Schemes should consider strategic currency hedging

Currency moves have a significant impact on portfolio volatility. Pension schemes have been shifting towards overseas assets to diversify returns and access attractive opportunities.

This is a welcome development, but it does mean that portfolios are, more than ever, exposed to currency volatility, which is likely to remain high.

Not only is Brexit uncertainty directly reflected in sterling moves, but US politics is creating volatility in the US dollar exposure that is dominant in global equity and bond portfolios. Hedging currency helps to protect a portfolio from resulting currency swings.

Which asset class should you hedge?

Sterling has now reached attractive levels that justify locking in currency profits and implementing a strategic hedge

Trustees should consider their schemes’ currency risk exposure and revisit their currency hedging policies. A key decision to make is how much overseas currency exposure should be hedged. The answer differs by asset class.

For asset classes with relatively stable underlying values, such as overseas bonds or absolute return strategies, currency contributes a significant proportion to risk and therefore full currency hedging is suggested.

On the other hand, global equities receive a greater portion of their overall risk from equity moves than currency and therefore the case for hedging is less strong than for bonds.

Historically, most of the equity risk reduction is achieved by increasing the level of hedging from zero to around half. In an effort to control volatility in a pragmatic way, hedging half of the currency exposure from overseas equities is reasonable.

However, the hedging case for equities is nuanced by specific scheme circumstances. Schemes with only small levels of currency exposure or schemes where currency provides some diversification with other investment risks will see less risk reduction benefit from currency hedging.

Furthermore, trustees’ tolerance for currency risk plays a part. They may be happy to weather short-term volatility in schemes with high funding levels or strong company covenants.

Additionally, schemes with a longer time horizon have more opportunity to recover from any currency losses and therefore may decide to remain unhedged given their higher risk tolerance.

What is the best way to hedge?

It is best to use the most operationally simple and cost-efficient option to implement the currency hedge. This may just entail switching to a hedged share class in pooled fund investments. For segregated mandates, the fund manager may be able to hedge currency on request.

Alternatively, a third party such as a custodian, currency overlay or liability-driven investment manager could hedge, which might be advantageous for schemes with various overseas funds since the hedge can cover currency at an overall portfolio level.  

This third-party route has, however, greater operational complications for schemes: there is portfolio disruption from needing either to invest the profit from the hedge or to raise money to pay for hedge losses, and new collateral requirements add extra complexity.

These complications are real, but need not dominate over hedging benefits.

Why now?

UK investors holding overseas assets with no currency hedging have benefited from sterling weakness both before and after the EU referendum, as sterling has fallen by 30 per cent against the US dollar since 2014.

Sterling has now reached attractive levels that justify locking in currency profits and implementing a strategic hedge if one is not already in place.

Sterling will remain vulnerable for the next couple of years as the UK’s weaker post-Brexit growth outlook and reduced capital inflows undermine the exchange rate, but valuations are now arguing for a recovery.   

Lucinda Downing is multi-asset investment manager at consultancy Aon Hewitt