Conscious Currency

A new approach to understanding currency

exposure

Ian Toner, CFA, Head of Currency Implementation

November 2010
Acknowledgements
This paper has taken shape through multiple iterations over the
course of the last year, so the author has a wide range of current
and former colleagues and others to thank for their input,
comments and support. Of particular note (and this is of course
an incomplete list), and in alphabetical order, are Janine
Baldridge, Bob Collie, Mike DuCharme, Tom Fletcher, Steve
Fox, Grant Gardner, Greg Gilbert, John Gillies, Joe Glynn, Joe
Hoffman, John Leverett, Kelly Mainelli, Aran Murphy, John
Osborn, David Rothenberg and Mike Thomas, each of whom
contributed significantly to improving this work, and Heather and
Calista Toner, who can now have their dining room table back.
All of the quantitative work included in this paper was performed
by Bin Wang, who has been an invaluable resource from the
very early stages of this work. Any errors in the paper are the
author’s own.

About Russell Investments

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to work for defined benefit and defined contribution pension
plans, public retirement plans, endowments and foundations,
and the life savings of individual investors.
NOVEMBER, 2010

Conscious Currency: A new

approach to understanding
currency exposure
By: Ian Toner, CFA, Head of Currency Implementation

SECTION I: INTRODUCTION
Most institutional investors have significant exposure to international
assets: few institutional investors hedge the currency exposure that
this entails. While institutional investors typically believe that this
currency exposure has little long-term effect, the reality is that it can
be seen as a significant concentrated bet on the behavior of their
domestic currency. In fact, for many institutional investors, this single
bet on the relative strength of their domestic currency can be seen as
the single largest unmanaged bet in their portfolio.

Despite the size and nature of this significant currency exposure, U.S.-based
investors have typically spent little time and focus on managing it while other
investors, where there is a higher propensity to hedge, tend to use relatively simple
approaches to the question of currency exposure. The techniques that U.S.
investors use point toward a conclusion that there is no need to hedge currency
exposure. Investors typically then consider whether it may be appropriate to hire an
active currency manager to provide what is described as “alpha.”
Recent thinking about the tools and concepts involved, both within Russell and in
the academic research community,1 has led Russell to begin to reconsider some of
these 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,” Òscar Jordà 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.

/ p2 Russell Investments // Conscious Currency

investor may adopt, as well as the scale and nature of the benefit the investor can
potentially 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 assumptions
about currency. The proposed implementation solution is referred to as Conscious
Currency, 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. When

investors 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. This
change 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 rate
differential between the two countries involved. This interest rate differential is reflected
in the pricing of the currency forward curve.2 Investors do, however, face the danger of
“currency surprise”: the difference between changes in exchange rates to be expected
on the basis of the pure interest rate differential and the actual changes in exchange
rates.
This effect can be very significant. Exchange rates can trend significantly, with those
trends coming to an end suddenly. Exchange rates typically exhibit significant volatility,
and the predictive power of simple interest rate differentials appears to be fairly limited
and time-dependent.

Hedging currency exposures

Some investors wish to minimize currency risk. They can do so using forwards. By
building a book of forward positions, they can ensure that the only changes in exchange
rates to which they are exposed are those caused by the current interest rate
differentials; they will be keeping the relationship between the assets involved
essentially constant as to today. We describe such a portfolio as being hedged.
The effect of investing in international assets, and then hedging the currency exposure
by use of the currency forward market, can be measured against hedged benchmarks.
A benchmark that represents “hedged equity exposure” attempts to describe the return
stream experienced by an investor from a particular home country who purchases an
international equity portfolio, and who then purchases a portfolio of currency forwards to
neutralize the potential exposure to currency surprise.

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

Russell Investments // Conscious Currency / p3

What is currency risk?
Investors have typically defined “currency risk” as being the currency surprise they might
experience in the range of their exposures to international assets.
Currency risk under this definition can easily be measured; it is the difference between
the hedged and unhedged versions of the benchmarks investors use to describe their
international exposures. Investors can plot the relative returns of these two benchmarks
and draw conclusions as to the potential outcomes they may experience if they decide
to hedge their currency exposure.
The problem here is that what is actually being measured is the effect of currency
exposure as experienced by an investor with a particular currency allocation – with that
currency 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 historical
effect of the currency exposure an investor would have experienced from a particular
portfolio? Currency risk under this definition is therefore dependent on two factors – the
behavior of the currency market, and the allocation structure of the portfolio as driven by
exposure to an unrelated asset class.
What this metric does not do is answer a much broader question: what is the risk / return
behavior of the currency market as a whole?

