Currencies can be extremely volatile, especially when major political events such as Brexit occur. This can have a significant impact – negative or positive – on the value of investments.
In a globally invested portfolio, currency hedging can help investors such as pension funds mitigate foreign currency risk.
When the UK voted to leave the European Union (EU) on 23 June 2016, the value of sterling relative to the US dollar fell sharply by about 17 per cent, to US$1.22 from US$1.47 in the span of four months. Overseas asset values soared following the collapse of the pound.
Defined contribution (DC) pension schemes that did not hedge against their overseas currency exposure received a boost, says Mercer partner and director of consulting Brian Henderson.
“In 2016, schemes that weren’t hedged clearly got the benefit from the weaker sterling, while schemes that were hedged missed out on that,” he says.
The reason why pension funds hedge is because it is a no sum game over time – sometimes they win and sometimes they lose – and they want to take away some of the currency risk.
“Normally, if pension funds have over 50 per cent in overseas assets, they should be thinking about hedging to try to take away some of the currency risk. And when they do hedge, they don’t typically 100 per cent hedge. As they increase hedging, they start to reduce risk and then continue the risk back up again, so there’s a kind of sweet spot,” Henderson adds.
Schemes review currency hedges
Since 2016, more DC pension schemes have taken the step to review their currency hedging positions, says William Chan, head of DC investment at pensions consultancy Hymans Robertson.
“The general trend over the past four years has been in aggregate more schemes moving towards at least some form of currency hedging, or schemes remaining unhedged,” he says.
Pension schemes are now bracing themselves for more sterling volatility as the UK could leave the EU on 31 December without a deal.
Chan thinks more schemes are prepared to at least have some degree of currency hedging protection relative to sterling.
“Post 2016, the schemes that have done the most in terms of currency protection have taken a neutral position of 50 per cent hedged, 50 per cent unhedged,” Chan says. “If sterling either
appreciates or depreciates, they will benefit partially, and the other half not – it diversifies them in a way against currency movements.” In July 2019, The People’s
Pension, a DC master trust, implemented a 70 per cent currency hedge for its US dollar, euro and yen exposures.
Chan says most DC schemes still lean more towards the unhedged side and for some it could be anywhere from 75 per cent to 85 per cent unhedged. If sterling depreciates, those schemes will still do quite well but they will not if the pound appreciates following a ‘good’ Brexit deal.
Those who have tried to hedge a lot of currency risk could suffer if sterling weakens and depreciates further, but they will be protected if it appreciates. Those that have continued to be hedged have in some ways benefited as the pound has risen.
In the run-up to the 2016 EU membership referendum, master trust Now: Pensions had a 100 per cent hedge on overseas investments, which dented its returns when sterling fell.
“We did not have a view on the outcome of the Brexit referendum back in 2016, so had not taken unhedged non-sterling exposure in June 2016,” says Ralph Frank, chief operating officer at Now:Pensions.
“If we want the currency exposure, because we have a view that the exposure will add to the portfolio’s return and/or balance and an edge in developing the view, we will leave the exposure unhedged. However, if we don’t have a view and can hedge the exposure cost- effectively, we will look to hedge the exposure,” he adds.
The exposure in the portfolio is a “deliberate choice” rather than an accidental consequence, he says.
If Now:Pensions has a particular currency view, it might take it directly such as buying US dollars and selling pounds – rather than by buying US equities to get US dollar exposure, for example.
However, the master trust does not have a view on Brexit – and whether there will be a deal or not by 31 December 2020 – and consequently has not taken a specific currency position ahead of the year-end.
Chan says pension funds are unlikely to make a bet on sterling. “We don’t expect pension funds to make a bet and move between global shares unhedged and hedged on a dynamic basis particularly around that December 31 period.”
Pension funds tend to make more long-term strategic decisions based on a 20- to 30-year time horizon.
Mercer does not advise pension schemes to take a long-term view on sterling. However, it does suggest that they should hold more overseas equities than UK equities.
More overseas exposure
Pension schemes have increased their overseas equities allocation compared to several years ago, but they still have an overweight bias to the UK.
The average scheme for members decades away from retirement has roughly between 70 to 80 per cent in equities and 20 to 30 per cent in more defensive and diversified asset classes, Chan says. Around 30 per cent of the 70 to 80 per cent equity allocation is UK domiciled, whereas only 4 per cent of the global passive index is UK domiciled.
If DC schemes invest in a dynamic diversified growth fund – which few do because the charges can be high – then that fund may make its own calls on currency to protect underlying assets or try to generate excess returns.
Over the years, Henderson says, pension funds have generally held the view that currencies are a risk management feature, rather than a speculative return feature.
However, River & Mercantile head of DC solutions Niall Alexander says his organisation is modelling different scenarios to help DC pension clients take opportunities the day after Brexit. “Whether it’s a deal or no-deal scenario, pension schemes could look at what opportunities has that created and how quickly can they come in and lock in those opportunities.”
The impact of currency moves on equity markets can vary a lot. The fall in sterling following the 2016 Brexit vote triggered a rally in the FTSE 100 index that ran for two years. That is because firms in the FTSE 100 generate the majority of their revenue from overseas earnings. Therefore, the depreciation in sterling resulted in an increase in their sterling- reported revenues.
However, the potential for a no-deal Brexit and potential operational issues would still likely result in an overall fall in values. Meanwhile, the net-negative impact on companies in the FTSE 250 would likely to be much greater as the bulk of their earnings are domestic-based.
What could happen to sterling?
While there was a spike in sterling volatility after the 2016 Brexit vote, 2018 and 2019 were relatively calm for the currency.
But on 20 March this year, the pound fell to its lowest level against the US dollar in the past 35 years against concerns the UK would leave the trading bloc without a deal.
The GBP/USD exchange rate moved from US$1.32 to US$1.15 in just a few days. Since then, the pound has broadly recovered, rising to US$1.29 as at 29 October – but it is still 12.2 per cent lower than it was before the Brexit vote.
River & Mercantile’s Alexander say if there is a bad no-deal scenario, the pound could fall again in the same way it did in 2016, although possibly not to the same extent.
“Also, a lot of companies are actually being more savvy about hedging their currency risk, whereas in the run-up to the 2016 EU referendum, many thought Brexit wouldn’t happen,” he says. If there is a good or acceptable Brexit deal, sterling would likely appreciate.
“There are several other political events aside from Brexit that could affect currency moves such as the China/US trade wars and the potential for Covid-19 lockdowns,” Alexander adds.
Pension schemes will have to brace themselves for sterling volatility in the run-up to Brexit day. Given more funds are thinking more carefully about their currency risk exposures, they should be well-prepared.