Conscious Currency

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Conscious CuA new approach to undeexposure

Ian Toner, CFA, Head of Currency I

November 2010

rencyrstanding currency

mplementation


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Acknowledgements

This paper has taken shape through multiple iterations over thecourse of the last year, so the author has a wide range of currentand former colleagues and others to thank for their input,comments and support. Of particular note (and this is of coursean incomplete list), and in alphabetical order, are JanineBaldridge, Bob Collie, Mike DuCharme, Tom Fletcher, SteveFox, Grant Gardner, Greg Gilbert, John Gillies, Joe Glynn, Joe

Hoffman, John Leverett, Kelly Mainelli, Aran Murphy, JohnOsborn, David Rothenberg and Mike Thomas, each of whomcontributed significantly to improving this work, and Heather andCalista Toner, who can now have their dining room table back.All of the quantitative work included in this paper was performedby Bin Wang, who has been an invaluable resource from thevery early stages of this work. Any errors in the paper are theauthors own.

About Russell Investments

Russell Investments provides strategic advice, world-classimplementation, state-of-the-art performance benchmarks and

a range of institutional-quality investment products to clients inmore than 40 countries. Russell provides access to some of theworlds best money managers. It helps investors put this accessto work for defined benefit and defined contribution pensionplans, public retirement plans, endowments and foundations,and the life savings of individual investors.


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/ p 2 Russell Investments // Conscious Currency

NOVEMBER, 2010

Conscious Currency: A newapproach to understandingcurrency exposureBy: Ian Toner, CFA, Head of Currency Implementation

SECTION I: INTRODUCTION

Most institutional investors have significant exposure to internationalassets: few institutional investors hedge the currency exposure thatthis entails. While institutional investors typically believe that thiscurrency exposure has little long-term effect, the reality is that it canbe seen as a significant concentrated bet on the behavior of theirdomestic currency. In fact, for many institutional investors, this single

bet on the relative strength of their domestic currency can be seen asthe single largest unmanaged bet in their portfolio.

Despite the size and nature of this significant currency exposure, U.S.-basedinvestors have typically spent little time and focus on managing it while otherinvestors, where there is a higher propensity to hedge, tend to use relatively simpleapproaches to the question of currency exposure. The techniques that U.S.investors use point toward a conclusion that there is no need to hedge currencyexposure. Investors typically then consider whether it may be appropriate to hire anactive currency manager to provide what is described as alpha.

Recent thinking about the tools and concepts involved, both within Russell and inthe academic research community,1 has led Russell to begin to reconsider some ofthese conclusions, and then to reconsider some of the appropriate behaviors the

1 For example (Examples include but are not limited to): The Beta Continuum: From Classic Beta to Bulk Beta, Mark Anson. Journal of Portfolio

Management, Winter 2008. When should investors consider an alternative to passive investing?, Geoff Warren and Don Ezra.

Russell Research Viewpoint, January 2010. The Carry Trade And Fundamentals: Nothing to Fear But FEER Itself, scar Jord and Alan M.

Taylor. NBER Working Paper 15518, November 2009. Do Professional Currency Managers Beat the Benchmark? Momtchil Pojarliev, CFA, and Richard

M. Levich. Financial Analysts Journal, Vol. 64, No. 5, 2008.


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Russell Investments //Conscious Currency / p 3

investor may adopt, as well as the scale and nature of the benefit the investor canpotentially reap by doing so. This has led us to reassess:

What currency risk is;

How investors can think more effectively about currency exposure;

How investors can develop a new grammar around currency exposure; and How currency risk (correctly defined) can be included in a global portfolio.

This new framework has led us to question many of the traditional assumptionsabout currency. The proposed implementation solution is referred to as ConsciousCurrency, and may drive significantly better returns for investors.

SECTION 2: POSING THE PROBLEM

The problem caused by currency exposure is believed to be well understood. Wheninvestors purchase assets denominated in a foreign currency, they expose themselves

to the risk of the exchange rate changing during the time they hold the asset. Thischange in exchange rate impacts the value of the asset in domestic currency terms.

Currency surprise

Some of the changes in exchange rates can be predicted, due to the interest ratedifferential between the two countries involved. This interest rate differential is reflectedin the pricing of the currency forward curve.2 Investors do, however, face the danger ofcurrency surprise: the difference between changes in exchange rates to be expectedon the basis of the pure interest rate differential and the actual changes in exchangerates.

This effect can be very significant. Exchange rates can trend significantly, with thosetrends coming to an end suddenly. Exchange rates typically exhibit significant volatility,and the predictive power of simple interest rate differentials appears to be fairly limitedand time-dependent.

Hedging currency exposures

Some investors wish to minimize currency risk. They can do so using forwards. Bybuilding a book of forward positions, they can ensure that the only changes in exchangerates to which they are exposed are those caused by the current interest ratedifferentials; they will be keeping the relationship between the assets involvedessentially constant as to today. We describe such a portfolio as being hedged.

The effect of investing in international assets, and then hedging the currency exposureby use of the currency forward market, can be measured against hedged benchmarks.