/ p4 Russell Investments // Conscious Currency

SECTION 3: THE OLD APPROACH TO CURRENCY RISK

The standard approach to currency exposure has been to look at the issue entirely in
the context of hedging. The investor asks a simple question: Should I hedge the
currency exposure I take on when I invest in international assets?
This simple question has traditionally been answered by use of an heuristic (or rule of
thumb) outlined in the following chart.3
High
High
Foreign Currency Exposure (%)

Consider Hedging
(Minimize Regret) Do
Do Not
Not Hedge
Hedge
(Unnecessary)
(Unnecessary)

Do
Do Not
Not Hedge
Hedge
Low

(Not
(Not material)
material)

Short
Short Long
Long
Evaluation
Evaluation Horizon
Horizon
For illustrative purposes only

This appears to outline a very simple and clear thought process. Investors should
concern themselves with hedging only when they have relatively high exposure to
currency, and then only when their evaluation horizon is relatively short-term. This
approach 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.

Russell Investments // Conscious Currency / p5

 For this heuristic to apply, the underlying behavior of the currency markets is
assumed to be random – and more severely random than other markets to which
investors are exposed.
 The evaluation horizon itself is often misapprehended, with most investors assuming
they 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 the
hedge / don’t hedge decision-making process depends on the currency markets being
random, with no real underlying long-term structure. This allows the investor to assume
that “currency returns will all wash out over the long term.” If, on the other hand, there is
some structure identifiable in currency returns (even if active currency managers may
not be very good at identifying it, and even if there is no presumptive ex-ante positive
return expectation), then the very simple approach falls down. This issue will be
important later in the paper.

Position on the evaluation horizon axis

Most institutional investors regard themselves as long-term investors – and most
institutional pools of capital have long-term obligations, with expectations of long-term
thought processes. These investors, then, will look at the heuristic above and assume
that they fit at the right-hand side of it, where hedging is only indicated at high levels of
exposure.
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. Most
investors 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. The
effect of currency will be important at each of these moments, none of which falls into
the “long-term” category.
This can be well illuminated by a thought experiment. For investors to place themselves
accurately on the evaluation horizon line, all they need to do is imagine the attitude of
their 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 the
risk asset portfolio. Unless they can honestly say that there would be complete
acceptance 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 investors
are likely to be in the “short-term” segment of the evaluation horizon axis.

Level of currency exposure

Investors have typically assumed that unless currency exposure rises to levels of 15% to
20% or higher, it is unlikely to be significant. Again, the view that the effect of this
exposure is random and is likely in the long term to be roughly zero, tends to drive this
thought process.
Reconsidering this view, however, may lead to the conclusion that this threshold should
be drawn at a lower level. Investors are generally keen to remove uncompensated risk

/ p6 Russell Investments // Conscious Currency

exposures,4 where that removal is cost-effective; they can instead reallocate that risk to
an exposure for which they expect to be rewarded. The costs of hedging currency risk
are typically very low – on the order of 12 to 15 basis points of the amount hedged. For
an investor with only 5% exposure to currency risk (well below that of most investment
portfolios 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 evaluation
and level of exposure are worthwhile issues to consider) and the detriments (currency
movements may not be entirely random; most investors are more short-term than they
may think; and even small exposures to currency contribute to uncompensated and
avoidable risk).
Looking at both benefits and detriments makes us ask whether there is a different way
to understand the issues. Can we develop some simple approaches that will allow us to
think about currency more clearly and that may help us improve total portfolio
outcomes?
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 about
currency into three mutually exclusive but collectively exhaustive groups.

Terminology
The core restatement relates to what a “neutral” exposure to currency is. We should
recognize that the decision to invest (on an unhedged basis) in international assets
involves 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, and
their asset allocation policies are also identical – but those asset allocations are set
based on the nature and structure of the underlying asset market, not the currency
market.

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% hedged
policy for regret-minimization reasons. The logic behind this is exceptionally well (and clearly) laid out in the
following 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 Thierry
Wuilloud. Russell Research Commentary, August 1994.
 “Statistical Estimates of the Normal Currency Hedge Ratio: Best Practice or Best Guess?,” Grant
Gardner and Douglas Stone. Russell Research Commentary, November 1995.

