What’s the single most important thing that pension plans should remember when considering currency hedging?
There are two important issues that you need to consider.
The first issue is what the plan’s benchmark exposure to foreign currency should be. Should it be equal to the plan’s exposure to foreign assets (which would imply unhedged benchmarks for foreign equities and bonds), or zero (which would imply fully-hedged bench-marks), or somewhere in between? This is a long-term strategic issue that should be reviewed on a regular basis as part of the overall evaluation of a long-term investment strategy.
The second issue is whether or not the currency exposures should be actively managed relative to their benchmark levels and, if so, by whom. This is an implementation issue that should be considered separately from the strategic issue.
Why should European pension plans consider adopting partially or fully hedged benchmarks on a long term strategic basis?
To reduce risk. It’s as simple as that. Most plans will find that, no matter how they define risk, partially or fully hedging their benchmark indices for foreign assets will help them to reduce it. Also, it’s a way of reducing risk that won’t materially reduce expected returns.
But isn’t it risky to speculate on foreign currencies?
Yes, it is risky to speculate but it’s also risky to retain a significant unhedged exposure to foreign currencies without doing anything about it. In most cases, hedging part of that foreign currency exposure back to your base currency will reduce this risk.
But is the degree of risk reduction /return enhancement material enough to be worth bothering about?
Yes, it is material enough to be worth bothering about. The reason you invest internationally in the first place is to gain the risk-reduction benefit that comes from international diversification. Our analysis suggests that, in most cases, there is scope to almost double this risk-reduction benefit by adopting a partially or fully-hedged benchmark for your allocation to foreign assets. In other words, the benefit that you gain from currency hedging is almost as significant as the benefit you gain from the decision to invest internationally in the first place.
But what if I’m a long-term investor, and I’m not too concerned about reducing risk?
You can always ‘trade in’ the risk reduction for extra returns, by taking more risk in other areas where you think you will get compensated for it over the longer term. For example, you could invest more in equities and less in bonds. There is no risk premium associated with passively holding foreign currency, so it’s better to reduce that currency risk and take the risk in an area that does offer a risk premium.
But don’t you get some extra diversification benefits from holding unhedged foreign currency exposure?
This is sometimes true for fairly modest levels of foreign currency exposure. Mostly, retaining significant unhedged exposure to foreign currencies will increase risk rather than reduce it.
But isn’t it pointless to hedge currency exposures that arise from investing in multinational companies if these companies themselves have exposure to many different currencies?
If you invest in a globally diversified portfolio of companies, then, no matter how globally diversified these companies are in their own right, the fact remains that you are taking on significant foreign currency risk. The mix of foreign currencies you are exposed to won’t be exactly the same as that indicated by the nominal country allocation of your portfolio, but that’s not the point. It still makes sense to hedge at least part of the foreign currency risk.
Maybe some of the foreign companies that you invest in have exposure to your base currency, so then the true underlying foreign currency exposure arising from your foreign equity holdings will be less than the full value of those holdings. This will be more than offset by the fact that many of the domestic companies that you invest in are multinationals too, and bring with them significant exposure to foreign currencies.
But what about the transaction costs that you incur through currency hedging?
The overall costs that you would incur through adopting a policy of passively hedging your currency exposures would typically be in the order of 0.1% to 0.2% per annum (as a percentage of the value of the assets being hedged). This is relatively small in relation to the risk reduction benefits, which are typically worth the equivalent of about a 1% pa return enhancement on the value of the assets being hedged. In most cases you will find that the costs are well worth incurring.
But don’t I need to have an enormous amount invested in foreign assets to make it practical to do something about it?
You only need to have at least E50m invested in foreign assets to be able to implement currency hedging in a cost-effective manner. If you have less than this internationally you should keep your allocation to foreign assets within reasonable limits to ensure that you are not taking on too much currency risk.
I now accept the strategic arguments, but I’m worried that this might not be a good time to implement currency hedging, because I think that my base currency might be overvalued at the moment. What should I do?
Don’t postpone making an investment strategy decision just because you are worried about the timing of it. The chances are that when you eventually come back to considering it again, you’ll still be worried about the timing of it, so therefore you will have the same problem to deal with. The good news is that there are two ways in which you can reduce the risk of getting ‘whipsawed’ by bad timing without putting a decision off until later.
Firstly, you can phase the strategy shift in gradually, eg, in four or five quarterly instalments. This spreads your ‘timing risk’ over a number of different dates.
Secondly, you can appoint an active currency overlay manager rather than a passive manager to implement the hedging, and give them scope to actively manage your currency exposures within specified ranges. This would effectively delegate a significant part of the timing decision to a manager with expertise in this area. Another advantage is that active currency management offers scope to enhance your returns over the longer term.
But isn’t it impossible to add value through active currency management?
The empirical data on the performance of specialist currency overlay managers suggests otherwise.
In May 1998, Brian Strange (then of Currency Performance Analytics) published a research paper entitled “Do Currency Overlay Managers Add Value”. This paper was widely regarded as the most comprehensive study of the performance of specialist currency overlay managers that had ever been conducted.
The Strange paper found that 80% of the 152 accounts included in the study had outperformed their benchmarks over the period since their inception. The average level of outperformance (including those accounts that had underperformed) was about 1.9% per annum. These results were shown to be highly statistically significant. Also, active currency management had, on average, slightly reduced the variability of returns.
These results may have overstated the average performance of specialist currency overlay managers to some extent, because the sample of accounts included in the study may have been biased towards those accounts that had outperformed. However, because the study covered such a high proportion of all currency overlay accounts that had ever existed, we believe that any such bias is unlikely to have had a material impact on the overall conclusions of the study. Two follow-up studies that have been published since have arrived at the same basic conclusions.
But I’m still not convinced. Isn’t active management a zero sum game? Why should active currency overlay managers continue to add value going forward?
Put it this way. Imagine what equity investing would be like if more than 90% of equities were held by passive investors who weren’t trying to beat the market. Imagine also what it would be like if the transaction costs of dealing in equities, including commission, stamp duty and market impact, averaged out at less than 0.1%. If these two conditions applied, you’d think that there would be lots of scope for skilled active equity managers to add value, wouldn’t you?
Well, conditions very similar to these do in fact apply in currency markets. A very high proportion of foreign exchange trading is undertaken by market participants who are essentially passive investors, in the sense that they aren’t trying to add value through active currency management decisions. Firstly, there are central banks and supranational organisations whose primary objective is to stabilise bond and currency markets. Secondly, there are inter-national investors. Thirdly, there are corporations and other market participants seeking to simply hedge out unwanted currency risks. Fourthly, there are tourists wanting to spend some money on holidays. These groups of participants all create market inefficiencies that those who are actually seeking to add value through active currency management can exploit.
It seems quite plausible that these market inefficiencies will continue to exist for the foreseeable future.
But if we decide to hire a currency manager, won’t we have only a few options to choose from?
There are plenty of high-quality providers of currency overlay management services available, most of which have experience in managing currency overlays for pension funds. We have 40 on our database at the moment.
Bill Muysken is global head of manager research at Mercer Investment Consulting in London