A benchmark that represents hedged equity exposure attempts to describe the returnstream experienced by an investor from a particular home country who purchases aninternational equity portfolio, and who then purchases a portfolio of currency forwards toneutralize the potential exposure to currency surprise.

2 Currency forward contracts can be thought of as spot transactions (so the price is set today) with delayeddelivery. The price is therefore adjusted by an amount equal to the interest rate differential today to reflect theeffect of the different interest rate environments.


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What is currency risk?

Investors have typically defined currency risk as being the currency surprise they mightexperience in the range of their exposures to international assets.

Currency risk under this definition can easily be measured; it is the difference betweenthe hedged and unhedged versions of the benchmarks investors use to describe theirinternational exposures. Investors can plot the relative returns of these two benchmarksand draw conclusions as to the potential outcomes they may experience if they decideto hedge their currency exposure.

The problem here is that what is actually being measured is the effect of currencyexposure as experienced by an investor with a particular currency allocation with thatcurrency allocation being driven by the structure of the equity or fixed income market.While this is interesting, it answers only a very specific question: What was the historicaleffect of the currency exposure an investor would have experienced from a particularportfolio? Currency risk under this definition is therefore dependent on two factors thebehavior of the currency market, and the allocation structure of the portfolio as driven byexposure to an unrelated asset class.

What this metric does not do is answer a much broader question: what is the risk / returnbehavior of the currency market as a whole?


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SECTION 3: THE OLD APPROACH TO CURRENCY RISK

The standard approach to currency exposure has been to look at the issue entirely inthe context of hedging. The investor asks a simple question: Should I hedge thecurrency exposure I take on when I invest in international assets?

This simple question has traditionally been answered by use of an heuristic (or rule ofthumb) outlined in the following chart.3

For illustrative purposes only

This appears to outline a very simple and clear thought process. Investors shouldconcern themselves with hedging only when they have relatively high exposure tocurrency, and then only when their evaluation horizon is relatively short-term. Thisapproach is quite compelling as long as the presumptions that underlie it are correct,and as long as the terminology is correctly understood and applied.

The problem most investors face with this chart is that these conditions do not apply.

There are three issues here:

3 This ground has been well covered in previous Russell research. Examples include the following papers: Currency Hedging Policy for U.S. Investors, Greg Nordquist and Mark Castelin. Russell Practice

Note No. 87, October 2004. Currency Hedging Policy Formulation for Canadian Investors, Bruce Curwood, Yoshimori Maeda

and Mary Robinson. Russell Research Commentary, October 2005. Revisiting the Normal Currency Hedge Ratio, George Oberhofer and Joseph Smith. Russell

Practice Note No. 122, February 2007.

Short Long

Evaluation Horizon

Short Long

Evaluation Horizon

ForeignCurrencyEx

posure(%)

Low

High

ForeignCurrencyEx

posure(%)

Low

High

Do Not Hedge

(Not material)

Do Not Hedge

(Not material)

Consider Hedging

(Minimize Regret)

Consider Hedging

(Minimize Regret) Do Not Hedge

(Unnecessary)

Do Not Hedge

(Unnecessary)

Short Long

Evaluation Horizon

Short Long

Evaluation Horizon

ForeignCurrencyEx

posure(%)

Low

High

ForeignCurrencyEx

posure(%)

Low

High

Do Not Hedge

(Not material)

Do Not Hedge

(Not material)

Consider Hedging

(Minimize Regret)

Consider Hedging

(Minimize Regret) Do Not Hedge

(Unnecessary)

Do Not Hedge

(Unnecessary)


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For this heuristic to apply, the underlying behavior of the currency markets isassumed to be random and more severely random than other markets to whichinvestors are exposed.

The evaluation horizon itself is often misapprehended, with most investors assumingthey fit into the long-term category when they are in fact more likely to be in the

short-term category. The level of foreign exposure that defines the point at which exposure is de minimis is

typically thought to be much higher than is in fact the case.

Currency market randomness

The first issue, then, is that of randomness. The usefulness of this approach in thehedge / dont hedge decision-making process depends on the currency markets beingrandom, with no real underlying long-term structure. This allows the investor to assumethat currency returns will all wash out over the long term. If, on the other hand, there issome structure identifiable in currency returns (even if active currency managers maynot be very good at identifying it, and even if there is no presumptive ex-ante positivereturn expectation), then the very simple approach falls down. This issue will beimportant later in the paper.

Position on the evaluation horizon axis

Most institutional investors regard themselves as long-term investors and mostinstitutional pools of capital have long-term obligations, with expectations of long-termthought processes. These investors, then, will look at the heuristic above and assumethat they fit at the right-hand side of it, where hedging is only indicated at high levels ofexposure.

In fact, however, most investors should place themselves at the other end of the scale.Most investors closely follow their performance on a monthly or quarterly basis. Mostinvestors have to reassess their financial positions on an annual basis. Most investors

will reassess the balance between assets and liabilities at least every five years. Theeffect of currency will be important at each of these moments, none of which falls intothe long-term category.

