European pension funds are grappling again with foreign-exchange risk, as the euro continues to climb against other major currencies.
Although the euro’s appreciation hit a roadblock in September after five months of gains against the dollar and other currencies, amid market jitters over German elections and the Catalan independent vote, the eurozone currency is resuming its climb.
Sources said that the most obvious impact of an appreciating euro can be seen on returns from emerging market local currency debt allocations, which coincidently were the top performer for many asset owners in the eurozone this year. Many pension funds upped these allocations in recent months, and the effect already has been felt in the quarterly returns across eurozone countries. According to Willis Towers Watson, currency movements since the start of 2017 on pension funds that did not hedge currency risk have trimmed returns year to date by 2.5 percentage points.
Luc Vanbriel, chief investment officer of Pensioenfonds KBC in Brussels, said: “We have decided to up our exposure to non-euro-denominated fixed-income assets earlier in the year from 20% to 25%. It was not the best decision so far due to the recent appreciation of the euro as these allocations include local currency emerging market debt. But we haven’t made any changes yet.” KBC has €1.6 billion ($1.8 billion) in assets.
Jose Marques, senior investment consultant at Willis Towers Watson in Lisbon, said that pension funds’ returns in the eurozone have suffered since the beginning of the year because of their exposure to overseas securities.
“(While) a 25% exposure to overseas currency is reasonable for many funds, if the euro appreciates, the value of your investments will be depressed on the 25% exposure. Some pension funds do currency hedging on their entire portfolio, but the risk reduction achieved by doing this needs to be weighed against the cost of hedging,” Mr. Marques said.
A typical European pension fund, according to the European Insurance and Occupational Pensions Authority, dedicates 25% of its allocation to global equities, 25% to global credit and 50% to euro-denominated fixed income assets.
Willis Tower Watson estimates — based on this typical portfolio makeup and an assumption that 50% of the overseas exposure is linked to the dollar — that this pension fund’s return from unhedged overseas investments would have suffered 2.5 percentage points. A pension fund that was 50% hedged would sacrifice 1.25 percentage points.
For some U.K. asset owners with high exposure to eurozone equities, the strength of the euro has been an additional headache. Strong projections on the performance of European equity, which triggered inflows back to these securities earlier in the year will mean some pension funds will need a currency hedge to win on these bets. European equity funds in 2016 had $113.4 net outflows. In 2017 year to date, EPFR recorded $32.7 billion net inflows.
Strathclyde Pension Fund
Strathclyde Pension Fund, Glasgow, Scotland is already addressing the issue. At the September investment committee meeting, pension fund executives decided to introduce a currency hedging program run by Legal & General Investment Management Ltd.
The £20 billion ($26 billion) pension fund's allocation to euro-denominated European equity, which excludes U.K. equities, makes up 15% of the total equity exposure. In investment documents shared by a Strathclyde executive, the pension fund highlighted that the currency hedging program is the result of a volatile relationship between the pound sterling and the euro. The executive declined to comment further on these developments.
Some sources said that currency hedging at the large pension fund level may be too complex. Mr. Marques advises that pension funds should not place tactical bets on currency on their own without external advice. "We advise that pension funds leave it up to their managers who can use a currency derivative option instead," he said.
In the eurozone, although pension fund executives may not be taking any drastic measures yet, the effects of currency movements have left them concerned about other parts of their portfolios amid concerns that the rising euro may force the European Central Bank to postpone plans to unwind quantitative easing.
Due to the appreciating euro, the European Central Bank may need to postpone its plans to exit quantitative easing, which was expected by market participants to start in 2018. And because the majority of European fixed-income allocations are dominated by eurozone bonds, pension funds had hoped ECB tapering would push the yields on eurozone government bonds back up, some sources said.
Philippe Desfosses, CEO at the €26 billion Etablissement de Retraite Additionnelle de la Fonction Publique in Paris, said any delay in tapering would further harm long-term investors.
"The ECB has bought a large portion of public debt contributing (thus) to depressed rates. A direct consequence of this policy is that in order to find the return, investors have to climb up the yield curve. But does it make sense for long- term investors and especially for pension funds to invest in bonds offering as low as 1.58% for the recently (issued) Austria 70-year bond?"
"At their current level, interest rates mean bleeding to death for long-term investors if they are forced to buy them. An investor has to be crazy to pretend that this is a good deal to get some 1.75% yield on a bond that is 70 or 100 years,'' he added.
The ECB is expected to provide an update on its plans to exit QE at the governing council meeting, Oct.26.
But "with the euro staying strong, it would take time for inflation to pick up in the eurozone on time and that could delay ECB's tapering plans next year. We consider it very difficult for ECB to start tapering with such a low inflation," Mr. Desfosses said.