Russell Investments // Conscious Currency / p7

Describing currency exposure in this way makes it clear that the current foreign
exchange (FX) exposure borne by investors is anything but a neutral exposure to the
currency markets. It is, in effect, an active portfolio of currency, and the investment
policy that drives the active allocations (and their changes) is being driven entirely by the
behavior of the other international assets.
In contrast, a neutral portfolio of currencies would be a portfolio of currencies that has
no necessary relationship to other asset classes, but that reflects the inherent structure
and characteristics of the currency markets as a whole. This is similar to the way we
think 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 argument
as to whether currency is an asset class. This argument (which has been ongoing for
years and is unlikely to be settled anytime soon) is interesting, but in practical terms it is
entirely sterile. What matters is only whether an investor is prepared to be exposed to
currency markets. This exposure may not bring an expectation of systematic return and
the currency markets may fail to meet a particular definition of “asset class”; however, it
remains 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 about
currency exposure.
1. The amount of currency exposure in the portfolio does not matter. The
particular currencies held and the weights in which they are held, do not matter.
2. The amount of currency exposure in the portfolio matters. The particular
currencies held and the weights in which they are held, do not matter.
3. The amount of currency exposure in the portfolio matters. The particular
currencies held and the weights in which they are held, matter.

Each of these ways of thinking leads to a conclusion about the most appropriate
approach to dealing with currency exposures:
1. Because neither the amount nor the nature of my currency exposure is going to
matter, I don’t need to worry about any form of hedging or management of that
currency exposure.
2. Because the extent of my currency exposure matters, I need to consider
whether to adjust that exposure through hedging. Because the nature of the
currency exposure does not matter, I don’t need to worry about changing the
weights of currencies I am exposed to in my portfolio.
3. Because both the amount of currency exposure and the nature of that exposure
matter, I need to consider not only adjusting the amount of exposure (through
hedging), but also changing the nature of that exposure (through some form of
currency management).

Investors with no currency management process in place are effectively placing

themselves in the first category. Investors with some hedging in place are choosing to
place themselves in the second category. Despite this, most investors are likely, on
reflection, to find themselves closer to the third of these opinions as to the nature of
currency 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 currency
management. Investors considering the nature of their exposure to currency are typically
presented only with a series of “active” investment management choices – as though the

/ p8 Russell Investments // Conscious Currency

only way to get coherent access to the currency market behavior is through an active
approach (whether by means of some form of dynamic currency hedging or through
formal active management). Many investors have been uncomfortable with this, feeling
that the currency market was efficient enough as to be an unpromising source of active
management return. Returns from currency managers have often supported that
skepticism.6
We believe there is an alternative approach that brings thinking about currency into line
with 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 about
other key portfolio exposures. This involves a simple staged process:
 Identifying and adopting a benchmark to describe and measure the neutral-bet
exposure 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 other
markets.
 Using that benchmark to represent currency as part of the risk assessment and
allocation process when setting target policy allocations at the total fund level –
essentially allowing currency to compete with other possible exposure sets for
allocation.
 Implementing the resulting decision through manager hiring decisions – including
possible exposures to the currency markets, either through strategies designed to
replicate the chosen benchmark, or through active strategies designed to produce that
return with additional alpha.7
This approach allows investors to treat currency exposure similarly to they way they deal
with other investment choices. They are free to choose an appropriate benchmark. They
are 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 they
would have achieved by following any of the current standard approaches.
Most important – this approach does not involve exposing the portfolio to any new asset
class, or exposure set. It simply involves attempting to describe one element of the
current exposure set more accurately, and to control it more directly. Doing this (even
without active management) should drive better portfolio efficiency, which in turn should
be 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 currency
positions, with a series of construction rules designed to be simple, clear and
reproducible, that meaningfully represent the behavior of the currency markets.

6
Although past Russell research has demonstrated that active currency managers have the ability to generate
positive returns, this is certainly not a universal property of those managers, and is generally regarded as
challenging. 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 Active
Currency Overlay,” Brian Meath, Janine Baldridge and Heather Myers. Russell Research Commentary, May
2000.

