Your Largest Unmanaged Exposure

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One American dollar leaves California and ends up as 80 Canadian cents in a Vancouver condo. Two years and a bubble later, the condo is sold, fetching 60 cents Canadian. That pile of change then flows to a highway in the United Kingdom, where it is now 40 pence of concrete and tollbooths. A year later, it is sold at 55 pence, and heads back across the Northern Atlantic, bound for the bank account of a former teacher in Burbank. Relatively straightforward for a sophisticated chief investment officer— unless one takes into account volatile and unpredictable currency exchange rates.

“I consider this”—meaning currency exposure and its potentially disastrous effect on portfolio valuations— “the number one issue that plan sponsors have to deal with,” says Cynthia Steer, an acknowledged expert on foreign exchange issues and Managing Director of Investment Strategy at Seattle-based Russell Investments. “Still, for United States-based institutional investors, it’s largely an invisible issue at the policy level—and it’s been the same way for almost 20 years. This will come home to roost for U.S. investors in 2011, 2012, and 2013 if they don’t wake up.”

The problem, Steer and her colleague Ian Toner believe, lies as much with the way chief investment officers and their Boards think about the problem—the “grammar” used to define currency risk,” according to Toner, the Director of Research and Communications at Russell Implementation Services—than the tools used to solve it. Neither, they assert, has evolved enough to confront a mounting and serious challenge, one Steer refers to as the “largest unmanaged exposure in institutional portfolios today.”

“I consider [currency exposure] the number one issue that plan sponsors have to deal with.”

The fact that many institutional investors fail to comprehend that they are exposed—and often exposed in a large way—to currency volatility through quotidian foreign investments is a product of various historical factors. For one, when many CIOs and investment staff started their careers, institutional portfolios in America and abroad were heavily domiciled in their home countries. Small countries with large institutional assets per capita—namely, Australia, the Netherlands, and Canada—were the first to increase their foreign holdings significantly and, as a result, “are further along in their FX practices,” according to Steer. On the other hand, because their home market was and is so big, as well as the fact that the American dollar was until recently unquestioned as the world’s reserve currency, U.S.-domiciled funds faced less pressure to evolve into FX-weary investors. A worldwide bull market since the early 1980s also contributed toward a focus elsewhere. This has changed—but institutional thinking about FX largely hasn’t.

It needs to. At the policy level, the “grammar” that Toner speaks of revolves around not just what is said, but to whom. If chief investment officers and their Boards have been discussing currency exposure in any meaningful way, they have tended to jump to the amount of hedge to put on, he says. “What we’re saying is that institutional investors don’t need to just focus on the hedge ratio—they need to take a step back and talk about how much exposure they want, and what good exposures and bad exposures are.” One example of this hypothesized exposure discussion is the developed/developing dichotomy. “Investors need to bifurcate developed and growth/emerging market currency risks,” says Raymond Chan, Vice President for Global Portfolio Solutions at Goldman Sachs Asset Management (GSAM). “There is a fairly large body of research that shows that the relationships between FX risk versus the assets holding that FX risk are not always consistent. For example, when betting on European growth via an equity investment, do you want the equity exposure, the currency exposure, or both?” GSAM argues that, in this case—and for other developed markets—foreign exchange is not central to the investment thesis, and “might add risk without [investors] being compensated. In emerging markets, on the other hand, you often don’t want to hedge out the currency risk.” In other words, is foreign exchange critical to the investment thesis, or simply along for the ride? “Taking out this noise, when appropriate, can substantially improve the risk-adjusted returns of the portfolio,” Chan says.

It is this paradigm—judging foreign currency exposure in risk-adjusted return terms—that FX-focused players are attempting to foist on asset owners. “We’ve had this discussion before—is this a distinct asset class?” says Collin Crownover, Head of Currency Management at State Street Global Advisors. “Really, who cares if it’s an asset class? It’s how you think about it that matters—and that should be in a risk-adjusted returns framework.” It’s a sentiment that relates closely with Steer’s assertion that FX is often the largest unmanaged exposure in an institutional portfolio: Don’t worry whether it deserves the asset class label, worry whether you’re managing your exposure. Some believe, when you move the discussion from the red herring of asset classes toward a focus on risk-adjusted returns, it naturally moves up the decisionmaking chain. Indeed, this is a discussion that needs to happen at the Board level, Russell’s Toner believes. “If it’s too detailed, it becomes a discussion between currency nerds,” he says. “This isn’t a currency nerd problem—this is a CIO, a Board problem.”

At least two pension funds—America’s two largest, in fact—have overcome the hurdle of, at the very least, acknowledging the existence of large currency risks. In an internal document obtained by aiCIO, the California Public Employees Retirement System (CalPERS) makes clear its understanding of the market—and how “any foreign investment creates an add-on foreign currency exposure.”

Investors “mostly focus on the asset, not the currency,” the report claims—a statement Steer and others agree with—and “ currency can be bundled or unbundled from the asset.” It also repeatedly refers to currency exposure in terms often used for other asset classes.

“If the risk-adjusted return is high, pursue for it’s (sic) own sake…if risk-adjusted return [is] limited or zero, then hedge to reduce risk,” the report asserts. CalPERS Sacramento neighbor, the California State Teachers’ Retirement System (CalSTRS), views the risk in a similar light. “I’m not sure I would say it is unmanaged, but I would totally agree that it is a critical asset class—although I’m not sure people will embrace it as a [definitional] asset class,” says CIO Christopher Ailman. “In our case, we have about a third of our assets outside the dollar, and we actually have taken the time to aggregate that across our portfolios of real estate, private equity, global equity, and fixed income. Eighty percent of that exposure, we manage in-house, mostly with the idea of being defensive. The goal is, since we’re denominated in dollars and pay benefits in dollars, we want to at least be able to hedge that exposure if we need to.”

If foreign exchange risk is the largest unmanaged exposure in an institutional portfolio today, one would expect more pension funds to follow suit and discuss the risks in a CalSTRS- and CalPERS-like way. They largely don’t. Reasons range from cost to resources to inexperience, but possibly the most commonly cited excuse for not managing currency exposure is the thought that, in the long run, currency fluctuations all come out in the wash.

Whether they do or not is not important. If currencies fluctuate wildly, as they are wont to do—Australia, for example, saw its dollar fall from 60 cents American to 50, only to appreciate rapidly to par during the global financial crisis—CIOs might not be around long enough to see the day when it does emerge from the laundry. For all the talk of long-term horizons, institutional investors still have short-term performance reviews, whether formal (Board-based) or informal (public-and media-based). CIOs are unlikely to consciously want to bet their employment on such vagaries.

“It’s pragmatic, forward thinking,” Steer concludes. “The idea that it’s not central is just a bit silly. What many hold today is an unmanaged, active currency portfolio. These are bets away from neutral positions, and many are not managing it.” For CIOs who want to mitigate risk to both their portfolios and careers, the time for ignoring the large implicit currency bet within most institutional portfolios has ended. —Kip McDaniel