The optimal benchmark for a currency overlay mandate
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James Binny joined Gartmore in 1998 as a senior investment manager within the Fixed Income and Currency Portfolio Management team. He acts as product specialist for the currency overlay product. Prior to joining Gartmore, James was a fund manager at GNI Fund Management, where he developed and managed two leveraged quantitative derivative funds. In addition, he advised other fund managers on risk control techniques and assessed potential leveraged quantitative fund managers. Prior to this, James was at NatWest Investment Management from 1990 to 1995. James gained a first in Engineering Science at Oxford University. Gartmore Investment Management plc, 8 Fenchurch Place, London EC3M 4PH, UK. Tel: ⫹44 (0)20 7782 2714; Fax: ⫹44 (0)20 7782 2081; e-mail: [email protected]
Abstract Having decided to implement a currency overlay programme, a pension fund must decide on the benchmark for that mandate. The answer is not always clear cut and can have a significant impact on the results of the strategy. There are a series of competing factors, which have differing influences on different pension funds’ selection of benchmark. As a result, there is no one ‘correct’ answer that applies to all. A careful assessment of an individual client’s needs and risk preferences, both investment and behavioural, is essential. This paper summarises the alternatives, together with the research already performed on the subject, then presents a methodology for assessing a pension fund’s optimum benchmark, which can be adapted to any base currency. I would emphasise that it is not possible to design a ‘black box’ that will inform precisely what the benchmark should be — it is necessarily an oversimplification. It can be a useful form of decision support, however, to be used in discussion with an experienced currency overlay manager or investment consultant and can provide a degree of structure to that discussion. Keywords: benchmark; currency; hedge; overlay; pension (fund); risk
Introduction Having decided to implement a currency overlay programme, a pension fund must decide on the benchmark for that mandate. The answer is not always clear cut and can have a significant impact on the results of the strategy. This applies to those pension funds that wish to control the unrewarded risk of unmanaged currency exposure, as well as those that are seeking to profit from the active management of that exposure. There are a series of competing factors, which have differing influences
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Journal of Asset Management
Vol. 2, 1, 22–34
on different pension funds’ selection of benchmark. As a result there is no one ‘correct’ answer that applies to all. A careful assessment of an individual client’s needs and risk preferences, both investment and behavioural, is essential. This paper summarises the alternatives, together with the research already undertaken on the subject. It then presents a methodology for assessing a pension fund’s optimum currency overlay benchmark, which can be adapted to any base currency. Note that it is not possible to design
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