This can be well illuminated by a thought experiment. For investors to place themselvesaccurately on the evaluation horizon line, all they need to do is imagine the attitude oftheir board and/or sponsor were they to experience three to five years of consistent,significant currency losses the result of which was to swamp the return stream from therisk asset portfolio. Unless they can honestly say that there would be completeacceptance of this result from their board, and no pressure for a change in strategy(even if a large contribution was needed due to the currency losses), then the investorsare likely to be in the short-term segment of the evaluation horizon axis.

Level of currency exposureInvestors have typically assumed that unless currency exposure rises to levels of 15% to20% or higher, it is unlikely to be significant. Again, the view that the effect of thisexposure is random and is likely in the long term to be roughly zero, tends to drive thisthought process.

Reconsidering this view, however, may lead to the conclusion that this threshold shouldbe drawn at a lower level. Investors are generally keen to remove uncompensated risk


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exposures,4 where that removal is cost-effective; they can instead reallocate that risk toan exposure for which they expect to be rewarded. The costs of hedging currency riskare typically very low on the order of 12 to 15 basis points of the amount hedged. Foran investor with only 5% exposure to currency risk (well below that of most investmentportfolios today), this translates to a cost of less than 1 basis point at the total plan level

significantly less than the likely contribution to total plan risk.Investors should therefore consider hedging at very low levels of currency exposure,and frame the decision to hedge currency exposure in terms of cost of hedging vs.uncompensated volatility avoided.5

Reconsidering the old approach

Rethinking the existing approach allows us to see both the benefits (length of evaluationand level of exposure are worthwhile issues to consider) and the detriments (currencymovements may not be entirely random; most investors are more short-term than theymay think; and even small exposures to currency contribute to uncompensated andavoidable risk).

Looking at both benefits and detriments makes us ask whether there is a different wayto understand the issues. Can we develop some simple approaches that will allow us tothink about currency more clearly and that may help us improve total portfoliooutcomes?

The answer to that question, we believe, is yes.

SECTION 4: TERMINOLOGY AND THREE QUESTIONS

To begin, we need to restate some terms. We can then divide possible opinions aboutcurrency into three mutually exclusive but collectively exhaustive groups.

Terminology

The core restatement relates to what a neutral exposure to currency is. We shouldrecognize that the decision to invest (on an unhedged basis) in international assetsinvolves the effective purchase of two portfolios: a portfolio of the underlying assets,and a portfolio of currency exposures. These two portfolios are identical in size, andtheir asset allocation policies are also identical but those asset allocations are setbased on the nature and structure of the underlying asset market, not the currencymarket.

4 And a random exposure by definition cannot be expected to be anything other than uncompensated: even an

expectation of diversification benefit requires that the behavior of the exposure be something other than random or there is no basis for making predictions as to likely future behavior.

5 The traditional default Russell advice to U.S. investors choosing to hedge has been to adopt a 50% hedgedpolicy for regret-minimization reasons. The logic behind this is exceptionally well (and clearly) laid out in thefollowing Russell papers:

Managing Currency Risk in U.S. Pension Plans, Grant Gardner. Russell Research Commentary,January 1994.

The Regret Syndrome in Currency Management: A Closer Look, Grant Gardner and ThierryWuilloud. Russell Research Commentary, August 1994.

Statistical Estimates of the Normal Currency Hedge Ratio: Best Practice or Best Guess?, GrantGardner and Douglas Stone. Russell Research Commentary, November 1995.


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Describing currency exposure in this way makes it clear that the current foreignexchange (FX) exposure borne by investors is anything but a neutral exposure to thecurrency markets. It is, in effect, an active portfolio of currency, and the investmentpolicy that drives the active allocations (and their changes) is being driven entirely by thebehavior of the other international assets.

In contrast, a neutral portfolio of currencies would be a portfolio of currencies that hasno necessary relationship to other asset classes, but that reflects the inherent structureand characteristics of the currency markets as a whole. This is similar to the way wethink about neutral as regards other exposure sets (e.g., real estate, commodities,equities, fixed income).

This also leads us toward one final core restatement, relating to the ongoing argumentas to whether currency is an asset class. This argument (which has been ongoing foryears and is unlikely to be settled anytime soon) is interesting, but in practical terms it isentirely sterile. What matters is only whether an investor is prepared to be exposed tocurrency markets. This exposure may not bring an expectation of systematic return andthe currency markets may fail to meet a particular definition of asset class; however, itremains an exposure in the portfolio and a sizeable one at that. For this reason we use

the term exposure set, rather than asset class.

Categories of currency exposure

There are three mutually exclusive, but collectively exhaustive, ways of thinking aboutcurrency exposure.

1. The amount of currency exposure in the portfolio does not matter. Theparticular currencies held and the weights in which they are held, do not matter.

2. The amount of currency exposure in the portfolio matters. The particularcurrencies held and the weights in which they are held, do not matter.

3. The amount of currency exposure in the portfolio matters. The particularcurrencies held and the weights in which they are held, matter.

