In 1923, Sir John Maynard Keynes famously quipped that, "the long run is a misleading guide to current affairs. In the long run we are all dead/This wisdom doesn't seem to have permeated through the ranks of global equity fund managers. Even as pension funds across the world rush to implement currency overlay and other hedging programs, most global mutual fund managers continue to espouse the mistaken view that currency gains and losses "wash out" in the long run.

In reality, mutual fund managers and other institutional investors should be very sensitive to the interim losses that can be produced by currency exposures. The way clients ultimately judge fund managers is by their performance-ignoring the potential effects currencies have on that performance, for better or worse, is a dangerous strategy. Indeed, when it comes to currency hedging, doing nothing is often the riskiest option of all.

State Street Global Markets, the investment research and trading arm of State Street Corporation, offers a bespoke Currency Hedging Analysis service. This service is designed to identify optimal strategic hedge ratios, which hedge against the volatility introduced by foreign currency exposure, while maximizing diversification benefits. Though the primary aim of this analysis is to reduce risk, the impact this optimization process has on fund performance can sometimes be startling.

For example, between the beginning of 2001 and the end of August 2007, an unhedged passive exposure to the MSCI World (Total Return) Index for a euro-denominated investor would have yielded a return of just 1.29%. However, using the optimal hedging strategy with profits reinvested at the end of each month in the underlying index would have returned a cumulative 31.15%. That's an overall performance gap of 29.86%.

Admittedly, the United States has the largest weighting in the MSCI Index and the timeframe in the example above was a period of dollar weakness. Nevertheless, regardless of the direction of currencies, an optimal hedging strategy reduces risk. The annualized standard deviation of the MSCI World Index during this period was reduced from 14.76% (unhedged) to 13.60% (optimally hedged). Even suboptimal mechanistic approaches to hedging, such as a 100% or a 50% hedge ratio, would have dramatically outperformed a zero hedging policy, while also reducing risk.

Appropriate hedging strategies can also help in the battle for recognition in a hugely competitive market. Success or failure in fund management is a matter of small degrees. A 2006 Standard & Poor's study on global equity funds revealed the difference between an average fund and a fund performing in the top quartile was just 2.7% when annualized over the previous five years. For most managers, currency is a by-product of asset allocation or security selection decisions. Hedging allows the uncompensated risk of currency exposure to be removed, freeing managers' risk budgets to be spent in the areas where they believe they have skill.

A harsh reality of modern asset management is that the top quartile funds with good risk-adjusted returns in turn get the coveted four- and five-star ratings. These toprated funds win more than 100% of net new money inflows, with lesser rated funds typically in redemption. Keynes was right in the long run. In the meantime, however, a sophisticated approach to currency hedging can reduce risk and make the difference between a fund (and its manager) being a stellar performer or an also-ran.

© 2007 Global Finance Media Inc. Provided by ProQuest LLC. All Rights Reserved.