Obviously, the currency impact on a U.S. pension plan in a given period can be either positive or negative, depending on the direction in which the U.S. dollar moves relative to the basket of foreign currencies held in the plan. A strong dollar means that foreign currencies have depreciated, reducing the U.S. dollar-based value of the foreign assets' returns; we're experiencing that now as the dollar flexes its muscle relative to the euro, yen, and other major currencies. On the flip side, when the dollar is weak, it has a positive impact on foreign-asset returns.

An institutional investor that analyzes only the total returns on its unhedged foreign investments, rather than considering asset returns and currency returns separately, is masking the impact that foreign currency fluctuations are having on its investments' performance. It's also missing the opportunity to manage the currency-specific portion of its investment risk through a well-designed hedging program. To get a better handle on this pension fund risk factor, plan sponsors should define how much foreign currency exposure the company wants to carry, and should integrate that metric into the asset-allocation process.

Risk budgeting can be a good approach for identifying the sources of risk in a portfolio. Risk budgeting allows the investor to look beyond the allocation of assets in a portfolio and reveals the largest sources of risk. For example, the risk inherent in an investment in unhedged global bonds may be characterized by an 80 percent allocation to currency risk and 20 percent to fixed-income–related risk. This analysis can also be performed at the total portfolio level to reveal the major risk factors associated with an asset allocation.

Plan sponsors should be asking the following questions as they develop a risk budgeting process:

What is our plan's currency exposure?

Before they can begin managing their currency risk, pension plan sponsors must understand how much explicit non-dollar exposure exists within their portfolio. In general, institutional investors have constructed diversified investment programs that include several asset classes from outside the United States. These include international developed equities, international developed sovereign and corporate debt, and emerging-market equity and debt.

Each of these asset classes has foreign currency exposure, but for the purpose of managing currency risk, investors should assess their explicit developed-market equity and fixed income exposure. Thoughts on managing emerging-market currency exposure are best left to a more expanded discussion—but, in short, we believe that emerging-market currencies offer a long-term risk premium, and we do not advocate a strategic currency hedge.

1. Note: While we offer NEPC's point of view on best practices, every portfolio has its unique goals and challenges.

How much of that exposure should we hedge?

We believe developed-market currency exposure largely represents an uncompensated risk. Since 1973, currency exposure as represented by the MSCI EAFE Index has provided an annualized return of approximately 0.6 percent, with a volatility greater than 8 percent. We believe this risk/return profile will likely persist over the long term for developed-market currencies. Incorporating this assumption into a broader asset allocation framework ultimately provides insight into the appropriate level of foreign currency exposure for U.S.-based investors.

Evaluating the impact of various foreign currency hedge ratios at the total portfolio level allows the investor to assess the overall impact of currency risk on expected return, and to determine how risk is allocated for a given asset allocation. Considering the return implications and risk budget of various foreign currency hedge ratios at the total portfolio level is likely to reveal the benefits of reducing developed-market currency exposure.

The benefits associated with a strategic currency hedging policy will be unique for each investor, but generally such a program offers a reduction in total portfolio volatility, while maintaining overall return expectations. That said, striving to reach a plan's ideal hedge ratio involves an unrealistic degree of precision.

As mentioned above, we believe developed-market currency exposure largely represents an uncompensated risk. And reducing an uncompensated risk increases the efficiency of the portfolio, as portfolio risk is either reduced or distributed to asset classes with a higher return-to-risk profile. Furthermore, the benefits of a developed-market currency hedge are largely achieved with a hedge ratio of just 50 percent. In most cases, we have found a strategic hedge ratio of 100 percent to be unnecessary, as a 50 percent developed-market currency hedge provides more than two-thirds of the risk-reduction benefit.

How should a currency-hedging program be implemented? 

If, as a result of this analysis, a pension plan sponsor decides to roll out a currency hedging program, it needs to consider several factors in planning the implementation. For starters, decision-makers should evaluate whether the company has access to the internal resources it needs to make a currency-hedging program work. If the answer is yes, they should next evaluate whether it makes sense to run the program in-house.

Properly managing currency risk requires a pension plan to assign a dedicated overlay manager, someone who takes direct responsibility for the hedging program. Plan decision-makers need to compare the time and costs needed to support the hedging program against the costs of hiring an external manager.

Another possible solution is to invest in only foreign-equity or foreign-bond funds that are benchmarked to a currency-hedged index. That said, although we find many skilled global-bond managers with both hedged and unhedged offerings, among equity funds the universe for currency-hedged products is less robust. This universe could grow if U.S. investors began to demand more currency-hedged products. Many of the managers offering unhedged equity funds in the United States demonstrate their currency-hedging capabilities either through currency-hedged products or through share classes hedged to a particular currency used by investors in other countries.

It's also important to note that for active portfolio managers of foreign allocations who adjust their investment portfolios to maintain a predefined target level of exposure to each particular country, a view on each currency relative to the investor's domestic currency is likely only a secondary consideration in the investment process. This is especially true for active managers with a bottom-up focus. Managers willing to shift to a currency-hedged mandate may be able to offer similar levels of alpha at reduced levels of volatility to the investor.

How much liquidity is necessary to maintain a hedge? 

Most hedging programs are implemented in the deep and liquid currency-forward market. Forward contracts are a direct, low-cost way to hedge currency risk. However, they may require the posting of collateral, depending on the underlying currency gains or losses, in order to minimize counterparty risk.