Each of these ways of thinking leads to a conclusion about the most appropriateapproach to dealing with currency exposures:

1. Because neither the amount nor the nature of my currency exposure is going tomatter, I dont need to worry about any form of hedging or management of thatcurrency exposure.

2. Because the extent of my currency exposure matters, I need to considerwhether to adjust that exposure through hedging. Because the nature of thecurrency exposure does not matter, I dont need to worry about changing theweights of currencies I am exposed to in my portfolio.

3. Because both the amount of currency exposure and the nature of that exposurematter, I need to consider not only adjusting the amount of exposure (throughhedging), but also changing the nature of that exposure (through some form ofcurrency management).

Investors with no currency management process in place are effectively placingthemselves in the first category. Investors with some hedging in place are choosing toplace themselves in the second category. Despite this, most investors are likely, onreflection, to find themselves closer to the third of these opinions as to the nature ofcurrency exposure and yet with a policy that does not reflect that thought process.

One reason for this disconnect has been an assumption about the nature of currencymanagement. Investors considering the nature of their exposure to currency are typicallypresented only with a series of active investment management choices as though the


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only way to get coherent access to the currency market behavior is through an activeapproach (whether by means of some form of dynamic currency hedging or throughformal active management). Many investors have been uncomfortable with this, feelingthat the currency market was efficient enough as to be an unpromising source of activemanagement return. Returns from currency managers have often supported that

skepticism.

6

We believe there is an alternative approach that brings thinking about currency into linewith thinking about other exposure sets. We call this approach Conscious Currency.

SECTION 5: CONSCIOUS CURRENCY: AN OVERVIEW

We propose that investors think about exposure to currency as they would think aboutother key portfolio exposures. This involves a simple staged process:

Identifying and adopting a benchmark to describe and measure the neutral-betexposure to the currency markets. The design of this benchmark will be based on the

actual structure of the currency market, rather than on the behavior or nature of othermarkets.

Using that benchmark to represent currency as part of the risk assessment andallocation process when setting target policy allocations at the total fund level essentially allowing currency to compete with other possible exposure sets forallocation.

Implementing the resulting decision through manager hiring decisions includingpossible exposures to the currency markets, either through strategies designed toreplicate the chosen benchmark, or through active strategies designed to produce thatreturn with additional alpha.7

This approach allows investors to treat currency exposure similarly to they way they dealwith other investment choices. They are free to choose an appropriate benchmark. Theyare also free to implement the solution in a number of different ways. They will end up,however, with a much more considered exposure to the currency markets than theywould have achieved by following any of the current standard approaches.

Most important this approach does not involve exposing the portfolio to any new assetclass, or exposure set. It simply involves attempting to describe one element of thecurrent exposure set more accurately, and to control it more directly. Doing this (evenwithout active management) should drive better portfolio efficiency, which in turn shouldbe hoped to drive better risk-adjusted return.

Conscious Currency: Measure

Measuring the behavior of the currency markets as a whole involves selecting a

benchmark to represent those markets. That benchmark will be a portfolio of currencypositions, with a series of construction rules designed to be simple, clear andreproducible, that meaningfully represent the behavior of the currency markets.

6 Although past Russell research has demonstrated that active currency managers have the ability to generatepositive returns, this is certainly not a universal property of those managers, and is generally regarded aschallenging. Despite this, Russell continues to believe that some active currency managers can create value.7 For details underlying the case for active currency management, see Capturing Alpha through ActiveCurrency Overlay, Brian Meath, Janine Baldridge and Heather Myers. Russell Research Commentary, May2000.


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Importantly, because the currency market is different in structure from the equity market,the construction of the benchmark for the currency market will likely look rather differentfrom the construction of the equity benchmark.

The nature of the currency market, then, is important. First we need to look at the basicstructure. Currency investment can be thought of as a process of borrowing (or buying)

in one currency and lending (or selling) in another essentially, a long/short process.This is in stark contrast to the equity market, which is typically a long-only marketstructure. Appropriate benchmark construction will recognize this: an equity benchmarkwill tend to have a long-only free-float capitalization-driven structure (although otherapproaches are making headway with some investors), while a currency benchmark willbe more appropriately built on a long/short basis.

In addition to this basic question of structure, we also need to look at the nature of thereturn-generation mechanism. Unlike equity markets, where there is an expectedinherent return from the enterprise that has issued the asset, currency returns arederived by price changes. These changes are generally understood to be driven be anumber of different factors. Three key factors are regarded as the core of marketbehavior:

Carry (interest rate differentials);

Valuation (purchasing power); and

Momentum (price trend).

While the degree of return from each strategy varies, and while views differ as towhether returns are related to some form of currency risk premium, there seems to beenough agreement among market participants that these three factors explain asignificant part of currency market return, and that they appear to do so on a consistentbasis to justify using them as a market proxy.

A good currency benchmark, then, is likely to use a simple, rules-based, long/shortportfolio construction methodology to build a benchmark portfolio that captures the core

behavior for each factor in a mechanistic way, but without attempting to time the relativestrength of each factor.

