By Charles Goodman
After the UK referendum to leave the European Union on 23 June, sterling has fallen against most major currencies. For the many British pension funds that had not hedged their foreign currency exposures, this will have been welcomed as a windfall that offset losses incurred from the underlying assets. Indeed, at the close of business of the post-referendum low on 27 June, the S&P 500 was down some 5% in dollar terms from the previous Thursday but up more than 6% in GBP terms. The same pattern holds true for the Nikkei and Eurostoxx.
Pension funds should not rejoice too quickly. In some ways this has been a fortunate break, and there is nothing to say that the next big move in exchange rates will not be a rise in sterling, which would create losses for British investors. The exchange rate has rarely been below 1.40 in the past and similar drops have been followed by climbs to as high as 2.00 or above as in 2007. If a future rise in the pound should happen to coincide with a drop in the value of return-seeking assets such as equities and property, it would be disastrous for many pension funds.
Historically, UK pension funds have often tended not to hedge their foreign currency exposures, and certainly much less than their counterparts abroad. Yet all the academic literature shows that while G-10 currency movements have little impact on portfolio expected returns, there is a very significant impact on portfolio volatility and stress scenarios. Currency therefore represents an unrewarded risk and hedging it out will improve the risk profile of any investor whose liabilities are in a single currency. Conversely, the absence of hedging increases the risk of large losses, which could be potentially catastrophic for pension funds without surpluses.
So why do UK pension funds not hedge more of their foreign currency risks? There are several explanations:
– A high home bias: The UK pensions industry has long had a fairly strong home bias, particularly in fixed income. Currencies have therefore rarely stood out as a major priority. However, the non-sterling portion of portfolios has grown steadily in the past decade and a currency shock would have a much bigger impact now than in the past.
– Bad experiences: Some pension funds have had a bad experience with investing in “currency as an asset class”, i.e. unconstrained, return-seeking strategies. Whatever the merits of such strategies, they clearly do not constitute hedging and indeed are not at all comparable to hedging approaches. Unfortunately, in some cases these bad experiences have tainted the views of pension trustees and consultants and have led them to avoid risk-reducing currency solutions.
– Past windfall gains: There is a certain false sense of security following short periods of one-off currency gains in the past. These short periods stick in the memory, but are often followed by long periods of currency losses that while less memorable may be highly damaging. Everyone remembers that in 2008, the depreciation of sterling generated one-off gains from currencies that partly alleviated the losses suffered in most of the investment portfolio during the global financial crisis. Far fewer people realise that excluding 2008, UK based investors consistently lost money from investments in US dollars, euros and yen between 2000 and 2015.
Currency movements are by nature cyclical and mean-reverting but have historically seen very large swings, such as the rise in the pound against the dollar from around 1.40 to above 2.00 just before the global financial crisis. The last few years have seen both unconventional monetary policy and unconventional market behaviours, and currency volatility has been to a large extent suppressed. As a result, post-2008 we have not seen the magnitude of movements in exchange rates that we had seen in prior periods. However, central bank policy decoupling has started and we are seeing higher currency volatility regimes again. It would not be surprising if we have re-entered a period where we see much larger currency movements on a regular basis.
From a long-term perspective it is a mistake not to hedge currency exposures, because they represent an unrewarded risk that contributes significantly to volatility and potential losses while contributing little in expected returns. British pension fund trustees and managers should take advantage of the current bout of sterling weakness to establish a sensible and robust hedging policy.
Charles Goodman is CEO at Edmond de Rothschild Asset Management (UK)
