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Home > Insurance Markets Viewpoints > Pension Funds—The Dangers of Taking Off-Benchmark Foreign Exchange Risk

Insurance Markets Viewpoints

Pension Funds—The Dangers of Taking Off-Benchmark Foreign Exchange Risk

by Mark Hogg

Pension funds in the United Kingdom with substantial investments in overseas equities have to take foreign currency risk into account. How should they approach this?

If you are investing in a foreign asset or basket of assets, whether you like it or not your investment return is going to come from two different sources. You will see a return or a loss on the underlying asset, of course. But when you sell that asset you will also see a gain or a loss on the translation back into your home currency. A UK investor buying Apple also buys exposure to the dollar, whether they are aware of this or not. When you are faced with that opportunity set you have a choice to make—in fact, three choices. You can ignore the currency risk, which is very much an active decision that has consequences. Second, you can hedge a portion, or almost all, of the risk away. And finally, you can try to actively manage the risk in pursuit of an enhanced return.

This decision matrix can and should only be resolved with reference to the unique requirements of each fund. The underlying question you are asking is: how do we view this risk in relation to our investment policy or objectives? There are plenty of academic studies that demonstrate that unmanaged currency risk has no inherent positive value. So if you manage global equities as a fund manager, and if you believe that if that risk is left unattended it has no inherent value, the obvious decision to take is to hedge it out, since the only thing that is likely to emerge from it is damage. If you are unsure of the potential outcome, then one decision could be to hedge out half the risk. The downside of hedging away all the currency risk is that the fund cannot then benefit from currency swings that move in its favor. The downside of not hedging at all is that adverse currency movements can kill your performance.

Between these two extremes, a 50% “passive” hedge (passive in that it is set and then left to operate) may be termed the “least-regret” currency hedging policy. You get half the upside and protect against half the downside of currency movements. With a 50% hedge in place you could then choose to tactically tilt the hedge by either increasing or reducing the percentage, based on your strategic directional views of the currency exposures. On a quarterly review of the hedge, you might, for example, decide to tilt it 5% or 10% away from the mid-point if you were bullish on the movement of the foreign currency against the pound. This is a reasonable way of combining a passive “overlay,” as it is called, with some active management.

However, the question then is whether the fund manager should manage the hedging in-house, including putting in place the necessary foreign exchange trading infrastructure, or whether to outsource the maintenance of the hedge to an external provider. The question equity or bond fund managers have to ask themselves is: do they want to morph into being currency managers as well? It is a very different skill set. Many managers will simply want the currency risk managed in a sensible way that is aligned with their overall investment strategy. In this case, outsourcing can make perfect sense.

There is another major point to take into account here, and that is the view the fund manager’s investor client base is likely to take of the currency element. Investors are becoming much more savvy about interpreting the attribution of returns from the fund. If the investor looks within the returns and sees that they are getting random currency returns that are giving them off-benchmark exposure, they are going to be asking some sharp questions. They will want to know how your currency exposure aligns to your investment strategy.

Can you give an idea of the scale of the risk potential contained in currency exposures?

An asset manager looking at a G51 investment in either bonds or equities has inherent price volatility in equities or bonds to contend with. That is where their core skill set usually lies. However, the underlying volatility of the asset class may, in some cases, be less than the foreign exchange risk in the portfolio and can easily end up dominating your returns. That is not going to make investors happy even if it is positive. They key is to ensure that you have a clear strategy that aligns your currency risk policy with your overall investment strategy.

If you want to take active off-benchmark currency risk, you need to ensure that you have the right to do this by agreeing your strategy with your investor base. And if you are going to go down this route, you need to maintain a really sound, competent analysis of your performance. Over and over again I see situations where managers take unstructured and random foreign exchange risk over time without doing the post-mortem analysis to ensure that the decisions they have been taking really do add risk-adjusted value to the portfolio. Remember that the concept of a risk-adjusted return is that you expect a proportionately higher return for a higher rate of risk. Plus you want that higher rate of risk to be factored in to your overall risk budget so that it is part of your strategic approach. If you do not analyze the risk and monitor your risk performance, you are simply flying blind.

Often, when people get around to doing this analysis, they are surprised by the outcome. They may well have put a lot of thought and effort into putting their foreign exchange decisions in place with respect to their portfolio and at the end of the year they find that all their efforts have canceled out to zero. From a technical perspective, all they have succeeded in doing is adding some additional variance to their portfolio, which is not a happy outcome when you are presenting to investors. So a fund manager needs to ask him- or herself if they really do have a proven ability to add active value in the foreign exchange space that can stand the test of time. They need to make a conscious decision about the extent of their risk allocation to active currency management.

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