BENCHMARK CHOICES

Over the last few years, a number of firms have begun to construct and issuebenchmarks designed to represent the totality of the currency exposure set. Most ofthese benchmarks have only limited live history, and many of them focus on a singlefactor.8 We can regard the current state of currency benchmarking as being similar tothe state of international equity benchmarking 25 years ago better than not attemptingthe exercise, providing a good approximation of the answer sought, but with plenty ofroom for improvement.

The focus of this paper is not on the precise methodology an investor should use to

select a particular benchmark. As long as the benchmark concerned has most of theproperties mentioned above and as long as it is designed to represent the currencymarkets in aggregate, it can be regarded as an appropriate choice for our currentpurposes.

8 Credit Suisse, FTSE and Deutsche Bank all provide currency benchmarks of the types discussed. Russell hascalculated internal benchmarks for manager assessment purposes for a number of years, although these arenot public.


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For the purposes of this paper, in terms of both the research performed and the possibleimplementation solutions, Russell has chosen to use a benchmark constructed byDeutsche Bank to represent the currency markets: the Deutsche Bank Currency Return(DBCR) index9. We believe this benchmark to have most of the necessary properties tobe an acceptable choice.

THE DEUTSCHE BANK CURRENCY RETURN INDEX

The DBCR is designed to provide an entirely rules-based approach to benchmarkingcurrency markets. This benchmark covers the G10 countries currencies and is designedaround a long/short approach.

The benchmark construction process is purposely simple. The three factors identifiedabove (carry, valuation and momentum) are each represented by a single model. Eachmodel is driven by a single public data point, with the currencies ranked in orderaccording to that variable: for example, in the carry model, the currencies will be rankedstrictly according to the interest rate. Within each model, once the investor hasperformed this ranking exercise, the portfolio is constructed by buying the three top-ranked and selling the three bottom-ranked currencies identified, with each buy and sell

decision equally weighted.10

The portfolios constructed by each model are combined intoa single portfolio, with each factor equally weighted.

The outcome of the process is a single portfolio of positions designed to capture thebehavior of the currency markets on the basis of the key factors involved but without theinvestor making value judgments as to the relative strength of those factors.

This benchmark has been published since 2007, with data available on a back-test basisfor 20 years prior. The behavior of the benchmark over the live period appears to beconsistent with that in the back-test period, as can be seen in the chart below plottingthree-year rolling excess return over the long term.

We look at DBCR returns when modeling on a funded basis, where the total return isgenerated by an allocation to a domestic cash account, which provides backing to a

currency forward book that replicates the DBCR return.

9 Indexes are unmanaged and cannot be invested in directly.

10 The resulting portfolio will clearly exclude some of the possible currencies. This type of benchmark is trying tocapture price-change behavior by identifying factors that drive those price changes (again, because the FXmarkets are quite different from the equity markets, where a full replication approach is appropriate). Little wouldtherefore be added (other than transaction costs) by including those currencies where there is no usefulinformation in the signal structure.


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For illustrative purposes only. As of March 1, 2010.

Each of the factors involved has contributed to the return at different strengths overdifferent periods. The chart below plots the contributions of each factor. It is interestingto note the important role of carry between 2000 and 2007 and also interesting to notethe way in which the other two factors provided diversification benefit when the carrytrade failed in 2008.

For illustrative purposes only. As of March 1, 2010.

What is interesting about this benchmark is the way in which it compares with otherpossible exposures, both in return and (more important) in diversification terms.

THE DBCR: RETURNS, RISK AND DIVERSIFICATION

Comparison of currency risk (expressed through the DBCR) with other possibleexposure sets is interesting.

DBCR Indices

As of March 2010

80

100

120140

160

180

200

220240

260

280

Jun-89

Jun-90

Jun-91

Jun-92

Jun-93

Jun-94

Jun-95

Jun-96

Jun-97

Jun-98

Jun-99

Jun-00

Jun-01

Jun-02

Jun-03

Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

DB Carry Excess DB Momentum Excess DB Valuation Excess

Basispoints

DBCR Excess Return over cash

Tracking Error = 4.9%

June 1989 to March 2010

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%10.0%

12.0%

Jun-92

Jun-93

Jun-94

Jun-95

Jun-96

Jun-97

Jun-98

Jun-99

Jun-00

Jun-01

Jun-02

Jun-03

Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

ThreeYearRolling

ExcessReturn

10.0%


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First, we look at risk and return.

RETURN & VOLATILITY STATISTICS

Charts provided for illustrative purposes only.EAFE FX = Morgan Stanley Country Index-Europe, Australasia, Far East Foreign Exchange (MSCI

EAFE FX) Hedge USD Index (Unhedged-Hedged); DBCR = Deutsche Bank Currency Returns Index;BC = Barclays Capital U.S. Aggregate Bond Index; Russell 3000 = Russell 3000 Index; MSCI EAFE =Morgan Stanley Country Index-Europe, Australasia, Far East (MSCI EAFE) Index.

