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CALLAN
INVESTMENTS
INSTITUTE
10 Charts to Help Frame a Policy
First Quarter 2016
Considering Currency Hedging in
an Equity...
Knowledge. Experience. Integrity. Currency – First Quarter 2016
We’ve recently heard a lot of institutional investors talk...
Knowledge. Experience. Integrity. Currency – First Quarter 2016
1990 2015
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1. Institutional investors have more non-U.S. ...
Knowledge. Experience. Integrity. Currency – First Quarter 2016
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CALLAN
INVESTMENTS
INSTITUTE
Currency Policy Issues to Consider
and Bonus Charts
Appendix
Knowledge. Experience. Integrity. Currency – First Quarter 2016
Issues to Consider in Establishing a Currency Policy
13
● ...
Knowledge. Experience. Integrity. Currency – First Quarter 2016 14
Callan Periodic Table of Investment Returns: Currency
A...
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Non-U.S. Currency Correlation Table
Periods ended March...
Knowledge. Experience. Integrity. Currency – First Quarter 2016 16
About the Authors
Janet Becker-Wold, CFA, is a Senior V...
Knowledge. Experience. Integrity. Currency – First Quarter 2016
Certain information herein has been compiled by Callan and...
About Callan
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Considering Currency Hedging in an Equity Portfolio: 10 Charts to Help Frame a Policy

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Are you considering currency management?

We’ve recently heard a lot of institutional investors talking about their fund’s currency exposure. From Callan’s viewpoint, this is a natural conversation given where we are in the currency cycle and the negative impact currency exposure is having on a lot of equity portfolios. Further, this particular cycle is hitting at a time when many institutional portfolios have more non-U.S. dollar exposure than ever, making the event particularly painful. However painful, we feel it’s important to remind investors to consider the context of the issue, and to rely upon a documented currency policy to guide decisions in times like the present.

In the following 10 charts we offer such context for this discussion. These graphical representations of relevant data over time help to frame the issues equity investors face around currency, including asset allocation, currency returns, risks, and correlations. Callan recommends a measured approach to managing currency, including creating a documented currency policy for the investment fund to ensure short-term decisions made during painful times are in line with long-term strategic goals of the plan.

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Considering Currency Hedging in an Equity Portfolio: 10 Charts to Help Frame a Policy

  1. 1. CALLAN INVESTMENTS INSTITUTE 10 Charts to Help Frame a Policy First Quarter 2016 Considering Currency Hedging in an Equity Portfolio
  2. 2. Knowledge. Experience. Integrity. Currency – First Quarter 2016 We’ve recently heard a lot of institutional investors talking about their fund’s currency exposure. From Callan’s viewpoint, this is a natural conversation given where we are in the currency cycle and the negative impact currency exposure is having on a lot of equity portfolios. Further, this particular cycle is hitting at a time when many institutional portfolios have more non-U.S. dollar exposure than ever, making the event particularly painful. However painful, we feel it’s important to remind investors to consider the context of the issue, and to rely upon a documented currency policy to guide decisions in times like the present. In the following 10 charts we offer such context for this discussion. These graphical representations of relevant data over time help to frame the issues equity investors face around currency, including asset allocation, currency returns, risks, and correlations. Callan recommends a measured approach to managing currency, including creating a documented currency