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As pound rebounds, case for currency hedging strengthens

U.K. DC plans should consider stand-alone programs, experts say

James Wood-Collins
James Wood-Collins said U.K. investors without a currency hedge in place have lost 4.5% on U.S. equities in the first four months of this year.

Trustees of U.K. defined contribution plans should consider implementing a stand-alone currency hedging strategy that takes advantage of the pound's position against other major currencies, sources said.

While a number of defined benefit funds already apply strategic currency hedging to protect against currency fluctuations, many DC plans do not have such positions in place, sources said. Instead, trustees rely on their equity money managers to hedge portfolios on their behalf.

But the case for a stand-alone currency hedging program is more relevant now than ever, sources said, for several key reasons.

The fact that DC plans are much larger in size, following the success of automatic enrollment in the U.K., is a factor in favor of a stand-alone program because the plans now have the scale and the skills to engage in a more sophisticated investment practice. U.K. DC plans count some 14.8 million members, according to The Pensions Regulator's 2016 data. The workplace DC market was 351 billion ($432 billion) at the end of 2016, according to research firm Spence Johnson.

The pound sterling's recovery in recent months, particularly apparent since British Prime Minister Theresa May announced last month that the U.K. general election would be held June 8, is another key factor.

Since the Brexit vote in June 2016 through May 24, the U.S. dollar has risen about 12% against the pound. But in the last eight weeks, the pound traded up 3.2% against the dollar, hitting a two-month high at $1.30 on May 25.

Although sterling remains low, there is no particular reason to think this is likely to continue, said Charles Goodman, head of business development at London-based Millennium Global, a currency management firm. “We would expect to see a wide variety of environments in the coming years, as we have done in the past,” Mr. Goodman added.

The U.K. currency's rebound seems to have prompted investors to revive hedging strategies, even causing some trustee-directed DC funds to overhaul their currency policies.

“There is 5% to 10% more demand for currency hedging from DC plans recently compared to previous years,” Joanna Sharples, investment principal at Aon Hewitt in London, said in an interview.

Trustees can implement active currency hedging programs as an overlay with the help of specialist currency manager or request their equity managers to provide it in the default fund.

Robert Bennett, senior manager, pensions investments at Siemens U.K., which implemented a currency hedging program in April for its DC plan, the 1.3 billion ($1.7 billion) Siemens Investor Plan, Camberley, England, said: “Our main focus when redesigning the DC investment strategy was our members, in particular, mitigating the risks they face when saving for retirement. The risks that overseas currencies can introduce for DC savers are often overlooked. We ensured that this wasn't the case for our members by carefully considering the risk and return trade-off and then implementing a currency hedging strategy that we believe will improve the investment experience of our members.”

There are practical challenges to developing currency hedging strategies for some DC retirement arrangements — one being the issue of beneficial ownership.

Where a sponsoring employer takes responsibility for the plan, like it would in a DB plan, it would likely be easier for to implement a strategic program, said James Wood-Collins, CEO of Record Currency Management based in Windsor, England. “But where the responsibility sits with an employee, it will be much harder to do it” because such action is not taken collectively.

The justification for additional fees is another challenge. Additional management costs for currency hedging a global equity investment range from 0.02% to 0.06% per annum, according to a recent paper from Aon Hewitt, “Does Currency Hedging Matter in DC?”

Reducing risks

Nevertheless, the magnitude of currency risk should not be downplayed, particularly for a DC plan.

“To leave all currency exposures unhedged in a portfolio can result in currency often becoming the second-largest risk in portfolios after equity risk,” said Shoqat Bunglawala, head of the global portfolio solutions group for EMEA and Asia Pacific ex-Japan, at Goldman Sachs Asset Management based in London.

Investors who didn't have a currency hedge in place this year have paid the price for it, said Mr. Wood-Collins.

“Having not hedged the currency risk would have cost a U.K. investor invested in U.S. equities some 4.5%, and in global equities 3.6%, in just the first four months of this year,” he said.

By comparison, during 2016, unhedged investors benefited from the sterling's weakness. The Aon Hewitt paper noted the advantages of sterling exposure to overseas equities in the year ended March 31.

Ms. Sharples said that “an investment in U.S. equities in sterling terms allowed a return of 35% to an investor with no currency hedging vs. 17% where currency hedging had been applied in the 12 months to March 31, 2017.” Average index returns of local currency Japanese equities were 14.5% in the same period vs. 32.8% returns in sterling terms.

Conditions now have changed. With the pound consistently rising since March, more DC funds should begin to recognize the need for active hedging, sources said.

“It is widely accepted that in the long run, currency effects increase the risk of a portfolio but have little or no impact on expected returns,” Mr. Goodman said. “Therefore, in general it makes more sense to hedge than not hedge for investors whose liabilities are well defined in a single currency, such as U.K. pension funds. In addition, we believe that there is a strong argument for an active hedging approach, with the aim of retaining some participation in favorable currency movements and avoiding excessive negative cash flows from the hedging process itself.”

Ms. Sharples said currency hedging offers an average 5% to 10% risk reduction over a 15- to 20-year investment horizon.

For some sponsors, the use of diversified growth strategies in a DC plan's default fund means it is not unusual to see active currency hedging embedded into the investment process, said Brian Henderson, partner, DC and financial wellness leader at Mercer in Edinburgh.

But sources point out the focus on equity return often means currency risk creeps into such strategies. An increasing need for currency management tools could lead more DC funds to become more sophisticated by adding currency hedging programs to a list of strategic objectives of the investment strategy rather than relying on existing offerings embedded by managers.

The “currency hedging strategy has been implemented across all of our investments, including the default strategy,” Siemens' Mr. Bennett said.

This article originally appeared in the May 29, 2017 print issue as, "As pound rebounds, case for currency hedging strengthens".