Swiss pension funds continue to face risks when hedging investments in US dollars or currencies from high-interest-rate countries.
Ueli Mettler, partner at consultancy c-alm, told IPE that hedging US dollar-denominated investments can produce a loss compared with leaving them unhedged if the dollar’s depreciation against the Swiss franc is smaller than the interest rate differential at the short end of the yield curve.
The short-term interest rate differential stood at 3.8% at the end of last year.
“If, assuming interest rates remain constant, the US dollar depreciates by more than 3.8% against the Swiss franc over the entire year, then hedging will be worthwhile. By contrast, if it depreciates less than this and even appreciates, then hedging will result in a loss,” Mettler added.
Last year, the slump in the US dollar significantly reduced returns on unhedged foreign currency investments.
Swiss pension funds, on average, hold 17% of assets in unhedged foreign currencies, with the remainder in Swiss franc assets or hedged back. Bonds in foreign currencies are generally fully hedged, developed market equities are partially hedged, and emerging market equities are usually unhedged.
Hedging nominal value investments reduces volatility, helping stabilise pension fund portfolios. But currency risk for equities represents only a portion of overall risk, as globally active companies generate revenues and incur costs in multiple currencies, partially offsetting losses.
As a result, hedging costs in equity portfolios often outweigh the volatility reduction achieved. Investors also tolerate higher price fluctuations in equities than in nominal assets, according to c-alm.
Some funds are hedging amid geopolitical uncertainty, while others are scaling back to capture interest rate differentials and potential gains from a weaker dollar.
Industry debates and dilemmas
The Swiss pension fund sector broadly agrees on hedging to reduce currency risk but disagrees on whether currencies are actually depreciating enough to justify current interest rate differentials, Mettler said. Swiss funds, therefore, tend to partially hedge foreign currency holdings.
The consultancy warns on “currency hedging costs”, noting that hedging in low-interest-rate countries such as Japan or Switzerland can generate a loss, while hedging in high-interest-rate countries can bring gains.
Interest rate differentials are sometimes viewed as hedging costs in a low-rate environment, but Tobias Bütikofer, senior investment consultant at c-alm, said they “merely reflect the international interest rate structure, and thus represent the economically correct price relationship between forward and spot transactions”.
Actual costs arise from bid-ask spreads in foreign exchange trading, but these are small compared with interest rate differentials, he added.
Hedging in low-rate environments presents a dilemma for pension funds. While hedging reduces risk, funds forgo the interest rate differential on foreign currency returns, Mettler said, explaining why optimal hedging ratio debates are strongest in low-rate countries.
“In high-interest-rate countries, it’s a no-brainer for investors to fully hedge their foreign currency holdings,” he added.