Russell Investments // Conscious Currency / p9

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 different
from the construction of the equity benchmark.
The nature of the currency market, then, is important. First we need to look at the basic
structure. 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 market
structure. Appropriate benchmark construction will recognize this: an equity benchmark
will tend to have a long-only free-float capitalization-driven structure (although other
approaches are making headway with some investors), while a currency benchmark will
be 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 the
return-generation mechanism. Unlike equity markets, where there is an expected
inherent return from the enterprise that has issued the asset, currency returns are
derived by price changes. These changes are generally understood to be driven be a
number of different factors. Three key factors are regarded as the core of market
behavior:
 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 to
whether returns are related to some form of currency risk premium, there seems to be
enough agreement among market participants that these three factors explain a
significant part of currency market return, and that they appear to do so on a consistent
basis to justify using them as a market proxy.
A good currency benchmark, then, is likely to use a simple, rules-based, long/short
portfolio 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 relative
strength of each factor.

BENCHMARK CHOICES
Over the last few years, a number of firms have begun to construct and issue
benchmarks designed to represent the totality of the currency exposure set. Most of
these benchmarks have only limited live history, and many of them focus on a single
factor.8 We can regard the current state of currency benchmarking as being similar to
the state of international equity benchmarking 25 years ago – better than not attempting
the exercise, providing a good approximation of the answer sought, but with plenty of
room 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 the
properties mentioned above and as long as it is designed to represent the currency
markets in aggregate, it can be regarded as an appropriate choice for our current
purposes.

8
Credit Suisse, FTSE and Deutsche Bank all provide currency benchmarks of the types discussed. Russell has
calculated internal benchmarks for manager assessment purposes for a number of years, although these are
not public.

/ p 10 Russell Investments // Conscious Currency

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

THE DEUTSCHE BANK CURRENCY RETURN INDEX

The DBCR is designed to provide an entirely rules-based approach to benchmarking
currency markets. This benchmark covers the G10 countries’ currencies and is designed
around a long/short approach.
The benchmark construction process is purposely simple. The three factors identified
above (carry, valuation and momentum) are each represented by a single model. Each
model is driven by a single public data point, with the currencies ranked in order
according to that variable: for example, in the carry model, the currencies will be ranked
strictly according to the interest rate. Within each model, once the investor has
performed 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 into
a single portfolio, with each factor equally weighted.
The outcome of the process is a single portfolio of positions designed to capture the
behavior of the currency markets on the basis of the key factors involved but without the
investor 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 basis
for 20 years prior. The behavior of the benchmark over the live period appears to be
consistent with that in the back-test period, as can be seen in the chart below plotting
three-year rolling excess return over the long term.
We look at DBCR returns when modeling on a funded basis, where the total return is
generated 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 to
capture price-change behavior by identifying factors that drive those price changes (again, because the FX
markets are quite different from the equity markets, where a full replication approach is appropriate). Little would
therefore be added (other than transaction costs) by including those currencies where there is no useful
information in the signal structure.

Russell Investments // Conscious Currency / p 11

 DBCR Excess Return over cash
Tracking Error = 4.9%
June 1989 to March 2010
12.0%
10.0%
10.0%
Three –Year Rolling

8.0%
Excess Return

6.0%

4.0%

2.0%

0.0%

-2.0%

-4.0%
Jun-95

Jun-97

Jun-99

Jun-01

Jun-08
Jun-94

Jun-03

Jun-05

Jun-07
Jun-96

Jun-98

Jun-00

Jun-04

Jun-06

Jun-09
Jun-92

Jun-93

Jun-02

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

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

DBCR Indices
As of March 2010
280
260
240
220
Basis points

200
180
160
140
120
100
80
Jun-00
Jun-99

Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06
Jun-07
Jun-08
Jun-09
Jun-90
Jun-91
Jun-92
Jun-93
Jun-94
Jun-95
Jun-96
Jun-97
Jun-98
Jun-89

DB Carry Excess DB Momentum Excess DB Valuation Excess

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

What is interesting about this benchmark is the way in which it compares with other
possible 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 possible
exposure sets is interesting.

/ p 12 Russell Investments // Conscious Currency

First, we look at risk and return.