In this table we compare the DBCR approach to equity and fixed income from the pointof view of a U.S. dollarbased investor. We also include the difference between theunhedged and hedged return of international equity the effect that has traditionallybeen described as currency risk, but which we now can more clearly describe as thecurrency effect of a particular equity portfolio (which provides little information about thecurrency market, or the true nature of currency risk).

This table shows a number of important facts. First, the return stream associated with

currency has been strong over the periods concerned during the 10-year period, infact, the currency return was greater than both equity and debt. Second, the volatility ofthe return, while higher than that of bonds, was significantly lower than the volatility ofequity. Third, when compared against the older definition of currency risk, the DBCRapproach has not only significantly better return, but also much lower risk.

Ten YearsEnded June 30, 2010

EAFEFX(Unhgd-Hgd) DBCR BC Aggregate Russell 3000 MSCIEAFE

Annualized Average Return 1.6 6.9 6.5 -0.9 0.6Max Monthly Return 6.3 3.4 3.7 10.5 13.0Min Monthly Return -5.8 -3.3 -3.4 -17.7 -20.2Annualized Volatility 7.7 5.0 3.8 16.7 18.1

Twenty Years Ended June 30, 2010


Annualized Average Return 0.7 7.4 7.1 7.9 4.4Max Monthly Return 7.4 3.9 3.9 11.2 15.6Min Monthly Return -6.9 -4.0 -3.4 -17.7 -20.2Annualized Volatility 7.9 5.0 3.8 15.3 17.3


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CORRELATION STATISTICS

Charts provided for illustrative purposes only

The correlation statistics are probably more important they are certainly as interesting.What is clear is that the DBCR has much lower correlation with bonds and equities thandid the older definition of currency risk and that it also has low correlation with that olderdefinition itself. This is true across both 10 and 20 years.

In summary, then, the DBCR, over the time period for which data is available, providedaccess to a relatively stable return stream. This return stream appeared to be able toprovide good diversification benefits for equity and fixed income investors. This returnalso appeared to be able to do a much better job at this provision than does exposure tocurrency risk as defined using the traditional approach. More important, this behaviorwas not confined to the period for which back-test data was available, but also continuedinto the live data set.

Conscious Currency: Model

Having defined currency risk, the investor should now allocate exposure to that risk if(and only if) it succeeds in competing for that allocation. Investors would do this bywhatever approach they normally use: in essence, they are simply separating thecurrency decision from the equity, fixed or other exposure-set decision but at the sametime keeping the decision about currency at the same level of the process as the othermajor exposure sets.

While the nature and process of this modeling exercise will depend upon the particularinvestor, there are a number of ways by which we can gain some insight into thepossible benefits an investor might harvest from taking this newer approach to currency

risk.

There are two questions we might hope to answer by conducting further analysis:

Does this new specification of currency risk improve the description of the totalopportunity set available to the investor?

If so, does this opportunity set improvement occur in such a way that the investormight be able to harvest benefits from a simple portfolio management process?

Ten YearsEndedJune 30, 2010


EAFE FX (Unhgd-Hgd) 1DBCR -0.2 1BC Aggregate 0.4 -0.1 1Russell 3000 0.2 0.2 -0.1 1MSCI EAFE 0.5 0.2 0.0 0.9 1

Twenty Years Ended June30, 2010


EAFE FX (Unhgd-Hgd) 1.0DBCR -0.3 1.0BC Aggregate 0.3 0.0 1.0Russell 3000 0.1 0.2 0.1 1.0MSCI EAFE 0.4 0.1 0.1 0.7 1.0


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IMPROVING THE OPPORTUNITY SET

The first question we can ask is whether using the Conscious Currency approach toanalyzing and describing currency risk can improve the opportunity set available toinvestors. Such an improvement would not come about because of the inclusion of anew asset class or exposure set after all, investors today have exposure to currency.

Any improvement in the opportunity set would instead be derived from an improveddescription of currency risk. For the effect we are attempting to identify to be real, wewould expect it to appear over multiple time periods, and from the standpoint ofinvestors in a range of home-country currencies. It would be surprising if it alwaysoccurred but we would expect it to be present more often in longer-term data sets thanin shorter-term data sets.

Whether such an improvement exists can be assessed by use of a simple mean-variance optimization process. This process compares the efficient frontiers of threedifferent universes of investment options. In each case, borrowing and shorting isprohibited, and each investment option is included on a funded basis (so any currencyallocation includes both a domestic cash return and the return from the currencybenchmark portfolio).

The three universes we compare are as follows:

UnhedgedDomestic equity, domestic fixed income, unhedged foreign equity, unhedged foreignfixed income.

HedgedDomestic equity, domestic fixed income, hedged foreign equity, hedged foreign fixedincome.

Conscious CurrencyDomestic equity, domestic fixed income, hedged foreign equity, hedged foreign fixedincome, currency.

We use the DBCR funded benchmark as our currency benchmark in all of the followingmodeling exercises.


