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More than a euro/dollar play?

This month's Off The Record survey looked at pension funds attitudes towards currency management. More than half of surveyed pension funds - 57% - believes that currency risk is unrewarded and that hedging it can reduce volatility without damaging returns. But less than a third - 31.5% - thought that currency markets are a good source of alpha.

Just over a quarter of respondents agreed with the statement that hedging is a waste of time over the long term because foreign exchange is mean-reverting. Some 5.5% said trading currency was just gambling.

So it is no surprise that 61% of the pension funds surveyed use currency management for hedging purposes. Just under a fifth use it to seek returns - alpha - too, while 30.5% said they did not make use of currency management at all.

One of these, a Belgian fund, called it a "zero sum game" as all its bonds and liabilities were in euros, while it took the currency risk in equities. "We simply hedge all currency risk with one-month forwards," explained a Dutch fund, whereas a second Dutch fund lamented that it was "difficult to find a currency manager with a consistent performance".

For three-quarters of respondents, currency hedging and return-seeking are completely separate decisions. Yet only a small majority, 55%, use different managers for the hedging and return-seeking part - 45% of pension funds use the same manager for both purposes.

Just less than 18% of surveyed pension funds changed the way they approach currency management over the last 12 months.  "[We] changed the maximum permitted hedge ratio in response to the weaker domestic currency (GBP)," said one UK fund.

Another UK pension fund manager believes that only the euro and the US dollar are return drivers in the present climate, and a macroeconomic bet on these is a matter of luck: "We terminated our mandate when it became clear what we needed was a lucky fundamental manager - and we prefer not to base our return expectations on luck."

While close to 55% of respondents believed that currency hedging is best done at the pension fund level, 35.5% thought it should be done by the individual asset managers. Only 6.5% said pension funds and individual asset managers were equally well equipped to do so. "It depends on the expertise or management approach of each manager," said a UK fund.

Of those funds that use some kind of currency strategy, a majority - 72.5% - hedge all asset classes that have exposure to foreign currency. Around 14% only hedge their fixed income exposure, while one respondent admitted to hedging only equities with exposure to foreign currency. Alternatives and commodity futures were also hedged by a Swiss fund and a UK fund respectively.

Permitted tracking errors from the benchmark varied from 1% by a global and a Latvian pension fund to 50% by a Dutch and a UK pension fund. A Swedish pension fund put the tracking error at 10% for fixed income and hedge funds, and at 50% for equities. Hedge ratios depended on asset classes and individual pension funds although half of the respondents put it at 70% or more.

Measuring success or failure of a currency hedge seems to be difficult. Some pension funds stated it had smoothed returns, while others said it had made no difference. "It has added on average 45 basis points per annum," said one Finnish scheme. Gains of 1-2% and 4% were attributed to a currency hedge by a Latvian and Dutch scheme respectively. 

The alpha managers received mixed reactions. For some it was still too early to say whether they had made a difference. However, one UK fund put the difference at plus five bps at fund level, while one Finnish scheme stated it added two bps to its total fund performance per annum.

"It has cost us money, which is unsurprising in an environment of weak domestic currency, given the manager's mandate," said another UK scheme. "But it has been significantly cheaper than a passive hedge would have been."
 

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