Rising dollar has managers on high alert

Some international-equity managers are wondering whether the drop in the greenback will continue, while others are beginning to implement currency hedges to protect their portfolios against a rise in the U.S. dollar. Even before Federal Reserve Chairman Ben S. Bernanke last week made comments supporting the dollar, some managers were anticipating a rise in the currency, following its 36.5% decline since February 2002. "This is a shift in mentality. Some are starting to question whether the ride is over," said Andy Iseri, investment consultant for global manager research at Callan Associates Inc. of San Francisco. "A lot of international-equity managers have started implementing some sort of hedging strategy," said John Wasnock, director of manager research at investment consultant Wurts & Associates Inc. of Seattle. Hedging creates the risk of added deviation from an unhedged benchmark, but if these managers are correct, their hedges can protect an institutional investor from the declines in foreign currencies. AQR Capital Management LLC of Greenwich, Conn., AllianceBernstein LP of New York and Baillie Gifford & Co. of Edinburgh, Scotland, are among those consultants who already are implementing hedges or talking about it to clients. The decrease in the value of the dollar over the past five years has been "a windfall" for some international-equity managers, said David Kabiller, founding principal at AQR. "While some of those investors may now be hedging, our approach for a long time has been active management of currencies," he said. Mr. Kabiller declined to provide AQR officials' view on the dollar, but various consultants pointed to the firm as an example of a manager preparing for a rise. The firm has been short on the dollar, and its positions are changing, but officials at AQR declined to say how. John Meyers, a spokesman at AllianceBernstein, couldn't make an official available for comment, while Roland Cross, spokes-man at Baillie Gifford, didn't return phone calls seeking comment. Officials at Thornburg Investment Management Inc. of Santa Fe, N.M., began hedging their international-equity portfolios in the fourth quarter of last year. Thornburg has been using forwards in anticipation that a multiyear slide in the dollar could soon come to an end. "It's a partial hedge," said Peter Trevisani, managing director at Thornburg. "If the dollar weakens, it won't be detrimental to the portfolio." He declined to say how much of the portfolio is hedged, but said that the firm will usually do rolling forwards on a six-month basis. (A forward currency contract allows a manager to buy or sell a currency at a future date at a set price.) Returns from currency bets can make a difference in the short term, but strategically, they don't generally add value, said Marc Friedberg, managing director at investment consultant Wilshire Associates Inc. of Santa Monica, Calif. Looking at 20 years of data, the average monthly currency return was a mere 0.005 percentage points — "very minimal," he said. In the short term, however, the change in the dollar's value can have a hefty effect on portfolio returns. Between January 2007 and February 2008, the Morgan Stanley Capital International All Country World ex-U.S. index, offered by Morgan Stanley of New York, returned 7.53% in dollar terms, while the local currency return was -1.68%. That means the return from currency was 9.2 percentage points. But between January 2004 and December 2005, the MSCI ACWI returned 17.1% in dollar terms, while the local currency return was 30.1%. An investor lost 13 percentage points because of the dollar's rise, Mr. Friedberg said. Investors most likely will see managers that have specialized currency teams implement hedges, Mr. Iseri said, while most international-equity managers will focus strictly on stock picking. Officials at Russell Investments of Tacoma, Wash., said that in aggregate, currency managers there have shifted their dollar positions from 3% short a year ago to 8% long now. The positive view on the dollar is spilling over into Russell's international-equity manager-of-managers portfolios as managers put in place defensive hedges, said Mark Thurs-ton, head of global equity research. "In the past, a manager that was hedging was taking away currency return potential," he said. "But now it's a defensive hedge because the dollar has gone too far." International-equity managers typically will hedge only small portions of their portfolios because they don't have the in-house expertise to make larger bets on currency movements, Mr. Thurston said. Most institutional investors give their managers some freedom to implement currency hedges as long as it stays within certain parameters, Mr. Friedberg said. While some clients don't allow hedging at all, most allow their managers to hedge between 10% and 20% of a portfolio, he said. The $1.5 billion Louisiana School Employees Retirement System in Baton Rouge invests $114 million in a core international-equity strategy run by Thornburg. Officials at the pension fund allow their managers to hedge at whatever level they need to protect their positions, said Brendan Brosnan, chief investment officer. "We leave that up to the manager," he said. Other pension funds implement currency strategies as part of their overall investment portfolio and will likely not allow their other equity managers to hedge. The $13 billion Public Employees Retirement Association of New Mexico in Santa Fe, for example, has $1.2 billion in notional assets earmarked to an active-alpha currency portfolio that should protect the fund from a rise in the dollar. "Presumably, those currency managers would be long the dollar and effectively short foreign currencies," said Robert Gish, investment director. Raquel Pichardo is a reporter at sister publication Pensions & Investments.