policy for the investment fund to ensure short-term decisions made during painful times are in line with long-term strategic goals of the plan. If you don’t have a documented policy on whether or not to hedge currency exposures in various asset classes, Callan recommends you establish one. We believe it’s paramount to separate policy from implementation. Currency hedging can impact the total fund or be targeted at individual asset classes. A brief look at hedging ratio options, ways to manage currency, and current events will leave you with a better understanding of the issues at play around currency hedging, and feel more confident in following a disciplined approach to currency management that is in line with your fund’s long-term goals and risk profile. See the Appendix for issues to consider in establishing a currency policy. Contact your Callan consultant or the authors with further questions: institute@callan.com Are you considering currency management? These 10 charts will help frame the issue 1
  3. 3. Knowledge. Experience. Integrity. Currency – First Quarter 2016 1990 2015 2 1. Institutional investors have more non-U.S. exposures than ever ● Over 25 years, we note a substantial increase in exposure to non-U.S. equity and fixed income investments for corporate (3% to 20%) and public funds (3% to 17%). Non-U.S. equity is typically a fund sponsor’s largest non-U.S. dollar-denominated exposure. ● The higher the currency exposure in the plan, the more it potentially contributes to volatility. ● While non-U.S. equity allocations have risen materially since 1990 (2% to 13% for corporate plans, 2% to 9% for public plans), currency obtained through real estate and private equity have also ramped up. However, exposure is much harder to quantify in these privately traded asset classes. Investments that have performed poorly due to currency hurt more than ever Sources: Callan’s Corporate and Public Fund Sponsor Databases. Real Estate Other Alternatives Cash Hedge Funds U.S. Balanced U.S. Fixed U.S. Equity Global Balanced Non-U.S. Equity Global Equity Non-U.S. Fixed 1990 2015 Average Corporate Fund Asset Allocation Asset classes with no currency exposure Asset classes with currency exposure 97% 3% 80% 20% Average Public Fund Asset Allocation 97% 3% 83% 17%
  4. 4. Knowledge. Experience. Integrity. Currency – First Quarter 2016 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 20152016 -75.0 -50.0 -25.0 0.0 25.0 50.0 75.0 100.0 Cumulative Returns for 15 Years ended March 31, 2016 CumulativeReturns 57.6 - Australia -38.9 - Brazil 21.7 - Canada 28.9 - Europe 11.5 - Japan -44.6 - Mexico 80.2 - Switzerland 2.0 - Taiwan 1.1 - UK -29.6 - India 28.0 - China -56.9 - Russia 2. Negative currency returns in past 2 years = concerned investors ● Looking at the last 15 years, we note a large dispersion in currency returns. ● From 2013 to present, currency returns have been mostly negative relative to the U.S. dollar. Sources: Callan, MSCI. European return series is the Deutsche mark through December 1998 and the euro thereafter. 3
  5. 5. Knowledge. Experience. Integrity. Currency – First Quarter 2016 0.0000 20.0000 40.0000 60.0000 80.0000 100.0000 120.0000 140.0000 160.0000 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 3. Historical currency movements put the current pain in perspective ● The U.S. Dollar Index measures the value of the dollar relative to a basket of foreign currencies of significant trading partners ● We observe a general downward trend (USD weakness) with periodic spikes to the positive (USD strength) U.S. Dollar Index: January 1973 – April 2016 Source: Federal Reserve Last price 89.891 High on 03.01.1985 143.906 Average 94.411 Low on 08.01.2011 69.025 4
