Charlotte Moore considers why pension schemes need to pay more attention to foreign exchange markets
- Prior to the financial crisis foreign exchange was viewed as a useful tool to capitalise on macro-economic trends
- Pension schemes can ill-afford to ignore the return of volatility to the currency markets
- Experienced investors, however, are taking a more active approach to managing these currency risks
Before the global financial crisis, foreign exchange (FX) was viewed as a useful tool to capitalise on macro-economic trends. But after 2008 the profits from this strategy evaporated, along with currency volatility as central banks around the world marched to the same low-rate drum.
Over the last 15 months, however, economic growth rates have started to diverge and the currency markets have come back to life. While the last year has been dominated by the strength of the dollar, more granularity is likely to emerge over the course of 2016.
Record Currency Management chief executive James Wood-Collins, says: "An increase in the breadth of different interest rate environments around the world along with a return to more normal volatility levels creates more opportunities for currency investors."
It's not only the return of an economic growth differential which is having an impact on FX markets: the recent collapse in commodity prices has a very significant impact on the value of countries' currencies which rely on global demand for these materials.
Pension schemes can ill-afford to ignore the return of volatility to the currency markets. FX is a useful tool to add some much needed alpha to portfolios given the current very low yield of traditional asset classes, such as investment bonds.
Harmonic chief investment officer, Patrick Säfvenblad says: "Currencies act as buffers in the global system and the return of different growth rates between economies makes it relatively easy to predict how currency pairs will move." This can provide a good additional source of return to a balanced portfolio, he adds.
Size of the market
The size of FX markets is another appealing characteristic. Phil Edwards, European director of strategic research within Mercer's investments business, says: "While currency is not a traditional asset class which can be bought and expected to generate return over time, foreign exchange markets are large and liquid."
In addition, there is a wide range of different market participants such as central banks and large institutions which use this market solely for hedging. Edwards says: "The different goals of these institutions provide many trading opportunities."
While pension schemes could exploit the opportunities in FX markets by appointing a specialist hedge fund manager, consultants recommend trustees regard currency strategies as just one tool in the kit of a hedge fund manager.
Edwards says: "In the past, schemes would allocate to hedge funds with a specific currency strategy but we now recommend they select managers which use a range of different instruments to express their views."
The return of a more normalised currency environment has enabled hedge fund managers to employ a broader range of more sophisticated investment techniques - it's no longer all about the carry trade.
Just as equity managers can choose to tilt their portfolio towards different investment styles such as value, growth and momentum, so currency managers can choose to exploit different trading strategies.
Wood-Collins says: "There is now a strong investor focus on the different drivers of FX returns." Along with the carry trade - which exploits the interest rate differential between two currencies - investors can also follow market momentum or reversion to fair value, as defined by the purchasing power parity model.
Edwards says: "More sophisticated pension schemes are looking for managers who will exploit these well-established sources of currency return premia." Along with hedge fund managers, there is a new breed of strategies which systematically capture these returns, often at much lower cost than hedge funds. These can be thought of as ‘smart beta' currency strategies.
Fixed income opportunities
But not only are systematic strategy providers taking advantage of currency opportunities, so too are fixed income managers. Bluebay Asset Management has recently launched a global sovereign fund which aims to generate a substantial source of the return from foreign exchange.
Current debt market conditions are forcing managers to think more laterally about generating decent returns. Russel Matthews, portfolio manager at BlueBay Asset Management, says: "There is very little yield in the investment grade markets - for certain sovereigns, yield is negative in nominal as well as real terms."
In addition to limited yield in the investment grade market, corporate bond liquidity is highly constrained due to balance sheet restrictions making it uneconomic for investment banks to act as intermediaries in this market.
In contrast to the limited options on the bond market, there are abundant opportunities in the FX markets. Matthews says: "If investors are prepared to move further down the credit spectrum, there are countries such as South Africa and Turkey where base rates are currently 6.5% and 7.5% respectively."
Despite these higher interest rates, many investors may well baulk at allocating capital to emerging economies. China's economic slowdown and the associated collapse in commodity prices have spooked many investors. But negative market conditions can provide rich hunting grounds - some assets will have been unfairly penalised.
Matthews says: "While some central banks have adopted the right policies to help to solve their country's economic woes, others are moving in the opposite direction and losing credibility."
With the right resources and experienced specialists, it's possible to carry out the necessary analysis to determine which economies - and associated currencies - will appreciate and which will decline, adds Matthews.
Not only are there more opportunities for decent levels of yield in FX but these markets are also large and highly liquid, suffering none of the constraints of bond markets. Matthews says: "It's possible not only to take large positions but also to change these positions quickly and easily in this asset class."
As well as considering the return opportunities offered by currency markets, investors should also consider the risks more normalised market conditions present. Edwards says: "The recent return of big currency moves means FX can be a significant problem for pension schemes."
Currency risk can be of particular concern for equity market investors - as illustrated by the recent performance of Japanese equities. Investors who did not hedge Japanese equity positions in recent years would have seen all their returns eroded by currency movements.
For truly long-term equity investors, currency should be less of a concern according to Franklin Templeton Solutions portfolio manager, Toby Hayes: "If an investor is holding global positions for at least a decade, then currency movements will come out in the wash."
However, it can take a long time for that law of averages to play out. Hayes says: "Macroeconomic themes can develop and persist for many years."
Pension funds need to carefully evaluate whether they should be hedging the currency risk associated with their international asset portfolio. Edward says: "Schemes should assess how much they can tolerate their domestic currency appreciating against their overseas investments."
That has to be balanced against many companies in the equity portfolio implementing their own currency hedging strategy; the dollar often being considered a safe haven when the market is risk adverse as well as the complexities and expense of maintaining a currency hedge.
Edwards says: "Most large and sophisticated pension schemes will, however, decide that it's worth hedging to protect them from currency moves eroding their returns from their international equity portfolio."
Experienced investors, however, are taking a more active approach to managing these currency risks. Säfvenblad says: "At first an investor will, for example, remove 75% of its currency risk from its equity portfolio."
But schemes soon recognise this policy is expensive. Säfvenblad says: "This can erode returns over the long term because the equity markets which perform the best are also those with the strongest currencies."
Over time institutional investors become more sophisticated in their hedging policy. Säfvenblad says: "For example, they will decide to increase their dollar hedge when the foreign currency is weakening in order to reduce hedging costs."
Rather than simply buying a hedge irrelevant of the current value of the currency, investors start to use market conditions to their advantage and consider whether a currency is likely to depreciate or appreciate over the medium term.
If, for example, a pension scheme had an allocation to both Norwegian and Canadian equities, it would make sense to hedge its exposure to the Canadian dollar but not to the Norwegian krone. Säfvenblad says: "The Norwegian krone is already very weak and unlikely to fall further but the Canadian dollar could still depreciate significantly."
Using a sophisticated hedging strategy helps an institutional investor to better understand the opportunities and threats available in FX. Säfvenblad says: "Very often schemes will then start to see currency as an integrated part of a portfolio which can both provide an additional source of alpha as well as helping to manage risk."
The newly galvanised foreign exchange markets are not something pension schemes can afford to ignore. Hayes says: "If an investor chooses not to ‘do' macroeconomics then they will invariably find that macroeconomics ‘does' them." It's far better to become familiar with the FX markets and use them to provide additional returns as well as manage currency risk.
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