If there has been one thing as volatile as the comings and goings in Westminster since the UK’s vote to leave the European Union, it has been currency markets, writes Joe McGrath.
After sterling’s plummet following the June 2016 referendum, every Brussels summit, meeting at Chequers or even declaration at the dispatch box has seen the pound moving up or down against other world currencies.
For traders playing the global FX markets, there has been plenty of opportunity to make a quick buck and even active fund managers could have squeaked out an extra basis point or two from the action. But for savers in defined contribution pension schemes, whose first knowledge of a currency fluctuation might be on the 10 O’Clock News, the position is most likely to have been an entirely passive one.
There are few options on investment platforms to ride a tear in the US dollar, and even fewer to shelter from the storm of a collapsing pound. But with no clear end to the Brexit negotiations and geopolitical tensions increasing around the world, currency markets – which trade close to $5 trillion each day – seem set to remain bumpy.
Currency movements can have a huge impact on an investment portfolio. They can either amplify or wipe out returns from international investments overnight. With DC pension investors looking to diversify their income streams and widening their portfolio’s geographic parameters, currency needs to be an important consideration.
For XPS Pensions Group chief investment officer Simeon Willis currency hedging should be seen to be a strategic decision and not a tactical one. “It is a starting point for protecting an investment,” says Willis.
By deferring the decision, an investor is implicitly opting not to hedge. While this can occasionally bear fruit – such as the near 20 per cent earned by the unexpected drop in the pound after the Brexit vote – investors should acknowledge that windfalls are not a prudent investment strategy. “For a lot of investments, it makes sense to currency hedge,” said Willis. “The lower the level of risk of the investment, the more important currency hedging is. Bonds or cash investments need to be hedged.”
This is because the risk of the currency can be much higher than that of the bond itself. Failing to hedge the risk of the currency could easily wipe out the return on the asset, if it were to move even a fraction of a percentage point.
But investors need to be aware that a decision to hedge is not just a binary “yes or no” decision.
Equities, which are a much riskier asset class than bonds, are different and there are a range of views on the level of hedging needed. Once seen as risky enough to offset any change in currency, some are taking a longer- term approach.
“If you have a scenario where currency depreciates, that will make companies more competitive in their market through exporting what they build or make,” says Willis. “This is covered by a rise in the value of the company, therefore, we say we will hedge 75 per cent of the risk.”
In some instances, hedging is not a worthwhile option and investors must be careful to avoid destroying the income they otherwise might have received.
One current example is in the US. “The US is further along its rate-rising cycle than the UK,” says Willis. “Deposit accounts in the US therefore are paying a higher rate. So, you cannot earn a 2 per cent return in dollars and remove the dollar exchange rate risk. You can either take the higher return along with the exchange rate risk, or not have exposure to the exchange rate and give up the higher return.”
Within equities, there are other considerations, too. While an active equity fund manager can use a range of tools to control his currency exposure, taking tactical bets using his specific strategies, most DC investors use passive managers due to the charge cap.
However, despite losing some of the nimbleness – and the cost – of an active manager, passive funds across all asset classes are usually well prepared for currency shifts, according to Buck Consultants investment consulting principal Celene Lee
When choosing funds, investors should be aware of their hedging approach, which should be clearly stated on key information documents. “Many diversified growth funds are themselves already highly hedged,” says Lee. “It is not that challenging if you want to manage the currency risk and the cost is not insurmountable in the case of passive equity.”
Due to the range of swaps, hedges and other derivative tools available to investment managers, the price of hedging should not offset the protection an investor gains by implementing it.
State Street Global Advisers global head of currency James Binney says: “For passive management with a constant hedge, transaction costs (depending on the currency) are going to be four to six basis points a year.”
There may be additional management fees to pay, but these should not be larger than transaction fees, says Binney. “These are relatively small costs relative to the swings in currencies,” he says.
Unlike wealth investors or those managing defined benefit pension schemes, DC investors have an additional element to consider.
“Looking at the glidepath, in the earliest stages of the investment period where there is a much longer time horizon, the ability to take risk is higher,” says Lee. “Towards the later end of the spectrum where a member is getting to the end of the glidepath, the portfolio will be running at a lower risk, so the expected returns will be coming down.”
At this point, from a risk budget point of view, an investor will want to have a tighter control of currency exposure, Lee says. This is something to consider for a DC investor that has stuck to the default fund for their whole investment journey.
Lee also recommends those managing available investment options take another look at default strategies, as volatile times look set to remain.
“Often, when you tell clients they should be reviewing a default fund, many clients think it is all-weather,” says Lee.
They are not. “If we did not have these extreme political events, we wouldn’t expect currency fluctuations to be a key driver for returns, but we are not living in usual times, therefore reviewing them is very good practice,” she says.
Willis says UK-based investors should expect more volatility at least in the short term, given the recent political wrangling.
Willis says: “Whatever happens tomorrow and what happens in the following couple of months, we will not get to the end of March and everything will be back to normal. There will be a sustained period of volatility.”
Investors need to be aware that the UK is not in a scenario where sterling is cheap and will just steadily appreciate, says Willis. “It is a question of how bumpy that ride could be along the way and do we want that affecting our investments?”
For Lee, trustee-based and other workplace schemes need to look at what investment options their members have on offer that can ride out tougher market conditions.
“Needless to say, it is not always possible to predict market volatility for decades or even months in the future,” she says, “so regular reviews are key”.