In an overlay, the currency risk of a company’s international assets is managed separately from its overall risk portfolio. The management is done, for the most part, by means of forward foreign-exchange contracts. The overlay doesn’t affect the existing asset allocation mix of stocks and bonds, and little or no cash is used to buy the contracts. Instead, the parties settle the profit or loss of the contracts at the end of a predetermined period, such as quarterly.
Pension-plan sponsors might find currency overlays a less jarring way to improve their returns than reallocating their stock and bond mix, currency-investment experts contend. “It’s a big deal to reallocate [pension fund] assets,” posits Finney, especially if the fund is significant compared to the company’s market capitalization.
An asset-allocation change, after all, can entail heavy lifting. It often involves the approval of many stakeholders, including the board and shareholders, management, human resources officials, corporate lawyers, money managers, and pension consultants.
Straight currency asset allocations in pension portfolios, however, are much less popular than overlays. Part of the reason, thinks Tom Hazuka, chief investment officer at Mellon Capital Management, is a widely held misperception among corporate executives that currency investments don’t generate decent risk-adjusted returns and consistent results over time.
That misperception is based on the execs’ use of currency derivatives as hedges. Since currency-derivatives markets lean toward efficiency, they don’t pack a great deal of alpha. Corporate executives incorrectly conclude from their experience in those markets that active currency management will also fail to generate appropriate returns compared to its risk profile, Hazuka, whose company actively manages currency, contends.
But managers would do better to focus on currency’s underlying asset class, global cash markets, rather than derivatives, he argues. That’s because currency prices, rather than being affected by supply-and-demand market forces, are moved by central bank decisions. And those tend to produce anything but efficient markets.
Another qualm about currency markets is that they tend to deliver inconsistent returns because the factors affecting price movements of underlying assets are hard to pinpoint. To be sure, sophisticated macro-economic models are needed to track such price movements. But consistently strong returns are still possible, Hazuka asserts. A “properly structured economic-valuation approach provides superior performance,” he adds, cautioning that “the investment must be handled vigilantly.”
Indeed, if general market conditions continue to coax portfolio managers to chase new and diverse ways to generate returns, actively managed currency is likely to find a secure place as an asset class in some pension portfolios. For now, however, most CFOs and their portfolio managers are proceeding with caution when it comes to trying to turn the alpha and omega of currency into a lucrative investment vehicle.
Marie Leone’s “Capital Ideas” column appears every other Thursday. Contact her at MarieLeone@cfo.com.