RETURN & VOLATILITY STATISTICS

Ten Years Ended June 30, 2010
EAFE FX (Unhgd-Hgd) DBCR BC Aggregate Russell 3000 MSCI EAFE
Annualized Average Return 1.6 6.9 6.5 -0.9 0.6
Max Monthly Return 6.3 3.4 3.7 10.5 13.0
Min Monthly Return -5.8 -3.3 -3.4 -17.7 -20.2
Annualized Volatility 7.7 5.0 3.8 16.7 18.1

Twenty Years Ended June 30, 2010

EAFE FX (Unhgd-Hgd) DBCR BC Aggregate Russell 3000 MSCI EAFE
Annualized Average Return 0.7 7.4 7.1 7.9 4.4
Max Monthly Return 7.4 3.9 3.9 11.2 15.6
Min Monthly Return -6.9 -4.0 -3.4 -17.7 -20.2
Annualized Volatility 7.9 5.0 3.8 15.3 17.3

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 point
of view of a U.S. dollar–based investor. We also include the difference between the
unhedged and hedged return of international equity – the effect that has traditionally
been described as “currency risk,” but which we now can more clearly describe as the
currency effect of a particular equity portfolio (which provides little information about the
currency 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, in
fact, the currency return was greater than both equity and debt. Second, the volatility of
the return, while higher than that of bonds, was significantly lower than the volatility of
equity. Third, when compared against the older definition of currency risk, the DBCR
approach has not only significantly better return, but also much lower risk.

Russell Investments // Conscious Currency / p 13

CORRELATION STATISTICS
Ten Years Ended June 30, 2010
EAFE FX (Unhgd-Hgd) DBCR BC Aggregate Russell 3000 MSCI EAFE
EAFE FX (Unhgd-Hgd) 1
DBCR -0.2 1
BC Aggregate 0.4 -0.1 1
Russell 3000 0.2 0.2 -0.1 1
MSCI EAFE 0.5 0.2 0.0 0.9 1

Twenty Years Ended June 30, 2010

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

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 than
did the older definition of currency risk and that it also has low correlation with that older
definition itself. This is true across both 10 and 20 years.
In summary, then, the DBCR, over the time period for which data is available, provided
access to a relatively stable return stream. This return stream appeared to be able to
provide good diversification benefits for equity and fixed income investors. This return
also appeared to be able to do a much better job at this provision than does exposure to
“currency risk” as defined using the traditional approach. More important, this behavior
was not confined to the period for which back-test data was available, but also continued
into 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 by
whatever approach they normally use: in essence, they are simply separating the
currency decision from the equity, fixed or other exposure-set decision – but at the same
time keeping the decision about currency at the same level of the process as the other
major exposure sets.

While the nature and process of this modeling exercise will depend upon the particular
investor, there are a number of ways by which we can gain some insight into the
possible 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 total
opportunity set available to the investor?
 If so, does this opportunity set improvement occur in such a way that the investor
might be able to harvest benefits from a simple portfolio management process?

/ p 14 Russell Investments // Conscious Currency

IMPROVING THE OPPORTUNITY SET
The first question we can ask is whether using the Conscious Currency approach to
analyzing and describing currency risk can improve the opportunity set available to
investors. Such an improvement would not come about because of the inclusion of a
new “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 improved
description of currency risk. For the effect we are attempting to identify to be real, we
would expect it to appear over multiple time periods, and from the standpoint of
investors in a range of home-country currencies. It would be surprising if it always
occurred but we would expect it to be present more often in longer-term data sets than
in 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 three
different universes of investment options. In each case, borrowing and shorting is
prohibited, and each investment option is included on a funded basis (so any currency
allocation includes both a domestic cash return and the return from the currency
benchmark portfolio).
The three universes we compare are as follows:
 Unhedged
Domestic equity, domestic fixed income, unhedged foreign equity, unhedged foreign
fixed income.
 Hedged
Domestic equity, domestic fixed income, hedged foreign equity, hedged foreign fixed
income.
 Conscious Currency
Domestic equity, domestic fixed income, hedged foreign equity, hedged foreign fixed
income, currency.
We use the DBCR funded benchmark as our currency benchmark in all of the following
modeling exercises.

