Is the post-Brexit environment an ideal time for UK investors to hedge their currency exposure? Sebastian Cheek finds out.
“There are not that many satisfied customers of return-seeking currency mandates and that has led to the currency topic being abandoned a bit as it has not been a big vote winner.”Charles Goodman, Edmond de Rothschild Asset Management
Currency markets have always been volatile, but never more so than in the period following the UK’s decision to leave the European Union. Sterling plummeted rapidly following the Brexit vote on 23 June, hitting less than US$1.28 on 5 July – the lowest point for 31 years.
However, while this was reason to panic for certain sections of the FX market, for UK pension funds who had not hedged their currency exposure, the weak pound would have afforded a windfall from the subsequent gain in the value of their underlying assets.
In some ways the boon from being unhedged was a fortunate break, and there is nothing to say that the next big move will not be a rise in sterling, which would create losses for British investors. The pound did bounce back on 12 September, hitting near $1.33, but at the time of writing had slipped again to around $1.30.
The reality, as always, is no one knows what markets will do, but in a lower for longer world in which yield remains scarce, institutional investors’ portfolios are becoming more globally diversified and the case for hedging foreign-denominated assets is becoming stronger. An important question therefore, is whether these assets should be left unhedged or whether a partial or
complete hedging strategy should be implemented?
In recent years, UK pension funds have generally tended not to hedge currency risk as prolifically as their European and global counterparts.
One reason is UK funds have traditionally had a high bias to domestic assets, making currency hedging unnecessary. That bias has reduced considerably over recent years however, with UBS’s latest Pension Fund Indicators report revealing in 2015 UK pension fund exposure to global equities was 13% higher than in UK equities – a shift, it seems, that has not been reflected in the appetite for hedging.
Another significant reason for the lack of hedging is the bad reputation gained by currency after the 2008/9 crisis. Some investors were burnt by hedging strategies which took too much alpha risk and subsequently underperformed.
Neuberger Berman head of currency Ugo Lancioni explains: “Back in 2007/8 carry and momentum were extremely popular. Carry was a dominant factor but when investors loaded up with carry they ended up having drawdowns when equity markets dropped and currency strategies based on carry underperformed.”
It is not just investors scarred by currency: some consultants also remain wary, having supported return-seeking currency strategies prior to the crisis and witnessed them implode in front of their eyes.
“There are not that many satisfied customers of return-seeking currency mandates and that has led to the currency topic being abandoned a bit as it has not been a big vote winner,” says Charles Goodman, chief executive of Edmond de Rothschild Asset Management (EdRAM) UK.
“Consultants have since been wary of raising the topic too closely,” he adds. “They have been remiss in focusing on this and trustees have in many cases been burnt by currency as an asset class and are a bit allergic to anything related to currency.”
But it is important to distinguish between momentum-based return-seeking currency strategies and those that hedge currency. While perhaps not as high up trustees’ agendas as other sources of portfolio risk, currency exposure is still a source of unrewarded risk and investors are encouraged to focus on the benefits of hedging – especially now sterling is at a low level.
EdRAM’s Goodman believes the debate around what currency hedging can offer in terms of portfolio returns is pretty pointless. This is because the expected return of currencies in general should tend towards zero and so cannot give an expected return. What trustees can and should debate, he adds, is the expected impact of hedging on the risk and volatility of the portfolio.
“The total volatility of the typical currency mix of a UK pension fund is probably between 5% and 10%. If you have a contributor to the portfolio that has an expected return of zero but a volatility higher than zero in the case of currencies – that is clearly an unrewarded risk.”
NOW IS THE TIME
Many experts believe the low sterling price makes now an ideal time to hedge. Aon Hewitt head of investment EMEA, John Belgrove, says timing should be based on the relative valuation point around the expectation of long run fair value between currencies, which is attractive at present.
