As a tool, currency hedging can form an important part of a defined contribution (DC) scheme’s overall approach to risk management. Yet, in the past, not all schemes have deployed hedging, with cost often cited as a reason.
But DC schemes, most of which have a significant exposure to overseas assets, have begun to pay more attention to currency fluctuations in recent years, particularly since the 2016 EU referendum, which prompted a veryswift decline in the value of sterling.
With few investment managers willing to guess where sterling will end the year, and the likelihood of an economic downturn in 2020 increasing, according to some economists, schemes may now view exchange rate movements as a risk they would like to take off the table.
Behaviour of sterling
Generally speaking, a global economic downturn will cause sterling to fall. Aon head of DC investment advisory Chris Inman points out that the UK economy tends to follow the global cycle reasonably closely, which means that any global event would be felt in the UK.
“At the same time, a weaker economic backdrop and/or increasing concern tends to push the US dollar higher and sterling lower relatively. However, the picture is not so clear-cut versus the euro as Europe is also highly exposed to global trade,” he explains.
While sterling might be expected to track lower during a global dip, its trajectory could be different depending on the nature of the downturn.
Alliance Bernstein portfolio manager, multi-asset solutions David Hutchins says: “If the downturn is related to a more general manufacturing-type slowdown or essentially a consumer-based slowdown, then there’s the potential sterling could actually appreciate in those markets.”
With most DC schemes invested in overseas equity and fixed income markets to achieve diversification, this means members are generally heavily exposed to currency risk.
There is no real reason to have a home bias in a DC scheme, says Hutchins, who would expect more than 90 per cent of equity assets held in a DC scheme to be outside the UK.
“The bit that often gets missed is the bit that’s in the UK stockmarket, because 70 per cent or 80 per cent of earnings of most UK-listed companies are overseas,” he says.
Mercer partner Wayne Fitzgibbon suggests that when a scheme buys a company, they are in fact, making two decisions: “They are buying the shares in the company but also taking a currency position.”
He explains that currency hedging balances out the risks of those two things.
A paper published by Aon in 2017, ‘Does Currency Hedging Matter in DC?’, concluded that currency movements can have a “significant impact on portfolio volatility and can dominate returns at times”, adding that “trustees should consider members’ exposure and likely tolerance for currency risk”.
The investment consultant’s research paper suggested that trustees “consider whether to introduce a strategic currency hedge, if one is not already in place.”
Essentially, currency hedging is all about risk, or rather taking the decision not to be exposed to the heightened risk and volatility associated with exposure to a basket of currencies
“Currency hedging is one tool available to DC schemes in overall risk management of the strategy,” says Hymans Robertson head of DC investment William Chan
“In theory, it removes the impact of currency fluctuations in foreign asset classes held within the strategy. In practice, the volatility of a currency hedged equity strategy has been lower – relative to an unhedged strategy – over the very long term (over 30 years), but there has been a reversal of this in more recent times.”
DC schemes are investing for the long term but some members will be nearing the end of their accumulation journey, while others will only just be at the start. For that reason, trustees are unlikely to want to take a tactical view of sterling or any other currency.
Hutchins says: “Wherever you are on the client path, it should make sense to have some form of hedging.”
Many agree that those DC schemes that have ‘got away’ with not hedging currency in the past few years, benefiting from a significant uptick in sterling valuations of pension investments overnight following the surprise Brexit result, would be wise to start doing so now.
XPS Pensions Group chief investment officer Simeon Willis says: “Sterling against a basket of currencies will have depreciated over the past five years, primarily because of what happened in 2016, and we saw the impact of this on pension schemes that didn’t currency hedge being quite a boost in their returns over what they’d have got if they had a hedged position.”
Hutchins adds: “If you’re one of those DC schemes that got lucky over the last five years and have not hedged at all, then you should certainly be looking to correct that and put some form of hedge in place.”
So, what is the best approach to hedging, given that most schemes will have a portfolio of global equities? The consensus seems to be that a 50 per cent hedge should be sufficient for an equity portfolio. Chan says that the 2016 referendum did prompt a review of currency within many DC schemes.
“If a scheme did change their approach, the most common change we saw among schemes was for those that previously did not employ any currency hedging to hedge a portion of their global equity assets to sterling – 50 per cent was a common outcome,” he explains.
“This would tend to suggest that there was no high conviction view of sterling’s long-term relative strength and employing a degree of currency hedging would simply allow schemes to avoid losses from foreign currency exposure if sterling appreciated.”
“For overseas equities, we recommend a 50 per cent strategic hedge to our UK DC clients,” says Inman. He notes that there is “no single optimal number” but that a 50 per cent hedge has historically reduced volatility over the long run and he describes it as a pragmatic solution.
Fitzgibbon says that the “most appropriate” hedge ratio is somewhere in the range of 40 per cent and 70 per cent for equities. Addressing how currency hedging would work for the bond portion of a DC scheme, Willis says: “Generally you want it to be fully hedged because the impact that currency movements can have relative to the overall level of return you expect from your bond can be much more significant.”
THE COST OF HEDGING
Trustees of DC schemes will always be conscious of costs, in particular those that may have to be passed onto members. But the costs of currency hedging are negligible.
“For DC investors that access pooled investment funds the main route to implement strategic currency hedging is through blending a hedged and unhedged version of the fund,” says Aon head of DC investment advisory Chris Inman.
“There is generally a 1 to 2 basis points extra cost for the fully hedged version of the fund. In terms of the underlying implementation by the fund manager, the largest part of the hedging cost tends to be the interest rate differential between each economy in the currency pair, as forward foreign exchange contracts, that are used to implement a currency hedge, are priced based on this difference.”