State Pension System Uses Expensive Currency Management to Reduce Volatility

By Megan Poinski,

ANNAPOLIS—The state pension system’s investment officers say that the $52 million it has paid a British company in currency management fees has resulted in some lower rates of return, but is likely to stay because it has achieved its goal of reducing volatile ups and downs in foreign stock values.

Since 2009, the pension system has paid British company Record Currency Management to try to reduce the impact of rising and falling foreign currencies to the system’s international investments.

Robert Burd, the system’s deputy chief investment officer, said that the system’s board had decided to increase its international investments. Former chief investment officer Mansco Perry hired Record Currency Management to protect the investments.

Today, Burd estimated about a fifth of the system’s investments, or about $8 billion, are in assets that use another currency.

“When a substantial portion of your investment is in non-U.S. equities, a substantial risk is falling currency prices,” Burd said. “This provides some protection against a devaluation.”

Uncertainties in foreign trading

Without managing the exchange rate of the currency, foreign investments are subject to two large uncertainties: How the investment is trading and its price, and the current exchange rate between the dollar and the other currency. For example, if the state has invested in Volkswagen, the company’s stock could have a successful day of trading. However, if the value of the euro falls on the same day, gains on the stock value could evaporate.

Burd said that Record Currency Management hedges the value of the state’s investments against the strength of the dollar. When the dollar is strong and a foreign currency loses value, the currency management overlay program protects more of the investment’s value for the retirement system, Burd said.

If the dollar is weaker, there is more of a chance that the investments will lose money in the currency transaction.

Because of the weakness of the dollar during the recession, the currency management overlay has not saved the retirement system any money yet. In fact, it has lost money. Without currency management, foreign investments would have had a 12.66% rate of return. With the currency management, they had a 12.61% rate of return.

Record Currency Management is also the most expensive of the retirement system’s advisers and managers. According to the retirement system’s 2011 comprehensive annual financial report, Record Currency Management cost $13.4 million that year. The second most expensive manager was Marathon Asset Management, which was paid $5.4 million for the year.

Currency manager met goal, system says

Burd said it is true that Record Currency Management commands more money than other managers. However, he said, they also manage the largest single portion of the system’s assets.

Although using currency management resulted in a lower return, Burd said that the program did meet one of its top goals: reducing volatility in foreign investments.

“Swings in value going up and down have become more modest, and our investments are more stable,” he said. “Because our investments are more stable, we can take risks and deploy them elsewhere.”

With the current state of the euro and the finances of the European Union, Burd said that the retirement system is in a great position to do well on its European investments. If the euro falls, he said, the retirement system is less likely to lose big. Additionally, he said, the stronger the dollar is, the more that investments in other currencies are hedged.

“I would say we are well positioned, should the euro and other foreign currencies decline,” Burd said.

If the retirement system decides that the strategy is becoming too much of a liability, Burd said that the contract with Record Currency Management can be cancelled at any time.

Similar programs used elsewhere

Other pension systems use many programs to hedge their investments in foreign currency, said Howard Pohl, a principal at Chicago-based investment consulting firm Becker, Burke and Associates. No exact figures exist, but Pohl said this is not an uncommon practice.

Pohl said that there are as many “best” ways to hedge foreign currency as there are different pension systems. Sometimes, investment managers will work on the currency exchange portion of the investment. Sometimes, when a substantial portion of a system’s investments is overseas, it makes sense for a state to contract with a currency management overlay firm.

Many systems have employed these kinds of strategies for years, Pohl said. But, with investments becoming more global and exchange rates becoming more volatile, “perhaps there’s been more of a strategic element in doing it recently.”

However, Pohl said, this isn’t a strategy that works for all systems.

“If you get it right, you win. If you don’t, you lose,” Pohl said. “It depends on the magnitude of your investment. The impact of volatility can go either way.”

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