  6. 6. Knowledge. Experience. Integrity. Currency – First Quarter 2016 4. Currency returns can hugely affect total return for USD investors ● Sometimes currency effect is positive, other times not ● Sometimes currency moves with equity returns, other times against Impact on MSCI EAFE Returns: 1971 – 2015 *EAFE local until 4Q1987, EAFE hedged thereafter. Sources: Callan, MSCI. Through 2015 1-Year 3-Year 5-Year 10-Year 20-Year 40-Year* MSCI EAFE (hedged)* 5.0 12.1 7.8 3.8 5.6 8.2 Currency Return -5.8 -7.1 -4.2 -0.8 -1.2 1.1 MSCI EAFE -0.8 5.0 3.6 3.0 4.4 9.3 -50 -25 0 25 50 75 201520102005200019951990198519801975 Currency Return MSCI EAFE (hdg)* Currency detracted 16% in 2005, dampening overall positive returns 5 Currency added 28% in 1985, boosting an already positive year
  7. 7. Knowledge. Experience. Integrity. Currency – First Quarter 2016 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 5.0 10.0 15.0 20.0 25.0 30.0 Rolling 5-year Standard Deviation for 35 Years ended March 31, 2016 StandardDeviation 14.8 - MSCI EAFE 13.8 - MSCI EAFE (hdg)* 18.7 - MSCI EAFE Average 17.0 - MSCI EAFE (hdg)* Average 5. Does currency hedging reduce equity volatility? ● Currency is not always additive to volatility (periods of low correlation to underlying equities). ● In recent rolling five-year periods, currencies have added to volatility. Sometimes. *EAFE local until 4Q1987, EAFE hedged thereafter. Sources: Callan, MSCI 6
  8. 8. Knowledge. Experience. Integrity. Currency – First Quarter 2016 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 -1.00 -0.75 -0.50 -0.25 0.00 0.25 0.50 0.75 1.00 Rolling 5-year Currency Correlation Relative To MSCI EAFE Local Currency for 25 Years ended March 31, 2016 Correlation -0.6 - Japan 0.2 - U.K. 0.1 - Euro* 6. Currency correlations to non-U.S. equity vary over time ● Currency’s contribution to EAFE (unhedged) volatility has risen in recent periods due to the higher correlation of sterling and euro to EAFE equities (MSCI EAFE local currency). ● The yen continues to provide diversification (low correlation to EAFE equities). *European return series is the Deutsche mark through December 1998 and the euro thereafter. Sources: Callan, MSCI. 7
  9. 9. Knowledge. Experience. Integrity. Currency – First Quarter 2016 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0 Rolling 5-year Correlation Relative To S&P 500 for 35 Years ended March 31, 2016 Correlation 0.81 - MSCI EAFE 0.81 - MSCI EAFE (hdg)* 0.73 - MSCI EAFE Average 0.76 - MSCI EAFE (hdg)* Average 7. Currency correlations to U.S. equity vary over time, too ● EAFE (hedged) and EAFE (unhedged) have similar correlations to the S&P 500 Index. ● Hedging does not seem to significantly change the diversification effect of non-U.S. equity. ● Currency exposure (as seen through EAFE unhedged) adds marginal diversification relative to the S&P 500 Index. *EAFE local until 4Q1987, EAFE hedged thereafter. Sources: Callan, MSCI 8
  10. 10. Knowledge. Experience. Integrity. Currency – First Quarter 2016 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 1516 0.0 2.5 5.0 7.5 10.0 12.5 15.0 17.5 Rolling 5-year standard deviation for 25 Years ended March 31, 2016 StandardDeviation 7.2 - Citi Non-US WGBI 3.1 - Citi Non-US WGBI (hdg) 3.0 - Barclays Aggregate 10.0 - Citi Non-US WGBI Average 3.5 - Citi Non-US WGBI (hdg) Average 8. In non-U.S. fixed income, does hedging reduce volatility? ● Unlike non-U.S. equities, hedging non-U.S. fixed income materially reduces volatility. ● Decisions on whether to hedge non-U.S. fixed income must consider the unique characteristics and implementation of the asset class. All the time. Sources: Callan, Barclays, Citi 9
  11. 11. Knowledge. Experience. Integrity. Currency – First Quarter 2016 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 -12.5 -10.0 -7.5 -5.0 -2.5 0.0 2.5 5.0 7.5 10.0 Rolling 5-year Returns Relative to MSCI EAFE for 35 Years ended March 31, 2016 RelativeReturns 3.8 - MSCI EAFE (hdg)* -1.1 - MSCI EAFE (hdg)* Average 9. Currency: To Hedge or Not To Hedge? ● Currency returns have been cyclical. ● The last period of sustained dollar strength was in the late 1990s. ● Where does the market go from here? *EAFE local until 4Q1987, EAFE hedged thereafter. Sources: Callan, MSCI Currency detracts Currency is additive 10
