By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) - U.S. public pension funds are embracing currency hedging to bolster returns that have soured in the past year and to prevent further buffeting from extreme market movements.
With equities and bonds as the main stars of the pension investing world, currency funds, which hedge their assets, have been viewed as an afterthought for years. But their track records of stabilizing portfolios while adding modestly to returns have caused them to gain traction.
Total inflows to currency managers soared nearly 160 percent to $13.0 billion in the first seven months of the year from $5.1 billion a year earlier, according to investment data analytics firm eVestment. That was up from $10.4 billion for all of 2015.
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By contrast, global macro hedge funds, which invest in currencies, interest rates and stocks, had outflows of $3.6 billion in the seven-month period amid poor returns, eVestment data showed. They had drawn inflows of more than $9 billion a year earlier.
"In a world of low returns, with movements in currencies generating gains, investing in currency funds has become more attractive," said Richard Benson, co-head of portfolio investments at Millennium Global Investments in London, which oversees $16 billion in assets.
Public pension systems across the United States are posting their poorest returns since the waning days of the financial crisis due to rock-bottom interest rates and choppy global equity markets. Funds ranging from the $302 billion California Public Employees' Retirement System, or Calpers, to the $17 billion Kansas Public Employees Retirement System have posted returns below 1 percent in the last year, far less than targeted levels averaging 7 percent to 8 percent.
Sluggish global growth and weak inflation have kept bond yields low and will probably continue to do so, driving institutional investors into riskier overseas markets with volatile currencies.
But the dollar's strength over the past year has stunted gains from abroad. By contrast, the weak dollar between 2001 and mid-2014 served as a tailwind for pensions, adding about 2.5 percent annually to returns, analysts said.
The net result is a pickup in demand for currency hedging programs.
Millennium's Benson said a currency program could add 1.5 to 2.0 percent to a portfolio's annualized return.
Hedging has reduced volatility and boosted returns for the $45 billion Maryland State Retirement & Pension System's since it started its currency plan in May 2009, said Deputy Chief Investment Officer Bob Burd.
The latest data showed that through March, the Sharpe ratio, a measure of risk-adjusted return, on Maryland's international equity portfolio rose to a reading of 0.56 with the currency program and 0.49 without it.
The program reduced the portfolio's volatility to 15.8 percent, versus nearly 17 percent without it from the plan's inception through March.
INCREASED FX DEMAND
Over the last year, some U.S. public pensions, including the Teachers Retirement System of the State of Illinois, have hired currency specialists for the first time.
TRS Illinois, with nearly $45 billion in assets, appointed New York-based Fischer, Francis, Trees and Watts as well as Adrian Lee & Partners in London this year to oversee $1 billion of roughly $8 billion in international equity exposure, its largest allocation, said Communications Director Dave Urbanek.
The Illinois retirement system is also seeking a currency adviser for its $5.4 billion private capital portfolio, Urbanek said.
Like other pensions, TRS has struggled in the last year, posting a return of just 0.1 percent net of fees in the year ended on June 30, according to its website. It also cut its long-term investment rate of return target to 7 percent from 7.5 percent, citing the sluggish global economy.
Other funds have expanded existing foreign exchange programs. Kansas, which posted a return of just 0.2 percent in its latest fiscal year, has added Adrian Lee as one of its currency managers to oversee half of its developed markets FX exposure in its international equity portfolio. London-based Insight Pareto has managed the other half since 1994.
The program has "successfully reduced the volatility of return for the international equity portfolio," said Chief Investment Officer Elizabeth Miller. Overseas stocks account for a quarter of the fund's assets.
Returns for currency funds are steady so far this year. The BarclayHedge Currency Index, with 66 FX programs, was up 1.4 percent for the first eight months of 2016. That followed returns of 4.7 percent last year and 3.4 percent in 2014.
Outsized gains in the yen and the Korean won, as well as sterling's steep drop after Britain decided to exit the European Union, have been primary currency market movers.
In contrast, global macro hedge funds were down more 1 percent for the year through August, BarclayHedge data shows, as investors struggled to navigate market turns such as the U.S. equity selloff early in the year and the slump in oil prices.
"Currencies are particularly good for portfolio optimization because they are so liquid," said Michel Del Buono, managing director and global strategist at Makena Capital in Menlo Park, California, which oversees $18 billion in assets.
"There's nothing else I can trade in that size so inexpensively to alter the risk-return profile of my portfolio."
(Reporting by Gertrude Chavez-Dreyfuss; Editing by Dan Burns and Lisa Von Ahn)