Councils that own foreign assets in their pension funds are exposed to foreign currency risk. Given the demise of Sterling over the past three years, these assets are now likely worth more in Sterling terms. Since the Brexit referendum in June 2016, the US dollar and Euro are approximately 12% stronger.
So how do funds hedge currency risk and how do you achieve the optimal result?
Funds should not make a currency hedging decision solely around a single event, such as Brexit, and it should definitely not be driven by a market view of the potential currency move. Macroeconomic events will always crop up in different guises and currency forecasts are notoriously difficult to make, and even more so around the timing of moves.
There is a phrase in currency markets which is ‘being right but being early simply means you are wrong’. Therefore, funds need to question whether they are willing to tolerate currency risks that can significantly impact the performance of the fund, or whether they will evaluate the materiality of the exposure, take an active hedging decision and design a hedging strategy to manage this exposure.
When deciding whether to hedge FX exposure, evaluating the cost of hedging against the risk is crucial, especially if the foreign assets are expected to be held for a long time. This is when interest rate differentials come into play. Currently hedging Euro assets back into Sterling benefits the value of the portfolio by approximately 1.3% per annum. Euro interest rates are in negative territory while UK rates are positive.
However, if a council owns US dollar denominated assets, then hedging the FX risk of these investments will come at a cost as US interest rates are higher than those in the UK. Currently that cost is around 1.75% per annum.
The vast majority of funds hedge currency risk using forward contracts, which are the most vanilla way to approach FX hedging. However, if the fund is looking for a more flexible approach to hedging that avoids the obligation of being fixed to one rate, it may have to pay a premium for an FX option. For funds that are looking to hold assets for a long period of time, this premium erodes returns and should therefore factor into the decision.
Other important considerations when hedging currency risk include liquidity. Hedge providers often require variation margin, which means the fund has to post collateral when the value of the hedging contract goes beyond an agreed point. On top of this liquidity requirement, is also a potential liquidity event when hedging contracts which may need to be rolled and cash is needed to settle at this point. This cash call may cause issues, so should be fully investigated before landing on a final decision about hedging.
There are lots of scare stories about hedging programmes ‘gone wrong’, but currency hedging reduces risk back to the currency denomination of the pension fund, which allows the success of the fund to be dictated by the performance of the assets that you have invested in, and not the impact of the currency.
Hedging the FX risk of foreign held assets requires considerable expertise, independent and impartial advice is available to help you navigate all options available and ensure that the right strategy is in place for your pension fund. After a thorough evaluation the trustees of the council’s pension fund may decide not to hedge; however, this will be an informed decision and ensure that the currency exposure to any future events will not come as a surprise.
Jackie Bowie is group CEO at independent hedging advisory JCRA