  12. 12. Knowledge. Experience. Integrity. Currency – First Quarter 2016 0.0% 20.0% 40.0% 60.0% 80.0% Quarter ended March 31, 2016 Europe Emerging Markets Frontier Markets North America Pacific Rim 12.7 17.4 1.7 64.2 4.1 10. Currency impacts U.S. equity returns too ● Earnings of companies in the S&P 500 have exposure to foreign currency. ● Investors can categorize stocks by country of domicile… ● Or by country of economic exposure. ● This chart shows economic exposure of the S&P 500 Index. ● Whether you realize it or not, all equity investors have exposure to foreign currency. S&P 500 Earnings – Percent from each region Source: MSCI 11
  13. 13. CALLAN INVESTMENTS INSTITUTE Currency Policy Issues to Consider and Bonus Charts Appendix
  14. 14. Knowledge. Experience. Integrity. Currency – First Quarter 2016 Issues to Consider in Establishing a Currency Policy 13 ● The currency policy should incorporate the investor’s: – Time horizon – View on the role of currency in the total fund and individual asset classes – Risk posture ● The currency policy should represent a long-term view ● The desired currency exposure will be expressed as a hedge ratio – It can be at the total fund level, the asset class level, or both – Hedge ratios generally range between 0% (fully unhedged) or 100% (fully hedged) ● The currency policy should also incorporate a statement of the method of implementation – Statement of strategic objectives: risk reducing and/or return enhancing – Active or passive – Internal or external
  15. 15. Knowledge. Experience. Integrity. Currency – First Quarter 2016 14 Callan Periodic Table of Investment Returns: Currency Annual Returns Australia 7.45% Australia 11.40% Australia -20.60% Australia 28.99% Australia 13.98% Australia 0.01% Australia 1.27% Australia -13.83% Australia -8.53% Australia -11.10% Brazil 9.39% Brazil 19.94% Brazil -23.67% Brazil 33.78% Brazil 5.01% Brazil -11.00% Brazil -8.90% Brazil -13.21% Brazil -11.25% Brazil -32.81% Canada 0.38% Canada 17.91% Canada -20.05% Canada 17.76% Canada 5.50% Canada -2.42% Canada 2.26% Canada -6.29% Canada -8.27% Canada -16.62% China 3.40% China 6.86% China 7.05% China -0.06% China 3.60% China 4.70% China 1.02% China 2.91% China -2.42% China -4.46% Europe 11.79% Europe 10.87% Europe -4.92% Europe 3.22% Europe -6.50% Europe -3.24% Europe 1.56% Europe 4.52% Europe -12.18% Europe -10.23% Mexico -1.75% Mexico -0.80% Mexico -21.19% Mexico 6.07% Mexico 5.85% Mexico -11.62% Mexico 7.46% Mexico -0.85% Mexico -11.14% Mexico -14.66% India 1.69% India 12.29% India -19.10% India 4.70% India 4.07% India -15.80% India -3.08% India -11.42% India -2.01% India -4.59% Japan -0.94% Japan 6.66% Japan 23.24% Japan -2.63% Japan 14.78% Japan 5.41% Japan -11.02% Japan -17.73% Japan -12.34% Japan -0.33% Russia 9.18% Russia 7.28% Russia -19.64% Russia 0.73% Russia -0.70% Russia -4.97% Russia 5.16% Russia -7.04% Russia -45.23% Russia -17.85% Switzerland 7.97% Switzerland 7.82% Switzerland 6.37% Switzerland 2.96% Switzerland 10.91% Switzerland -0.32% Switzerland 2.16% Switzerland 2.92% Switzerland -10.50% Switzerland -0.73% Taiwan 0.79% Taiwan 0.46% Taiwan -1.17% Taiwan 2.60% Taiwan 9.70% Taiwan -3.71% Taiwan 4.27% Taiwan -2.57% Taiwan -5.69% Taiwan -3.79% UK 14.00% UK 1.71% UK -27.77% UK 12.32% UK -3.05% UK -0.74% UK 4.59% UK 1.89% UK -5.86% UK -5.47% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Sources: Callan, MSCI
  16. 16. Knowledge. Experience. Integrity. Currency – First Quarter 2016 15 Non-U.S. Currency Correlation Table Periods ended March 31, 2016 Australia Brazil Canada China (EEC) Europe India Japan Mexico Russia Switzerland Taiwan UK Australia Brazil Canada China Europe (EEC) India Japan Mexico Russia Switzerland Taiwan UK Correlation for 10 Years ended March 31, 2016 Correlation for 5 Years ended March 31, 2016 1.00 0.86 0.75 0.15 0.65 0.54 0.12 0.66 0.60 0.54 0.66 0.65 0.85 1.00 0.79 0.25 0.60 0.51 -0.01 0.70 0.63 0.45 0.61 0.62 0.75 0.82 1.00 0.17 0.52 0.43 -0.03 0.64 0.63 0.32 0.51 0.62 -0.07 0.11 0.29 1.00 0.28 -0.01 0.15 0.19 0.39 0.39 0.46 0.11 0.45 0.63 0.68 0.04 1.00 0.38 0.24 0.37 0.53 0.78 0.53 0.57 0.36 0.41 0.22 -0.20 0.24 1.00 0.00 0.61 0.44 0.39 0.41 0.35 0.31 0.07 0.23 -0.15 0.05 -0.08 1.00 -0.34 0.13 0.49 0.26 -0.19 0.65 0.68 0.60 0.11 0.47 0.69 -0.17 1.00 0.70 0.27 0.55 0.59 0.54 0.55 0.60 0.39 0.48 0.34 0.21 0.69 1.00 0.56 0.67 0.53 0.48 0.58 0.53 0.19 0.67 0.41 0.11 0.55 0.69 1.00 0.77 0.35 0.61 0.67 0.71 0.37 0.44 0.33 0.06 0.67 0.78 0.76 1.00 0.44 0.37 0.43 0.56 0.17 0.69 0.13 0.11 0.32 0.50 0.60 0.57 1.00 Sources: Callan, MSCI