Russell Investments // Conscious Currency / p 15

 Comparison Of Efficient Frontiers
10 Years Ending 2009 - US $ Based Investor

7.50

7.00

6.50

6.00
R eturn %

5.50

5.00

4.50

4.00
1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00
Risk (St. Dev.) %

Conscious Currency Unhedged Fully Hedged

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 a
significant improvement in the efficient frontier caused by adoption of the Conscious
Currency 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 unhedged
portfolio. 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 ending
2009). However, when similar analysis is performed for investors based in other
domestic currencies, we find similar results, although the scale of the improvement
varies. 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 produce
an improved frontier, but that over longer time spans, the effect becomes increasingly
stronger and more dominant.11
We therefore have good evidence that the proposed approach may provide benefits for
the investor.12 It remains to be seen whether investors would be able to harvest this
benefit 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 analysis
will, of necessity, be both time-period-dependent and also highly dependent upon the benchmarks chosen to
represent the different possible investment opportunities.
12
It is important to note here that we are restricting the discussion to the asset side of the investor’s behavior.
The way the asset side interacts with the liability issues that the investor is facing is, of course, key – but is
essentially independent of the current discussion.

/ p 16 Russell Investments // Conscious Currency

HARVESTING THE BENEFIT OF CONSCIOUS
ONSCIOUS CURRENCY
Before an investor can seek to harvest the benefits potentially available from this
approach, the opportunity to do so would have to occur in a portfolio the investor might
actually be prepared to purchase – and efficient frontier portfol
portfolios rarely look
comfortable.
To model this, we can create some simple portfolios that use uncomplicated rules but
different approaches to currency exposure, and then track their performance. These
portfolios are constructed by use of benchmarks that repres
represent domestic and
international equity and fixed income allocations, as well as the DBCR to represent
currency risk in the Conscious Currency portfolio. Different levels of international
exposure (ranging between 5% and 50%) are placed into each portfolio. The portfolios
are then “invested” and their performance tracked by use of index returns and
rebalanced to policy monthly. The end results are plotted for comparison purposes.
The three portfolios, similar to the above analysis, are as follows:
 Unhedged
60%
% equity/40% fixed income. International equity and fixed income unhedged.
 Hedged
60% equity/40% fixed income. International equity and fixed income hedged.
 Conscious Currency
Domestic 60% equity/40% fixed income. International placed half into DBCR funded
and half into a 60% equity/40% fixed income hedged portfolio.
The outcome is again fairly clear, and can be seen in the following chart.

USD Based Investor Model Portfolios

10-Year
Year Risk & Return Ending June 2010

3.5

3.25
Return (Annualized, %)

2.75

2.5
Unhedged

Hedged
2.25
Conscious
Currency
2
7 8 9 10 11
Risk (Standard Deviation, %) The direction of the arrows represents
increasing international exposure

For illustrative purposes only

Russell Investments // Conscious Currency / p 17

The Conscious Currency outcome is significantly better than the alternatives. While most
or all of the international return premium gained by increased exposure to international
assets is captured, there is a risk-reduction effect from this increased exposure, rather
than 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 portfolio
outcomes than those who adopted either the hedged or the unhedged approach.
Investors adopting the Conscious Currency approach seem, then, to have been able to
harvest better outcomes from what appears to be a fairly consistent effect in the
markets; we think it’s unlikely that what we’re seeing is a simple data anomaly. Standard
portfolio construction tools should allow investors to construct asset allocation policies
that seek to capture this advantage.

Conscious Currency: Implement

Having defined the desired asset allocation to include the Conscious Currency
approach, 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 implements
an allocation to the exposure concerned by placing an appropriate amount of cash in a
short-term vehicle and then by overlaying that with a currency portfolio.14 Implementing
an allocation selected on this basis can be done in a similar approach without the
investor suffering “cash drag” from the cash allocation. Indeed, the allocation to cash
that is involved may well be used not only for collateralization of the short components of
the 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 benchmarks
and a Conscious Currency benchmark;
 Appoint investment managers for international asset portfolios, using unhedged
benchmarks to ensure minimal disruption of their standard process; and
 Appoint a single Conscious Currency manager. This manager manages the cash
component (if any) of the strategy, removes the currency risk that has been assumed
through the unhedged allocation to international mandates and creates exposure to
the currency benchmark the investor has selected in the size and nature required by
the policy.
This approach would provide the investor with an efficient portfolio structure, involve
minimal disruption to the current managers and result in a clearer and more appropriate
exposure to the currency markets. The investor could reasonably expect an improved
chance for better portfolio outcomes

13
Further analysis of this effect, for investors in different domestic base currencies, can be found in the
appendix to this paper. Again, the normal time period and data consistency caveats apply; at the least, these
results 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 structural
exposure to a type of beta to which they are today inefficiently exposed.