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For illustrative purposes only. As you move from left to right on the graph - increasing risk - there are

investments that can offer higher return potential. However, as with any type of portfolio structuring,

attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

There is a clear result from this exercise. Over the 10-year period concerned, there is asignificant improvement in the efficient frontier caused by adoption of the ConsciousCurrency approach. For example, at the 6% return level, the adoption of this proposed

approach reduces risk at the total portfolio level to nearly half that of an unhedgedportfolio. This is a fairly dramatic effect we will see shortly whether this is harvestable.

This result is for U.S.-based investors over one particular time period (10 years ending2009). However, when similar analysis is performed for investors based in otherdomestic currencies, we find similar results, although the scale of the improvementvaries. This is also true as to time periods analysis shows that over short periods,there are times when the effect of the Conscious Currency approach does not producean improved frontier, but that over longer time spans, the effect becomes increasinglystronger and more dominant.11

We therefore have good evidence that the proposed approach may provide benefits forthe investor.12 It remains to be seen whether investors would be able to harvest thisbenefit by use of a reasonable portfolio.

11 Details of some of these analyses are included as an appendix to this paper. Results of this type of analysiswill, of necessity, be both time-period-dependent and also highly dependent upon the benchmarks chosen torepresent the different possible investment opportunities.12 It is important to note here that we are restricting the discussion to the asset side of the investors behavior.The way the asset side interacts with the liability issues that the investor is facing is, of course, key but isessentially independent of the current discussion.

Comparison Of Efficient Frontiers

10 Years Ending 2009 - US $ Based Investor

4.00

4.50

5.00

5.50

6.00

6.50

7.00

7.50

1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00

Risk (St. Dev.) %

Return%

Conscious Currency Unhedged FullyHedged


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Russell Investments //Conscious Currency

HARVESTING THE BENEFIT OF CONSC

Before an investor can seek to harvestapproach, the opportunity to do so woulactually be prepared to purchase andcomfortable.

To model this, we can create some simdifferent approaches to currency exposportfolios are constructed by use of beninternational equity and fixed income allcurrency risk in the Conscious Currencexposure (ranging between 5% and 50are then invested and their performanrebalanced to policy monthly. The end r

The three portfolios, similar to the abov

Unhedged60% equity/40% fixed income. Intern

Hedged60% equity/40% fixed income. Intern

Conscious CurrencyDomestic 60% equity/40% fixed incoand half into a 60% equity/40% fixed

The outcome is again fairly clear, and

For illustrative purposes only

2

2.25

2.5

2.75

3

3.25

3.5

7 8

Return(Annualized,

%)

Risk (Stan

USD Based Inv10-Year Risk & R

Unhedged

Hedged

ConsciousCurrency

IOUS CURRENCY

he benefits potentially available from thisd have to occur in a portfolio the investor mightefficient frontier portfolios rarely look

ple portfolios that use uncomplicated rules butre, and then track their performance. These

chmarks that represent domestic andocations, as well as the DBCR to representportfolio. Different levels of international) are placed into each portfolio. The portfoliose tracked by use of index returns and

esults are plotted for comparison purposes.

analysis, are as follows:

tional equity and fixed income unhedged.

tional equity and fixed income hedged.

e. International placed half into DBCR fundedincome hedged portfolio.

can be seen in the following chart.

9 10 11ard Deviation, %)

stor Model Portfoliosturn Ending June 2010

The direction of the arrows representsincreasing international exposure

/ p 17


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The Conscious Currency outcome is significantly better than the alternatives. While mostor all of the international return premium gained by increased exposure to internationalassets is captured, there is a risk-reduction effect from this increased exposure, ratherthan an increased risk as seen in the unhedged portfolio.

Again, this is not simply a U.S.-based investors result. Indeed, the outcomes appear

relatively consistent for investors based in a wide range of markets.13 In most instances,investors who adopted the Conscious Currency approach produced better portfoliooutcomes than those who adopted either the hedged or the unhedged approach.

Investors adopting the Conscious Currency approach seem, then, to have been able toharvest better outcomes from what appears to be a fairly consistent effect in themarkets; we think its unlikely that what were seeing is a simple data anomaly. Standardportfolio construction tools should allow investors to construct asset allocation policiesthat seek to capture this advantage.

Conscious Currency: Implement

Having defined the desired asset allocation to include the Conscious Currencyapproach, the investor then must decide upon the best implementation of the allocation.

A key point is that the modeling exercise performed above used funded benchmarks.These benchmarks are constructed under the assumption that the investor implementsan allocation to the exposure concerned by placing an appropriate amount of cash in ashort-term vehicle and then by overlaying that with a currency portfolio.14 Implementingan allocation selected on this basis can be done in a similar approach without theinvestor suffering cash drag from the cash allocation. Indeed, the allocation to cashthat is involved may well be used not only for collateralization of the short components ofthe currency allocation, but also as part of a broader synthetic mandate.

An investor might, then make the following decision:

Model the potential allocation structure by use of hedged international benchmarksand a Conscious Currency benchmark;

Appoint investment managers for international asset portfolios, using unhedgedbenchmarks to ensure minimal disruption of their standard process; and

Appoint a single Conscious Currency manager. This manager manages the cashcomponent (if any) of the strategy, removes the currency risk that has been assumedthrough the unhedged allocation to international mandates and creates exposure tothe currency benchmark the investor has selected in the size and nature required bythe policy.