Managing a forward hedge can become problematic if the total portfolio doesn't have the appropriate liquidity to support the cash flow required for posting collateral. For example, when foreign currencies are appreciating relative to the domestic currency, the underlying foreign asset-class positions will experience currency gains. At the same time, the currency hedging program will need to post collateral as short currency positions experience losses.

Implementing currency hedging through an international equity or bond manager's product minimizes decisions around liquidity levels for currency-hedging activity, as the portfolio manager takes responsibility for managing these exposures.

Before implementing any currency-hedging structure, a pension plan sponsor should conduct a comprehensive review of all sources of liquidity in its portfolio. This review should highlight the importance of integrating solutions for managing currency with the overall asset-allocation process, and with a clear understanding of the overall portfolio's liquidity profile.

Should a pension plan sponsor actively or passively manage currency hedges? 

We believe the management of a currency hedge to be strategic in nature. We encourage investors to begin the process by defining their currency hedging policy as a long-term strategic exposure (e.g., 50 percent currency hedge ratio). The benefits of such a policy can largely be achieved with a passive approach, as we believe the strategic reduction in developed-market currency exposure reduces uncompensated risk in an investor's portfolio. Employing a strategic hedging policy ultimately improves portfolio efficiency, as developed-market currencies offer a meaningful level of volatility but do not offer a material risk premium.

Upon defining a long-term currency policy, pension plan sponsors may find value in utilizing active currency strategies to complement the strategic allocation. Active management of currencies is no easy task, but if done well, it can improve both the return and risk profile of the plan. An active strategy expresses views on the direction of currencies, attempting to hedge higher levels of individual currencies that are expected to depreciate and lower levels of individual currencies that are expected to appreciate.

When using an active approach, plan sponsors can build off their target strategic hedge ratio and allow an active manager to shift foreign currency exposure within a range of predefined currency hedge ratios. This can be specified on an absolute basis by defining currency hedge ratio bands (e.g., 40 percent to 100 percent) or based on tracking error constraints relative to the passive long-term hedge ratio target.

Overall, the investor can target a strategic currency hedge that benefits overall portfolio efficiency, while adding a potential alpha source that can reduce losses from currency hedging when the home currency depreciates.

How should behavioral challenges be addressed? 

Much of our approach to hedging currency risk differs from the way U.S. institutional investors typically manage their portfolios. Thus, a long-term strategic asset-allocation decision may feel like the expression of a change in direction. It would be natural for investors to sense that they have taken a strong position against foreign currencies by hedging away some or all of that exposure.

Moreover, hedging currency exposure will cause an investment portfolio to behave differently from its peers. The impact of foreign currency exposure on returns to major developed-market indices, such as the MSCI EAFE and Citigroup WGBI, has been as much as 20 percent per year—both positive and negative. For a portfolio in which 25 percent of assets are allocated to foreign investment, this would result in a difference in total portfolio returns of 5 percentage points.

It's important for pension plan sponsors to be prepared for differences in returns and peer rankings if they undertake a currency-hedging program. It's also crucial to view outcomes in terms of risk-adjusted returns, given the lower overall volatility of portfolios with currency hedging in place.

Currency Hedging as a Long-Term Portfolio Risk Management Solution

Hedging currency exposure is a long-term strategic decision. Plan sponsors should evaluate the pros and cons of implementing currency hedging in a time frame long enough to understand why a hedging program might make sense. Looking back at the plan's returns and currency-related risk over only the latest quarter, year, or even several years may undermine the decision-making process. The tendency of investors to view decisions through a short-term lens means corporate investment managers need to thoroughly understand the reasoning behind the pension plan's hedging of foreign currency exposure. Such an understanding will minimize second-guessing on a day-to-day basis.

Plan sponsors must also be thoughtful about how they gauge the success of a hedging program. When the program is new, they may look at the differential between hedged and unhedged asset classes. However, after sufficient time has passed, they should consider a more robust set of metrics—such as relative volatility of hedged exposures, improvements in portfolio Sharpe Ratio, and exposure to drawdowns.

In general, the added volatility of developed-market foreign currencies is not compensated with a reliable expected return. We encourage investors to understand the magnitude of currency risk in their investment programs, the potential benefits of reducing that risk, and the associated challenges in implementing solutions.

Those pension plan sponsors that choose to reduce exposure to developed-market currencies through currency hedging will introduce long-term portfolio benefits, such as maintaining return expectations while reducing overall portfolio volatility. Or, if desired by plan sponsors, minimizing developed-market currency risk in the total portfolio-risk budget allows for risk to be redeployed more efficiently and increases the likelihood of meeting long-term portfolio objectives.

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Bradley S. Smith is a partner in NEPC's corporate group with more than 20 years of industry experience. He holds the Chartered Financial Analyst (CFA) designation as well as the Certified Employee Benefit Specialist (CEBS) designation.

Disclaimers and Disclosures

• Past performance is no guarantee of future results.
• All investments carry some level of risk.   Diversification and other asset allocation techniques do not ensure profit or protect against losses.
• The opinions presented herein represent the good faith views of NEPC as of the date of this report and are subject to change at any time.
• This report contains summary information regarding the investment management approaches described herein but is not a complete description of the investment objectives, portfolio management and research that supports these approaches.  This analysis does not constitute a recommendation to implement any of the aforementioned approaches.