/ p 18 Russell Investments // Conscious Currency

Appendix A: AUD-based

Efficient Frontier Portfolios

AUD Based Investor 10 Years Ending July 2010
8.5

8
Return (Annualized %)

7.5

6.5

5.5

5
1 2 3 4 5 6 7 8
Risk (Standard Deviation %)
Unhedged Hedged Conscious Currency

AUD Based Investor Model Portfolios

10 Year Risk & Return Ending June 2010
8

7
Return (Annualized %)

2
5 5.5 6 6.5 7 7.5 8 8.5
Risk (Standard Deviation %)
Unhedged Hedged Conscious Currency

The direction of the arrows represents increasing international exposure. The

improvement in results achieved appears to happen over multiple time periods, and to
be present for investors in a wide range
nge of home domiciles.

Charts provided for illustrative purposes only

Russell Investments // Conscious Currency / p 19

Appendix B: CAD-based
Efficient Frontier
CAD Investor 10 Years to End June 2010
6.8
6.6
Return (Annualized %)

6.4
6.2
6
5.8
5.6
5.4
5.2
5
1 1.2 1.4 1.6 1.8 2
Risk (Standard Deviation %)
Unhedged Hedged Conscious Currency

CAD Based Investor Model Portfolios

Oct 2000 - Aug 2010 Risk & Return
5.5

5
Return (Annualized %)

4.5

3.5

2.5

2
6 7 8 9 10

Risk (Standard Deviation %)

Unhedged Hedged Conscious Currency

The direction of the arrows represents increasing international exposure. The

improvement in results achieved appears to happen over multiple time periods, and to
be present for investors in a wide range of home domiciles.

Charts provided for illustrative purposes only

/ p 20 Russell Investments // Conscious Currency

Appendix C: EUR-based

EUR Based Investor Efficient Frontiers

10 Years Ending June 2010
7.5

7
Return (Annualized %)

6.5

5.5

4.5

4
1 1.5 2 2.5 3

Risk (Standard Deviation %)

Hedged Unhedged Conscious Currency

EU Based Investor Model Portfolios

10 Year Risk & Return Ending June 2010
3.5

3
Return (Annualized %)

2.5

1.5

0.5
8 9 10 11 12

Risk (Standard Deviation %)

Unhedged Hedged Conscious Currency

The direction of the arrows represents increasing international exposure. The

improvement in results achieved appears to happen over multiple time periods, and to
be present for investors in a wide range of home domiciles.

Charts provided for illustrative purposes only

Russell Investments // Conscious Currency / p 21

Appendix D: GBP-based
Efficient Frontier Portfolios
GBP Based Investor Jan 2003 - July 2010
12

11

10
Return (Annualized %)

5
1 2 3 4 5 6 7 8 9
Risk (Standard Deviation %)
Unhedged Hedged Concscious Currency

GBP Based Investor Model Portfolios

Jan 2003 to End Aug 2010 Risk & Return
8.25

7.75
Return (Annualized %)

7.5

7.25

6.75

6.5
7.5 8 8.5 9 9.5
Risk (Standard Deviation %)
Unhedged Hedged Conscious Currency

The direction of the arrows represents in

increasing international exposure. The
improvement in results achieved appears to happen over multiple time periods, and to
be present for investors in a wide range of home domiciles.

Charts provided for illustrative purposes only

/ p 22 Russell Investments // Conscious Currency

Appendix E: JPY-based
Efficient Frontier Portfolios
JPY Based Investor June 2001 - July 2010
4.5

4
Return (Annualized %)

3.5

2.5

1.5

1
0 1 2 3 4 5 6

Risk (Standard Deviation %)

Unhedged Hedged Conscious Currency

JPY Based Investor Model Portfolios

June 2001 to End Aug 2010 Risk & Return
8 8.5 9 9.5 10 10.5 11 11.5 12 12.5
0.25
Return (Annualized %)

-2E-15

-0.25

-0.5

-0.75
Risk (Standard Deviation %)

Unhedged Hedged Conscious Currency

The direction of the arrows represents increasing international exposure. The

improvement in results achieved appears to happen over multiple time
periods, and to be present for investors in a wide range of home domiciles.

Charts provided for illustrative purposes only

Russell Investments // Conscious Currency / p 23

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