This approach would provide the investor with an efficient portfolio structure, involveminimal disruption to the current managers and result in a clearer and more appropriateexposure to the currency markets. The investor could reasonably expect an improvedchance for better portfolio outcomes

13 Further analysis of this effect, for investors in different domestic base currencies, can be found in theappendix to this paper. Again, the normal time period and data consistency caveats apply; at the least, theseresults demonstrate an interesting behavior set.14 Structurally, this is not dissimilar to a portable alpha approach, but the nature of the exercise is quite different

rather than attempting to harvest alpha from one beta source, investors are instead gaining efficient structuralexposure to a type of beta to which they are today inefficiently exposed.


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Appendix A: AUD-based

5

5.5

6

6.5

7

7.5

8

8.5

1 2 3

Return(Annualized%)

Risk (

EffiAUD Based I

2

3

4

5

6

7

8

5 5.5 6

Return(Annualized%

)

Risk (Stan

AUD Ba10 Year Ri

Unh

The direction of the arrows representimprovement in results achieved appbe present for investors in a wide ran

Charts provided for illustrative purposes onl

4 5 6 7 8tandard Deviation %)

cient Frontier Portfoliosvestor 10 Years Ending July 2010

Unhedged Hedged Conscious Currency

6.5 7 7.5 8 8.5ard Deviation %)

ed Investor Model Portfoliossk & Return Ending June 2010

dged Hedged Conscious C urrency

s increasing international exposure. Theears to happen over multiple time periods, and toge of home domiciles.

/ p 19


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/ p 20 Rus

Appendix B: CAD-based

5

5.2

5.4

5.6

5.8

6

6.2

6.4

6.6

6.8

1 1.2

Return(Annualized%)

Risk (

CAD Inves

Unhedg

2

2.5

3

3.5

4

4.5

5

5.5

6 7

Return(Annualized

%)

Risk (S

CAD BaseOct 2000

Unhedg

The direction of the arrows represenimprovement in results achieved apbe present for investors in a wide ra

Charts provided for illustrative purposes on

sell Investments //Conscious Currency

1.4 1.6 1.8 2

tandard Deviation %)

Efficient Frontieror 10 Years to End June 2010

ed Hedged Conscious Currency

8 9 10


d Investor Model Portfolios- Aug 2010 Risk & Return

d Hedged Conscious Currency

ts increasing international exposure. Thepears to happen over multiple time periods, and tonge of home domiciles.

ly


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Appendix C: EUR-based

4

4.5

5

5.5

6

6.5

7

7.5

1 1.5

Return(Annualized%)

Risk

EUR B1

0.5

1

1.5

2

2.5

3

3.5

8 9

Return(Annualized%

)

Risk (

EU Bas10 Year R

The direction of the arrows representimprovement in results achieved appbe present for investors in a wide ran


2 2.5 3

Standard Deviation %)

sed Investor Efficient FrontiersYears Ending June 2010

Hedged Unhedged Conscious Currency

10 11 12


ed Investor Model Portfoliosisk & Return Ending June 2010

nhedged Hedged Conscious Currency

increasing international exposure. Thears to happen over multiple time periods, and toe of home domiciles.

/ p 21


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/ p 22 Rus

Appendix D: GBP-based

5

6

7

8

9

10

11

12

1 2 3 4

Return(Annualized%)

Risk

EfficGBP Based

6.5

6.75

7

7.25

7.5

7.75

8

8.25

7.5 8

Return(Annualized%)

Risk (S

GBP BasJan 2003 to

U

The direction of the arrows representsimprovement in results achieved appebe present for investors in a wide ran


sell Investments //Conscious Currency

5 6 7 8 9

Standard Deviation %)

ient Frontier PortfoliosInvestor Jan 2003 - July 2010

Unhedged Hedged Concscious Currency

8.5 9 9.5


d Investor Model PortfoliosEnd Aug 2010 Risk & Return

hedged Hedged Conscious Currency

increasing international exposure. Thears to happen over multiple time periods, and toe of home domiciles.


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Appendix E: JPY-based

1

1.5

2

2.5

3

3.5

4

4.5

0 1 2

Return(Annualized%)

Ri

EfJPY Base

Un

-0.75

-0.5

-0.25

-2E-15

0.25

8 8.5 9 9.

Return(Annualized%)

Risk (

JPY BasJune 2001

The direction of the arrowsimprovement in results achperiods, and to be present

Charts provided for illustrative p

3 4 5 6

sk (Standard Deviation %)

ficient Frontier Portfoliosd Investor June 2001 - July 2010

edged Hedged Conscious Currency

10 10.5 11 11.5 12 12.5


ed Investor Model Portfoliosto End Aug 2010 Risk & Return

Unhedged Hedged Conscious Currency

represents increasing international exposure. Theieved appears to happen over multiple timefor investors in a wide range of home domiciles.

rposes only

/ p 23


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