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premia can be dominated by the currency impact, hence why investors hedge 100% of the currency exposure to protect the fixed income risk premia from its impact. Pickering at BESTrustees says that many investors hedge between half to all of their assets, with a preference around the start of the scale to get the best value for money. However, Ghosh says his investment team have decided to remove their hedge on equities, believing they can take advantage of currency movements – they have spotted the potential to make additional returns. “We were 65% hedged for a long time, now we can take advantage of currency move- ments to defend our capital,” he adds. “We look at the strength of sterling and when it is at what we deem to be a fair rate, we do not hedge. When it is weak, we use a hedge to defend our capital.” The Centrica team monitors the purchas- ing power parity (PPP) measurement and looks at currency spot values daily. “It is a question that is at front and centre of our investment outlook,” Ghosh says. “We consider $1.40 to be fair value currently under the PPP measure – but it would have to get to $1.26 before we would hedge.”
PROTECTION STRATEGIES Pickering at BESTrustees says that uncer- tainties about Brexit have brought currency risk into focus for trustees. “Many may have made a one-off gain with the fall in the pound after the UK’s vote to leave the European Union, but it has also spurred trustees to look into how they need to be protected for further currency moves.” This is a sensible default approach, accord- ing to Ghosh, who thinks more pension schemes should be encouraged to think about it. Even funds without the sophisti- cated team at Centrica should be hedging, he says. “It is not a particularly difficult thing to think about,” Ghosh adds. “Consultants should be advising their clients to do it all the time. Looking historically, there are oscillations and mean reversions that can be captured.” Hedging contracts usually cover between three and nine-month exposure to diversify
the roll risk, according to experts. At some points, a fund may need to finance these contracts so may have to divest some assets to do so, according to its strategic asset allocation.
“On the operational side, it is not straight forward,” Ghosh says. “You have to ensure you are hedging the right exposures and there are calls for capital to oversee, which can come at the same time at equity market falls. So, there are operational challenges, but there are practical solutions for them, too.”
In the Netherlands, the €1.5bn (£1.29bn) Nedlloyd Pensioenfonds (NPF) has taken a different approach. Randy Caenen, NPF’s head of finance, con- trol and risk, says that the fund hedges its currency risk for developed and emerging market fixed income holdings through mandates with its investment managers. “We approach currency risk on a strategic level and monitor it on an ongoing basis,” Caenen says. “NPF does not engage in tac- tical asset allocation, meaning that there is no explicit view on currency movements or action taken in the short term to gain from currency movements.” The Rotterdam-based pension fund holds around 30% of its assets in non-euro-de- nominated currency, with the US dollar making up around 15%. “Regarding geopolitics, it is hard to predict what will happen,” Caenen says. “Is a potential trade war going to have the big- gest impact or a shift in currency, or both at the same time? We do use stress tests with severe but realistic scenarios to assess the vulnerability of our total portfolio to shocks.” He adds that as the pension fund itself was not taking decisions at a security-selection level, but rather uses multiple investment managers to do so. Caenen believes that implementing a hedge would be operationally difficult and expen- sive for something that might not be that effective in the end. “Strategic asset alloca- tion decisions are made on how to diversify across regions,” he says. “Times are changing, and monitoring of assumptions is needed. We believe that tak-
ing a well-priced risk will lead to a higher (expected) return.”
A GATHERING STORM This theme of change was echoed by Tha- nos Papasavvas, founder of consultancy ABP Invest.
“Currency risk is going to be a central theme in the next few years as volatility across asset classes in general and FX in particular becomes prevalent in portfolios.”
This pick up in risk will be driven by several factors, including a divergence in policy between central banks around the world and these players making mistakes in tight- ening up too quickly – or slowly. In turn, market participants’ reactions to these events will – as they have done in the past – add to the impact of any policy change or misstep, with a backdrop of geo- political uncertainty adding to the mix. Technical and regulatory changes too, have led to banks’ trading desks becoming much more active in search of better price and liquidity in currency markets, too, says Papasavvas. “They have been upgrading their skill-set and knowledge in technology.” With all this in mind, is now the time to reconsider an active currency fund to boost returns?
One London-based pension investor says she was looking to get out of a sequence of rolling contracts and take active exposures “on extremes” but remained skeptical of the efficacy of straight currency investment funds. For Pickering’s clients, there is not much interest. “Active currency management was once seen as an opportunity, now it is seen as happenstance – it is a risk too far for most trustees when other asset classes have come along,” he says. Ghosh is unconvinced, too. “We have and have found it to have mediocre results. The objective starts out sound, but as the assets pile into the industry, its ability to profit seems to go away. It is disappointing that more consultants are not aware of the potential for failure of these funds as the money gathers in them.”
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