For global investors, portfolios embed two distinct return drivers: the performance of the underlying assets and the translation of those returns back into base currency. While the former is usually deliberate, the latter is often accidental, even in default DC pension strategies.
For UK investors global diversification introduces foreign currency exposure. While DC pension asset allocation decisions are typically deliberate, currency exposure is usually treated as residual, accepted implicitly rather than governed explicitly. Yet currency movements can materially shape portfolio outcomes, particularly during periods of market stress or regime change.
Let’s take developed market fixed income as an example. Currency volatility typically exceeds that of government bonds and investment-grade credit. As a result, unhedged currency exposure overwhelms the risk characteristics of this asset class, and a defensive allocation is unintentionally transformed into material volatility. This can undermine the role fixed income is intended to play in terms capital preservation, diversification and stability in domestic currency terms.
The picture is more nuanced around equities. Equity volatility is sufficiently high that currency movements do not always dominate total returns, and foreign currency exposure, particularly to the US dollar, has historically provided diversification benefits for non-US investors.
The structure of global equity markets has changed, however. US equities now account for a dominant share of global indices, so leaving global equities unhedged embeds a large and increasingly concentrated exposure to the US dollar.
The dollar has historically exhibited safe-haven characteristics. But. structural developments, such as reserve diversification by central banks, greater geopolitical fragmentation and concentrated allocation to US equities, suggest that relying on persistent dollar strength as an implicit hedge may be less reliable over longer horizons.
Against this backdrop, fully unhedged or fully hedged equity positions represent extreme choices. A strategic partial hedge allows investors to reduce unwanted currency-driven volatility, while retaining historical safe haven benefits without requiring a directional view on the dollar.
In pensions, asset classes are not the only factor to consider when it comes to currency risk. An investor’s age is also important; so, currency hedging decisions should not be static across an investor’s lifetime.
For younger investors holding some foreign currency exposure within financial portfolios can provide diversification against domestic economic shocks. But as investors approach retirement, their earning potential declines and financial assets increasingly dominate the balance sheet. Unhedged foreign currency exposure introduces volatility without a clear economic rationale.
Currency hedging practices within DC master trusts vary. Currency risk has historically been viewed primarily through a return-based lens, with currency exposure accepted implicitly ,not managed as a deliberate component of portfolio design.
A hedge ratio of 0 per cent implicitly assumes full confidence in the dollar’s ability to outperform the pound sterling and provide diversification during equity market stress. While this assumption is not unreasonable given historical experience, it overlooks the risks associated with a large, passive exposure to a single foreign currency. and ignores the role of human capital in shaping an investor’s effective currency exposure.
A strategic hedge ratio recognises these trade-offs. It seeks to mitigate the risks associated with concentrated dollar exposure while preserving diversification benefits. Importantly, empirical evidence suggests this is achieved at relatively modest hedge ratios.
Currency risk is a structural feature of global investing Its impact varies materially across asset classes, market regimes and stages of the investor lifecycle, and should therefore be governed as a deliberate element of portfolio design. In practice, this means portfolios must hedge fixed income exposures; partially hedge equities with explicit recognition of currency concentration; allow hedge ratios to evolve across the lifecycle; and favour stable, governable policies over mechanically “optimal” solutions.
In an environment of increasingly concentrated equity markets and uncertain currency regimes, treating currency risk as a first-order strategic decision is essential to delivering resilient long-term investment outcomes.