From the blog: Following the UK referendum to leave the EU earlier this month, most major currencies have risen against sterling.
Indeed, at the close of business on June 27, the S&P 500 index was down some 5 per cent in dollar terms from the previous Thursday, but up more than 6 per cent in GBP terms.
Pension funds should not rejoice too quickly, though.
For the many British pension funds that had not hedged their foreign currency exposures, this will have been welcomed as a windfall that offset losses incurred from the underlying assets.
British pension fund trustees and managers should consider taking advantage of the current bout of sterling weakness to establish a sensible and robust hedging policy
Indeed, at the close of business on June 27, the S&P 500 index was down some 5 per cent in dollar terms from the previous Thursday, but up more than 6 per cent in GBP terms.
Pension funds should not rejoice too quickly, though. Correlation is not causation, and there is nothing to say the next large movement in exchange rates will not be a rise in sterling, which would create losses for British investors.
The exchange rate has rarely been below 1.40 in the past, and similar drops have been followed by climbs to as high as 2.00 or above, as in 2007.
Skip hedging at your own peril
Historically, UK investors often tend not to hedge for various reasons – high home bias, bad experiences with investing in 'currency as an asset class', but also a false sense of security following similar short periods of one-off currency gains in the past.
These short periods stick in the memory, but are often followed by long periods of currency losses that, while less memorable, may be highly damaging.
All the academic literature shows that G-10 currency movements have little impact on portfolio expected returns, but the impact on portfolio volatility, stress scenarios and short-term returns is very significant.
Currency is therefore an unrewarded risk, and hedging will improve the risk profile of any portfolio that has liabilities in a single currency.
Conversely, the absence of hedging increases the risk of large losses, which could be potentially catastrophic for funds without surpluses.
It is a mistake not to hedge currency risks, and British pension fund trustees and managers should consider taking advantage of the current bout of sterling weakness to establish a sensible and robust hedging policy.
Charles Goodman is the chief executive of Edmond de Rothschild Asset Management UK
