility and risk than as an opportunity to create value." When it comes to earning more than Treasury bill rates on the company's $594 million in cash, he says he would much rather buy back Kimberly-Clark shares.

Yet there may be at least one place for currencies within today's corporations—their pension plans. With the value of the dollar falling, investment banks and pension consultants are now pitching currency both as a new source of so-called alpha returns (something beyond the "beta," or average, returns available from the public financial markets) and as a hedge against financial market risk. They insist that plan sponsors are overlooking a way that could help solve the funding problems many sponsors face.

Take General Motors. It began hedging the currency risk of its sizable portfolio of international equities 15 years ago, but has since begun to seek alpha as well from the activity. Initially, says David Holstein, managing director of global equities for the company's asset-management division, the company sought to hedge up to 100 percent of the portfolio's currency risk. Now, the plan takes a trading position in a number of currencies. Its three largest positions are in the dollar (short), the yen (long), and the pound sterling (long). And only 50 percent of the currency risk posed by its $15 billion in international equities (out of total plan assets of roughly $90 billion) is hedged today.

Comments Holstein: "Over the long term, we realized that one doesn't get paid for currency hedging." And given the cost involved even in that, he adds, "it behooves you to get some alpha—active management can add value." Of course, that assumes that companies can find currency managers who usually make the right calls, offsetting the stiff fees managers charge.

An Inefficient Market
The case for pursuing alpha returns rests on the currency market's inefficiencies, which reflect both its vast liquidity and the varying agendas of its participants. The average daily trading volume of the global cash market is $1.9 trillion, dwarfing the world's most liquid equity and bond markets (see chart, page 88). And unlike participants in the equity and bond markets, in which most everyone seeks a profit, many currency-market players behave with other goals in mind. Central bankers try to nudge exchange rates in one direction or another for macroeconomic or geopolitical reasons, corporate managers use hedging strategies to protect transaction revenues generated abroad, and tourists exchange currency simply for purposes of local spending.

"There are few other markets where such a large number of participants are so accepting of price and unconcerned with profit," observed Scott Arnott, vice president of global fixed income and currency at Goldman Sachs Asset Management, in a June 2004 report.

Arnott contends that currency-price movements have become more discernible, perhaps as a result of the market's newfound maturity. As an asset class, currency is relatively new, dating only to 1971, when the United States and its trading partners abandoned the gold standard for floating exchange rates. While investment managers in the United Kingdom soon began using currency, those in the United States didn't follow suit until pushed by currency volatility in the late 1980s. Even then, the practice took another decade to develop, says Bill Muysken, global head of research for Mercer Investor Consulting.

Now, however, investment managers here are relatively comfortable with the modeling technology used to pinpoint price movements, according to Muysken. And they have been trying to sell their skills to institutional investors. In 2004, for example, Mercer conducted 28 currency-manager searches on behalf of clients, four times as many as the year before. Most of the searches involved pension funds.

The Overlay Route
Most corporate plan sponsors, however, remain largely deaf to arguments for currency as an alternative investment (alongside real estate, private equity, venture capital, and so on). Many believe that it's hard to produce returns big enough to offset the expense involved. "Individual managers may have terrific alpha potential, but they tend to charge high fees," says Louis Finney, a senior consultant at Mercer.

One way to minimize the cost is to use an "overlay" on top of a plan's existing allocation instead of making an outright allocation. With an overlay, one or another risk of a plan's asset allocation is managed separately from the assets themselves. With currency, such overlays are usually executed by means of futures contracts, which are less expensive than cash. Overlays are also less jarring than a new allocation, which typically requires approval from a sponsor's board and shareholders.


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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