By Laura Matthews

NEW YORK (Reuters) -Overseas asset managers and pensions are adding protection against a weakening dollar, concerned about the U.S. currency's diminishing ability to diversify their U.S. equity portfolios. 

Because such stock funds carry built-in dollar exposure, investors with other home currencies that had not neutralized the foreign exchange risk were cushioned when the dollar was strong if Wall Street performed badly. 

But the dollar's correlation with other U.S. assets, and the impact of its fall on portfolio performance, came into sharper focus when the Trump administration announced far-reaching global tariffs on April 2, sending U.S. stock indexes and the greenback sharply lower. The dollar hit a three-year low against a basket of currencies, raising risks for investors whose portfolios once benefited from the natural hedge.

Now, managers are reducing dollar exposures and increasing the hedge ratios for U.S. stock portfolios where clients' investment policies allow them to do so.

About 10% of Russell Investments pension fund clients in Europe and the UK have already increased hedge ratios on their international stock portfolios, said Van Luu, global head of solutions strategy for fixed income and foreign exchange for Russell in London.

One client raised it to 75% from 50%, highlighting the desire to have a greater portion of U.S. stocks protected against the weakening dollar.

"If what we're seeing persists... then you will have more clients taking action in that direction," said Luu.

'MORE HOSTILE'

The dollar is down 10% for the year, and 6.5% since U.S. President Donald Trump's so-called Liberation Day in April. Meanwhile, the S&P 500, the benchmark U.S. stock index, has recovered 24% since an April slump and is up 5.3% this year, flirting with record highs.

The MSCI gauge of global stocks, minus the U.S., has risen 16% for the year.

"It's not enough to look at the stock market and say it is more or less back to where it was, so nothing happened," said Peter Vassallo, FX portfolio manager at BNP Paribas Asset Management, who manages currency exposures across its asset classes.

BNP has been reducing dollar exposures for its clients that include pension funds, sovereign wealth funds and central banks.

It has sold U.S. dollars across stock and fixed income portfolios, and built up what Vassallo described as a sizable position in options for funds that allow these strategies.

He said the euro, yen and the Australian dollar are among the primary currencies it bought against the dollar, a big contrast to how the asset manager ended the previous year with a small "overweight" in the U.S. dollar.

"This switch towards a more uncertain policy regime created an environment where we as market participants see the U.S. as more hostile to international capital flows, international trading," Vassallo said.

After a June review, Justin Onuekwusi, chief investment officer at St. James's Place, said it is maintaining a strategic hedge that allows it to reduce overseas currency exposure in favor of the pound by up to 20%.

The strategy "has been beneficial for our clients' returns year to date," he said. Onuekwusi said he now sees the dollar as closer to its longer-term fair value and has marginally reduced dollar hedging across managed portfolios.

Foreign investors hold more than $30 trillion in U.S. securities, about $17 trillion of which is in equities and more than $12 trillion in long-term debt, according to data published in April by the U.S. Treasury Department.

Marcus Fernandes, global head of currency management at Northern Trust, said the divergence in the correlation of risk is more than in the past.

"That's why people are thinking faster than before, 'I need to increase my hedge ratio'," he said. "Once those conversations start, they usually end with increased hedge ratios," he said.

COST INCENTIVE

Data from Russell showed that a euro-hedged version of the MSCI USA index was flat for the year through May, while the euro-unhedged version was down 8.3%, showing the benefit of hedging for euro-based investors.

The dollar is down 13% against the euro on concerns about flip-flopping U.S. trade policies and growth.

"FX is back on the boardroom agenda," said Joe McKenna, head of fund solutions at MillTech, a London-based FX and cash management company. "What was once handled quietly in the back office is now drawing the attention of CIOs and CFOs, driven by renewed dollar volatility."

Managers hedge currency exposure by selling the dollar against their respective base currency like the euro or the pound in the FX forwards market, and also use derivatives like options. When the dollar weakens, the hedge position gains in value while the dollar exposure on the underlying stock portfolio loses.

Forward selling of the dollar is the largest in four years, according to John Velis, Americas macro strategist at BNY Markets, suggesting investors are unwilling to carry long dollar exposures, even with the potential for it to rally if U.S. tariff policy changes or the Israel-Iran conflict resumes.

Investors reallocating to U.S. assets to meet benchmark weights after April's selloff are now hedging those exposures, he told Reuters.

"It communicates that dollar volatility is a concern," said Velis. "It can be policy volatility as well as macroeconomic volatility that's causing people to... not keep that dollar exposure because of the fears of the dollar decline."

(Reporting by Laura Matthews in New York; Additional reporting by Dhara Ranasinghe in London; Editing by Alden Bentley and Bill Berkrot)