What Brexit politics mean for currency risk

Asset diversification has also driven risk reduction, although this is partially offset by higher currency risk.

Currency fluctuations can create significant uncertainty over the value of a pension scheme’s overseas assets relative to its sterling-denominated liabilities.

There are many approaches to dealing with currency risk, ranging from adopting a full hedge at all times, through to deciding consciously not to hedge and simply accepting currency risk as something from which you will occasionally ‘win’ or ‘lose’.

The premise supporting the latter is that, over the longer term, any volatility should cancel itself out, suggesting there is no need for schemes to incur the cost of hedging, both financially and in terms of governance.

However, principles of good housekeeping surely require that currency risk should not be left unmanaged. The question is whether passive or active management is best.

Currency hedging is a strategic decision. As such, any programme should be consistent with a portfolio’s wider investment strategy and risk appetite. It shouldn’t seek to generate profit in isolation, but focus on protecting capital while adding value.

Evaluating the scale of risk stemming from a portfolio’s individual currency exposures, and understanding the fair value of these currencies relative to sterling, helps build a picture of the risk that the portfolio faces from potential currency movements.

Hedging is, after all, not free. Minimising the costs incurred and the impact of cash flows generated by the hedge – from potential collateral calls – are important parts in the decision-making process. Collectively, these factors should determine the hedge.

The current environment of ongoing economic uncertainty generated by Britain’s vote to leave the EU highlights the importance of hedging against currency risk. The fall in sterling since Brexit has presented an opportunity for pension schemes to take a more dynamic approach to managing their currency risk and move away from an ‘all or nothing’ approach to hedging.

Sterling’s rally in the weeks leading up to the recent UK general election perhaps made that opportunity appear a little more obvious. The unexpected outcome of that election, and the more uncertain political outlook which has resulted, undoubtedly highlight the potential risk in continuing to ignore the currency risks of overseas assets.

Nick Edwardson is a product specialist, multi-asset at asset manager Kames Capital