NEW YORK - As U.S. pension funds diversify their investments overseas, money managers are moving beyond hedging of currency risk and are actively exploiting volatility to boost returns, experts say.
Foreign exchange is no longer treated merely as an afterthought of foreign investment, but as an active asset class, said Ezra Zask, a money management consultant. "The notion is that if we are stuck with the [currency] exposure, we may as well try to make some money out of it," he said.
Mr. Zask estimated that at least half money managers retained by pension sponsors to manage exchange risks are expected to go beyond basic hedges to enhance returns. Approaches vary and include fundamental, technical, portfolio insurance, and options, he noted.
Picking Up Speed
A growing number of managers are pitching the profit potential of foreign exchange, said Varick Martin, managing director of corporate foreign exchange at Chemical Bank.
"It's both supply- and demand-driven," he said, "One could say the demand wasn't realized until pension funds were made aware of the impact of currency movements."
The U.S. dollar has an average annual standard deviation of 3.5% of 4% against major currencies, Mr. Martin said. "In the long run, the gains and losses even out," he said. "But who has that staying power? It's hard to justify big [currency] losses on a yearly or quarterly basis."
The fact that short-term currency swings could be as large as equity moves in local currency terms is not lost to pension sponsors said David DeRosa, a portfolio manager at BEA Associates. His company has been retained by the California State Employees Pension Fund to manage part of a $2 billion currency overlay program on its foreign equity investments.
Many Dollars Involved
Mr. DeRosa estimated that $250 million is added each month to the foreign exchange money funds already under management. The amount exceeds $1 billion in some months when large portfolios make placements, he said.
In a new trend, a small number of pension funds are participating in pools of managed derivatives that speculate on currencies, Mr. DeRosa said.
The main reason that U.S. pension funds have not matched their European counterparts in currency management is attributable to the dollar's weakness in recent years, he said, predicting explosive growth when the dollar turns up.
A recent survey by the Philadelphia Stock Exchange shows that only 32% of U.S.-based funds hedge their foreign exchange exposure, compared with 63% of European funds.
There's fierce competition to capture this largely untapped market.
Mr. DeRosa at BEA expects that firms with expertise in futures and options - those that can construct cost effective and flexible hedging programs - will increase their market share.
But Mr. Zask said that despite several well-publicized cases in which "boutiques" like BEA and Paretto Partners attracted some big clients, traditional investment banks like Rothschild International would continue dominating the field.