©  Copyright 2002 Rogers Media. The following article first appeared in the February 2002 edition of BENEFITS CANADA magazine.

Increases in the foreign property limit to 25% in 2000 and 30% last year were welcomed by pension plan administrators. An increased allocation to foreign equities requires administrators to confront the currency risk of foreign equities on a policy level, as opposed to a strategic or tactical level, which is the fund manager's job.

A recent currency study can help administrators with policy development. William M. Mercer Investment Consulting's Survey of Pension Plans On Currency Issues (conducted in 2000 with responses from more than 100 large funds) explores investment beliefs on currency issues relating to pension plans, and looks at how large plans around the globe are addressing currency issues.

The report illustrates that investment beliefs among funds in all countries vary, as the distribution of responses to the survey is similar in all nations represented (Australia, Canada, Japan, the U.K. and the U.S.). Most of the funds range from US$1 billion to US$5 billion in size. The median plan respondent was just under US$2 billion. The unweighted average allocation to non-domestic assets across all respondents was 27%, except for the U.S. where the average was 20%.

INVESTMENT BELIEFS
A large group (41%) of respondents believe that the impact of currency hedging on investment returns is negated over 10 years or more. Twenty-one per cent cite time frames of five years or more, while 10% of pension plans do not believe that the impact is eliminated. Interestingly, almost one-third of plans surveyed (29%) do not have an opinion on the issue.

We can assume that the impact of currency hedging on long-term expected returns is close to zero. In fact, it has a small negative impact if transaction costs are included. While the expected impact may be close to zero, the actual impact can vary considerably, even over periods of 10 years or more. This is evident in the long, steady decline of the Canadian dollar.

The majority of all plans surveyed (88%) think that currency hedging can reduce investment risk. However, respondents are somewhat divided on how often this occurs. Half of all plans believe that currency hedging reduces investment risk in most cases. An analysis of currency hedging on investment risk for large pension plans around the world reveals that the impact of this strategy varies according to the base currency of the pension plan, as well as its benchmark asset mix and the particular definition of investment risk used for measurement.

The impact of currency exposure on investment returns is not strongly correlated with the returns for the underlying investments. As a result, plans may reap the benefits of diversification by holding some exposure to foreign currency. But as currency exposure increases, the diversification benefits that can be gained shrink until a point is reached where adding further exposure increases, rather than reduces, the overall level of risk. This lowest risk point varies according to asset mix and the period of review. In terms of the survey, 60% of plans agree that unhedged currency exposure provides diversification benefits, as long as the currency exposure isn't too high.

The survey also asks pension plans whether currency exposure should be fully hedged to match the exposure of the plan's liabilities. More than half (55%) believe it should in some, but not all, cases. One-third of plans (33%) say it should not be hedged to match the currency exposure of liabilities. Only one of the respondents had adopted fully hedged benchmarks for both non-domestic equities and non-domestic bonds.

It has been argued that fully hedged benchmarks provide the best possible risk/return outcomes over some periods, and unhedged benchmarks offer the best possible risk/return outcomes over others. A 50% hedged benchmark has been advocated to prevent a fund manager from ever being 100% wrong.

However, the survey indicates that this argument has not gained widespread acceptance among large pension plans. Nearly half of plans (48%) disagree with the concept of a 50% hedged benchmark, while 36% say this approach should be adopted in some, but not all, instances.

NON-DOMESTIC PORTFOLIOS
Pension plans believe that, most often, the best way to handle currency exposure in non-domestic equity portfolios is simply to allow it to be driven by the decisions that the managers take on country/regional allocations, either explicitly or through stock selection decisions. Only a handful (6%) of plans do not agree with this approach.

The argument supporting this tactic has often been advanced by non-domestic equity managers who do not hedge currency exposures when asked to justify this approach in meetings with current or prospective clients. Interestingly, the responses illustrate how this stance has gained acceptance among large pension plans worldwide.

The U.S. fund management and research firm, Bridgewater Associates, produced a research paper in 1998, The Importance of Making Independent Currency Overlay and Asset Underlay Decisions, which runs counter to this line of thinking. The analysis is persuasive. It illustrates that between 1970 and 1997, non-domestic equity managers who favoured equity markets in countries with stimulative monetary policies, falling bond yields and excess capacity in their economies actually added substantial value through their equity market allocation decisions. However, if they had left their currency exposures unhedged, about 20% of this added value would have been negated through the currency allocation decisions implied by such an approach.

In other words, these managers could have added more value by simply adopting a policy of passive hedging to eliminate any overweight or underweight currency exposures arising as a result of their equity market allocation decisions. They could have added even more value by underweighting the currencies of countries that were overweighted in their equity portfolios, and vice versa.

VALUE ADDED
Respondents to the survey are somewhat divided on whether better active non-domestic equity managers can enhance fund returns and reduce risk over the long term through an active currency management strategy. While 12% believe this approach is successful, 26% say the effect is so minimal that it is not worth pursuing.

A greater percentage of plans (43%) do not believe that good active, non-domestic managers can reduce risk and boost returns through active currency management, while a sizable number of plans (19%) are uncertain. The responses indicate a relatively low level of confidence in the ability of non-domestic equity managers to add value through active currency management.

There is greater uncertainty among pension plans as to whether active currency management adds value. The majority (49%) of respondents agree that better specialist currency overlay managers can add value over the long term through active currency management, even if there isn't enough of a difference to be worthwhile. But 10% do not agree that this approach adds value, while 41% are uncertain.

Respondents were also asked if at least one of their fund's investment managers could add value through active currency management. Half (52%) say they have a manager who can achieve this goal, even though 24% regard the difference as minimal. Almost one-quarter (23%) do not have a manager who can add value through this strategy and 26% are uncertain.

Overall, the survey illustrates that there are few areas of currency belief where plan administrators hold common views, and that differences of opinion are common in all countries. Still, formulating an investment belief about currencies is crucial for setting a policy to address the risk that pension plans will face by virtue of greater foreign equity exposure. BC

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