  17. 17. Knowledge. Experience. Integrity. Currency – First Quarter 2016 16 About the Authors Janet Becker-Wold, CFA, is a Senior Vice President and the Manager of Callan's Denver Fund Sponsor Consulting office. Janet joined the investment management business in 1991. Her experience at Callan includes all facets of investment consulting including investment policy analysis, asset and liability studies, as well as manager search and structure. She has a particular expertise in international investing and currency management. Her clients include corporate, public, and non-U.S. based funds. Janet is a member of Callan's Management, Manager Search, and Defined Contribution Committees, and is a shareholder of the firm. Janet received an MBA in Finance from the University of Colorado and a BS in Biology from the University of Texas. She earned the right to use the Chartered Financial Analyst designation. Andy T. Iseri, CFA, is a Senior Vice President and a non-U.S. investment consultant in Callan's Global Manager Research group. He is responsible for research and analysis in the non-U.S. and global asset class including developed and emerging equities, issues surrounding currency management, as well as matters related to ESG investing. He oversees manager searches, conducts on-site visits, and attends finalist interviews. Andy is a shareholder of the firm. Andy earned a BS in Business Administration - International Business at California State University, Sacramento. He belongs to CFA Institute, CFA Society of Sacramento, and earned the right to use the Chartered Financial Analyst designation.
  18. 18. Knowledge. Experience. Integrity. Currency – First Quarter 2016 Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Investments Institute (the “Institute”) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute’s permission. Institute clients only have the right to utilize such material internally in their business. © 2016 Callan 17
  19. 19. About Callan Corporate Headquarters Callan 600 Montgomery Street Suite 800 San Francisco, CA 94111 1.800.227.3288 1.415.974.5060 Follow us on Twitter: Follow us on LinkedIn: www.callan.com @CallanAssoc Callan Associates Denver 1.855.864.3377 New Jersey 1.800.274.5878 Callan was founded as an employee-owned investment consulting firm in 1973. Ever since, we have empowered institutional clients with creative, customized investment solutions that are uniquely backed by proprietary research, exclusive data, ongoing education, and decision support. Today, Callan advises on $2 trillion in total assets, which makes us among the largest independently owned investment consulting firms in the U.S. We use a client-focused consulting model to serve public and private pension plan sponsors, endowments, foundations, operating funds, smaller investment consulting firms, investment managers, and financial intermediaries. For more information, please visit www.callan.com. About the Callan Investments Institute The Callan Investments Institute, established in 1980, is a source of continuing education for those in the institutional investment community. The Institute conducts conferences and workshops, and provides published research, surveys, and newsletters. The Institute strives to present the most timely and relevant research and education available so our clients and our associates stay abreast of important trends in the investments industry. If you have any questions or comments, please email institute@callan.com. Regional Offices Atlanta 1.800.522.9782 Chicago 1.800.999.3536

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