Currency markets are the largest in the financial world. Every day, some $5tn is transacted, according to Nasdaq, 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 movement can upturn an entire investment portfolio – 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 – currency markets take their lead from sentiment 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 soaring or falling, while volatility in a seemingly distantly connected sector or land, can have a massive influence on how a euro, pound, dollar or peso moves against its peers.
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 choppiness, could shrewd investors be using the volatility to their advantage?
RIDERS ON THE STORM
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 that specialises in currencies, said its volumes had hit a post-crisis high.
Elsewhere, Thomson Reuters said a spike in volatility in March had seen currency trading volumes on its platforms rise 28% in 12 months, just narrowly missing February’s total, which was 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 Savings 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 international equity holdings.
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 committees, this geographical dispersion has brought currency risk into play. In the past 12 months alone, the pound has 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 millions, if not billions, of pounds a move that might make a foreign holiday seem expensive – or cheap – could mean the difference between solvency and insolvency for a pension scheme.
Alan Pickering, chair of BESTrustees, who advises UK pensions on their investment 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 it 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.
“For those schemes that have very long time horizons, the ebb and flow of the currency 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 opportunity 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 underlying 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 equities, generally require a less precise currency hedge to capture their risk premia return. The return from fixed income risk 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 movements 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 purchasing 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.”
WEATHERING THE STORM
Pickering at BESTrustees says that uncertainties about Brexit had 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, according to Ghosh, who thinks more pensions should be encouraged to think about it. Even funds without the sophisticated 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 Nedlloyd Pensioenfonds (NPF) has taken a different approach.
Randy Caenen, NPF’s head of finance, control 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 tactical 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-denominated 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 biggest 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 expensive for something that might not be that effective in the end.
“Strategic asset allocation decisions are made on how to diversify across regions,” he says.
“Times are changing, and monitoring of assumptions is needed. We believe that taking a well-priced risk will lead to a higher (expected) return.”
A GATHERING STORM
This theme of change was echoed by Thanos Papasavvas, founder of consultancy ABP Invest and former currency investment manager at Investec Asset Management.
“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 tightening 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 geopolitical 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,” he adds.
“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.”