Pensions and currency: What next?

Peter Davy looks at the case for currency in European pension portfolios

Has currency had its day? When it comes to hedging, it seems unlikely. By and large, the case for pension funds to consider addressing their foreign currency risk has now been made. Increasing exposure to international assets as well as the recent return of volatility to currency markets has seen fewer funds simply ignoring the risk. In the UK, for instance, more than a quarter hedge, according to Mercer’s most recent survey of European pensions funds. Similarly, the Dutch and the Swiss are also fairly likely to hedge at least some of their currency risk.

“It’s fairly widespread now,” says Parker King, managing director of Putnam’s Currency Investment Unit. Even in Germany, where regulatory issues have made overlay problematic, the company is beginning to pick up some clients, he adds.

Of course, even in the UK that means that there are a lot that don’t hedge, and elsewhere in Europe it is even less common. However, there are often good reasons for that.

Some in France, Spain and, indeed, Germany have little in the way of exposure outside the Eurozone. Others, after examining their foreign currency basket, may conclude that those they are invested in are negatively correlated to their other assets, making hedging counter-productive. And others will simply conclude it’s not worth the effort: funds that are heavily slanted towards equities can find that the impact of currencies on their fund is fairly negligible, given the volatility they already have. (With a bond portfolio, it’s a different story.)

As King explains, it’s about striking a balance. “Do you really want to deal with a bunch of hedging if you’re only looking at reducing the plan’s total risk from 12 per cent to 11.7 per cent?”
However, whatever they decide, pension funds increasingly at least ask the question, and if the argument for looking at currency risk hasn’t been completely won, “the trend is definitely in that direction”, says King. Or, as Michael Huttman, chief investment officer at Millennium Global puts it: “If you don’t address that risk it means you have a random impact on your portfolio. That’s intolerable in other asset classes and it’s becoming ever less tolerable in currency.”

Poor returns
Active currency management, though – and particularly management on an absolute return basis – looks more fragile.

In part, that’s because it is much younger. At Record Currency Management, founder Neil Record says the company has been putting hedges in place for pension funds for the last 23 years. “It’s an argument that was made early on and pretty easily,” he says. By contrast, the growth in currency for absolute return has been far more recent and rapid.

“In 2003 we had no UK pension fund clients on an absolute return basis,” he remarks. “Today we have 128 – and they’re all big funds.” Together, he reckons these clients account for some 20 per cent of UK pension funds by asset size, while worldwide he estimates there is now about US$500 billion invested in currency management.

Whether this growth can last, though, is another matter. On the one hand, the trend towards
pooled currency funds has opened up active currency management to a far wider market of smaller funds. On the other, returns over the last couple of years have been disappointing. Many of the funds, for instance, relied on carry strategies, focussing, for instance, on the Japanese Yen and New Zealand Dollar. While there was low volatility in the currency markets these did well. Following the US sub-prime crisis and the return of volatility, though, they were hit hard.

“Not all managers have performed poorly, but it’s fair to say a lot have struggled,” explains
Jason Allan in the Investments Advisory practice at KPMG. That’s a problem not just because
many funds were persuaded into currency a couple of years ago on the basis of a strong run at the start of the decade, but also because it wasn’t just about returns; pension funds were after diversification as well.

“One big reason for putting forward active management was that it was expected to have a correlation with other asset classes of close to zero,” explains Allan. Unfortunately, the recent poor
run has been matched by falling equity markets.

How much of an impact this has had is hard to say. Taking the figures from Mercer again, the proportions of UK and European pension funds making allocations to active currency management in its 2007 survey were eight per cent and four per cent, respectively. The figures this year are 3.9 per cent and 2.3 per cent. However, the number of funds taking part in the survey this year has increased, so it’s impossible to draw a direct comparison.

But perhaps the more important question anyway is whether the recent performance should be putting pension funds off. And here, not surprisingly, the currency managers say the answer is unequivocal: They should stick with it.

Making the case
The difficulty, argues Bruno Crastes, CEO of CAAM, is that investors in currency need to either look to funds that make short-term gains from arbitraging the market noise or – more usually – take a long term view. In such cases, there is still value in currencies, because ultimately they are mean reverting, but too many investors become disillusioned after a couple of years not seeing any results. “The one to three year time horizon with currencies is a real trap,” he warns.

Consider cable: Over the last couple of years it’s been between $1.90 and $2.10. “The guys buying dollars and looking at it over that period would have been thinking they’d made a bad trade and cutting those positions,” explains Crastes. Those taking a five year perspective, though, will have been happy to wait it out and are now, perhaps, seeing the start of the trend they have
been expecting.

“If you take a three to five-year horizon, there are massive opportunities in the currency markets,” says Crastes, and this shouldn’t be such a hard argument to make to pension funds. “After all,” he says, “their time horizon is really that sort of period, if not longer.”

Furthermore, there are new opportunities opening up as currency managers increasingly look to widen the strategies they use and – crucially – look to emerging market currencies for returns and greater diversification.

Partly, that interest is driven by the fact that the last couple of years have seen it easier to continue to make returns from emerging market, rather than developed market, currencies. It is also more practical than it was.

“There’s been a dramatic improvement in the liquidity of the instruments available,” explains Michael Shilling, chief executive of Pareto Investment Management. “If you go back five years it was very expensive to trade, and if you did so in any great volume you would struggle. Now you can be quite a lot more active.”

Of course, such currencies can be very volatile, but this can bring benefits in terms
of diversification, since many emerging market currency are not just uncorrelated to those of the G10, but also to each other and, after all, currencies are traded in pairs. Stick to a currency basket
of G10 nations and you have 45 possible combinations of trades. Increase it to 33, by including emerging markets and you have 528. “Sometimes volatility can work in your favour,” as Laura Ambroseno, a product specialist in the global structured products team at Morgan Stanley Asset Management.

Of course, that won’t stop funds making losses sometimes but then, as Ambroseno notes, this is the second time in a decade where equities have seriously underperformed. As pension funds look to a greater range of investments to provide the returns and diversification they need, the opportunities in currency are growing and, for pension funds at least, these are opportunities that have only just begun to be explored.

Written by Peter Davy, a freelance journalist