Feature
Currency markets are the largest in the financial world. Every day, some $5trn (£3.8trn) is transacted, according to Nas- daq, equal to 25 times the volume traded on every stock market around the globe combined. However, despite the size of this vast ocean of money that ebbs and flows in markets that never close, just the smallest move- ment can upturn an entire investment port- folio – and often these movements come out of the blue.
While most securities move on the back of something physical – a fall in sales or potential M&A activity, for example – cur- rency markets take their lead from senti- ment and the actions of others, making their direction much harder to predict. An unexpected referendum result or an early morning tweet can send a major currency soar- ing or falling, while volatility in a seemingly distantly connected sector or land, can have a mas- sive influence on how a euro, pound, dollar or peso moves against its peers.
its best ever month. The last time pension fund investors saw such volatility, their portfolios looked very different. A distinct home bias could be detected in portfolios until the 2008 crisis made many change their minds. According to the Pension and Lifetime Sav- ings Association, UK pension funds with less than £100m in assets held 30% of their portfolios in UK equities in 2008. Funds with £2bn or more were only slightly behind with 20%. By 2012, however, when stock markets had fallen around the world, both ends of the scale had shifted at least 10 percentage points out of London-listed companies, while retaining a consistent level of inter- national equity holdings.
strategy, says that as defined benefit (DB) schemes work towards self-sufficiency, all risks are being reduced wherever possible. Just 14% of UK DB schemes were open to new members and future accrual in 2018, according to The Pensions Regulator (TPR). Furthermore, some 40% are closed to future accrual, a number that has doubled from the 20% recorded by TPR in 2010. This means many pension schemes now have an approximate wind-up or end date they can work towards. Unlike open schemes, which can take on risks that may level out in the future, for these closed schemes any risks that are not rewarded, or will not have the time to play out in order to be so, are being taken off the table – and currency is seen in that category by most.
Currency risk is going to be a central theme
A slide in the value of a home currency can hurt a pension fund portfolio – on a paper basis – in a matter of hours if the investor has not made provision to try and hedge out the risk, but as markets regain some of their usual pre-crisis chop- piness, could shrewd investors be using the volatility to their advantage?
THIS TIME IT’S DIFFERENT After almost a decade of markets being soothed by quantitative easing, volatility has come back to the fore.
This volatility has spread into currency markets, providing peaks and troughs for traders to exploit. In the first three months of 2018, CLS, a US-based settlement house specialising in currencies, said its volumes had hit a post-crisis high. Elsewhere, Thomson Reuters said a spike in volatility in March 2018 had seen currency trading volumes on its platforms rise 28% in 12 months, just narrowly miss- ing the previous month’s total, which was
in the next few years as volatility across asset classes in general and FX in particular becomes prevalent in portfolios. Thanos Papasavvas, ABP Invest
By 2018, Mercer’s annual survey of all sizes of UK pension investors found that just 7% of portfolios were held in domestic equities. But while the message of diversification has been understood and implemented by trustees and pension investment commit- tees, this geographical dispersion has brought currency risk into play. In the 12 months to the end of November, the pound jumped up to $1.43 and down to $1.26 against the dollar and between €1.15 and €1.10 against the euro.
When amplified by a portfolio worth mil- lions, if not billions, of pounds a move that might make a foreign holiday seem expen- sive – or cheap – could mean the difference between solvency and insolvency for a pen- sion scheme. Alan Pickering, chair of BESTrustees, who advises UK pensions on their investment
28 April 2019 portfolio institutional roundtable: Managing volatility
“For those schemes that have very long time horizons, the ebb and flow of the cur- rency markets may ultimately have no effect – it might all level out – but this is not the case for the shorter term investors,” Pickering says. Chetan Ghosh, chief investment officer of the £8.5bn Centrica Pension Schemes, says his team sees currency risk as an opportu- nity to defend their capital.
“In evaluating our currency risk, we look at how risky the underlying asset is, to see if we should hedge it,” he says. “If the under- lying asset has low volatility, we will hedge 100% of the currency risk as we do not want the asset to become a currency play.” Assets that are more volatile and have higher expected risk premia, such as equi- ties,
generally require a less precise
currency hedge to capture their risk premia return. The return from fixed income risk
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