“Above $2 you might say that is a good time to take off hedging, while south of $1.30 you might say is a good time to add it,” he says. “Post-Brexit, UK sterling got down to the low $1.20s and we saw that as a good time to add some hedging.”
Lancioni agrees the drop in the pound post Brexit represents an opportunity to hedge at much more appealing levels. He alludes to historical data on the real effective exchange rate from the Bank of England, which shows sterling has fallen about 17% in real terms since before Brexit – and is about 20% cheaper than the pre-crisis level on average (see chart inset – click to enlarge).
“From a long-term valuation perspective, sterling has dropped a lot,” he says. “Our assessment is based on long-term inflation differentials, so we look at the real value of those currencies and this big drop in sterling has made it more attractive. We would recommend taking advantage of those opportunities as over the long run this level will make the country more competitive.”
BUT HOW MUCH?
Now might be seen as an opportune time to strike hedges, but exactly how much to do is the next key question.
Many experts have attempted to establish whether there is an optimal hedge ratio which minimises expected volatility. Each scheme will of course be different, but received wisdom is that fixed income portfolios should be fully hedged, while equity or balanced portfolios should be partially hedged, if at all.
The underpinning theory of being unhedged in an equity portfolio is that in the long run, currency movements are a zero-sum game. There will be currency volatility but it is negligible next to the equity volatility and so hedging adds an extra cost drag to the portfolio.
For fixed income, the argument goes that currency volatility dominates bond volatility and investors are advised to hedge because they run the risk of the movement of the total return being too driven by the currency movements and not the underlying bond components.
Investment time horizon is also important. According to Aon Hewitt’s Belgrove, it is sensible for long-term investors with a globally diversified portfolio to be unhedged on equities and fully hedged on the bond component. But, he adds, if equity investors’ time frames are short, it is sensible to hedge somewhere in the region of 50% plus.
Belgrove says: “If you think about a diversified portfolio which has equities and bonds and a global dimension, you will be partially hedged if you 100% hedge bonds but don’t hedge equities. We think that makes sense as an overall portfolio context and it is an easy way to implement. The rationale is hedging around half eliminates the volatility, but doesn’t add to your cost burden as much as fully hedging and in particular does not give rise to difficult cashflow problems because if you hedge currency you have to keep meeting cashflows.”
Neuberger Berman has crunched the numbers using its own hedge ratio tool and at the time of writing recommends a hedge ratio of 70% for global equity managers
because of the current low sterling level – compared to around 40% pre-Brexit.
HEDGED VS. UNHEDGED
By way of illustrating the benefits of hedging a bond portfolio, it is worth considering the performance of emerging local markets, both currency hedged and unhedged, over the last 15 years – the time period over which the JPMorgan GBI-EM index, a metric for the performance of the asset class, has existed.
Hedge fund firm WHARD Stewart observes the currency unhedged index has returned 9.1% annualised, in sterling terms, with a volatility of 11.5% while the currency hedged index has returned 5.4% with a volatility of 4.6%. The unhedged returns are significantly higher, around 6.5% per annum, due to the yield (carry) that stems from taking the FX exposure, but the volatility is 2-3 times greater.
WHARD Stewart head of research Darrell Tonge says: “In fact, the additional FX risk being taken is greater than created from the underlying foreign bond portfolios themselves. While the returns of the hedged index have been lower, the reward-to-risk ratio (or Sharpe ratio) of the hedged index is superior.”
While sterling remains at low levels, investors are faced with a choice: spend a bit of money to add full or partial hedging, or remain unhedged and enjoy the current, but perhaps short-lived, windfall.
But making a decision is complicated as Brexit itself has not yet taken place. When the nature of the deal becomes clear there could well be more downward moves in the currency, in which case the unhedged investors will again flourish, potentially giving a false sense of security.
Goodman fears that for schemes to really begin to address currency hedging, will take a period of sterling strength, causing them to see losses from currency exposure.
“It won’t be too late [to hedge],” he says, “but it won’t be perfect timing.”