National Grid U.K. plan gradually moving to match future liabilities

The National Grid U.K. Pension Scheme, London, is in derisking mode.

“There is a long-term strategy for the scheme, which is designed to match future liabilities,” said Stuart Waldron, London-based chief operating officer at Aerion Fund Management Ltd., the in-house money management unit that runs 80% of the £15.4 billion ($25.8 billion) defined benefit plan.

“We have been moving 1% of the assets into fixed income from equities each year as part of this strategy. We will retain return-seeking assets for a significant time period — whilst we are a reasonably mature scheme, the time horizon remains long term.”

The fund is closed to new employees and has 120,000 participants, 83% of whom are retirees.

About 58% of the assets are in fixed income, across domestic and international allocations, and 27% are in equities across the U.K. (£1.2 billion) plus allocations to Japanese, North America, European and emerging markets totaling £2.9 billion. “Over the next 20 years or so, those return-seeking assets will be moved gradually to a liability-matching portfolio,” said Paul Sharman, CEO of Aerion.

As the pension fund continues to mature, Aerion is looking at every part of the portfolio for potential drags on performance.

The latest example of that is examination of its currency exposure.

The fund has a significant exposure to overseas equities - currently about £3.5 billion, said Mr. Sharman. Because of those international allocations, the fund has 36 individual currency exposures.

The top five — covering the U.S. dollar, yen, euro, Swiss franc and Australian dollar — account for 87% of the total exposure. The top 10 currencies account for 95% of total currency exposure.

Fifteen months ago, Aerion decided it was time to look at the effect these exposures were having on the value of the plan.

“We started a review of how we managed currency risk,” said Mr. Sharman.

The fund has had a passive hedging strategy in place since 2007, with 50% of currency exposure hedged and 50% unhedged. Being pound sterling-based, the fund historically had passively hedged 50% of its currency exposures back to the home currency. “It is a passive strategy because once the hedge ratio is set, the exposure is mechanically hedged at 50%, and no judgment is made on varying that ratio,” said Mr. Waldron.

Aerion officials decided to analyze historical currency movements and found a dynamic hedging program would have generated significant returns for the fund. So executives looked at their options. “We looked at fundamental overlay, carry trades and other options,” said Mr. Sharman. And then Aerion executives met with people from the money management arm of Berenberg Bank and looked at its quantitative approach to currency overlay.

After three due diligence visits to Hamburg, Germany, where Berenberg runs its currency hedging program, Aerion's executives took the dynamic currency hedging strategy to the pension fund trustees. The strategy was approved in November 2013, and by mid-January the program was up and running.

“We dynamically hedge 19 (overseas currencies) because of the size of our exposure - anything over £10 million we will hedge,” said Mr. Sharman. In exposures of between £100,000 and £10 million, the manager has retained a 50-50 hedge. National Grid “wants to benchmark us against its old 50-50 benchmark. Our foreign exchange exposure will vary depending on where we decide to put assets overseas - we wanted something flexible because of that.”

Berenberg's quantitative models identify trends in individual currency pairs, said Matthew Stemp, director, relationship management for U.K. institutional clients at Berenberg in London, and the firm then buys or sells currency forward contracts depending on whether there is appreciation or depreciation.

“In a strong uptrend when a currency, for example the U.S. dollar, is appreciating vs. sterling, the models will indicate that there should be no hedging and the portfolio will benefit from the strength of the U.S. dollar vs. sterling,” said Mr. Stemp. “When the U.S. dollar starts to depreciate against sterling, the models will indicate that we should sell exposure through one-month currency forwards to lock in an exchange rate at the prevailing rate, thus protecting the sterling investor from a depreciation in the U.S. dollar assets.”

Berenberg, which dynamically hedges about e10 billion ($13.8 billion) of nominal exposure in its currency strategies for clients, covers the spectrum of the pension fund's exposures.

“We look at so many currencies because, although you may be getting down to small exposures, a lot of these currencies are correlated with the larger currency exposures,” said Mr. Stemp. “If you are able to dynamically hedge those, you achieve a much better return.”

Over the long term, Aerion's analysis has forecast an additional 10 basis points per year for the pension fund, just by implementing the strategy.

Berenberg's strategy hedges the fund's actual exposure. Aerion provides the currency manager with its asset exposures and “within 24 hours we have hedged it,” said Mr. Stemp. “It is managed 24 hours, six days a week. All the time a currency market is open we have people in Hamburg ready to change the hedging ratios as currencies move. We don't run a process of buy and sell automatically - it is all run by individual portfolio managers.”

He said that while currency is “incredibly liquid, so quite inexpensive,” slippage — any difference in price between the time of the trade order and execution — can cost a fund dearly. “The slippage you can pick up by trading large amounts can be critical - if we are one basis point away from the best price, that costs the client. We spend time and effort making sure we get the best price and at the best time,” said Mr. Stemp.

It is too early to tell whether the strategy has been a success, said Aerion's Mr. Waldron. “Currency markets have been quite flat - we will see the benefits as trends develop. That is the dynamic part of it. Since implementation in mid-January, we have been in a fairly benign climate and the overlay has performed in line with what we would expect,” he said.

But Berenberg's Mr. Stemp thinks implementation has come at the right time, and that it is part of a bigger trend of pension funds abandoning their passive currency hedges and going active. They include the $287.7 billion California Public Employees' Retirement System, Sacramento, which said in a February asset allocation plan that it was breaking with its 22-year traditional of passive currency hedging. Sydney-based superannuation fund AUSCOAL Super, which has A$7.9 billion (US$7.1 billion) in assets, also announced in February that it was shifting its passive currency overlay program to an active, dynamic hedging strategy, combating the effects of currency risk on more than A$1.6 billion of international equities exposure.“We are entering a market where currency differentials will be greater than they have been in the most recent past, as many economies are recovering at different speeds, and there is a divergence in interest rates,” Mr. Stemp said.

Although 80% of the fund is run in-house, Mr. Waldron said recognition that internal expertise cannot cover all bases means the internal capabilities are “constantly under review, and the Berenberg arrangement is a good example of where a third party has a specific skill set that can add value to our fund.”

Aerion outsources parts of its overseas developed and emerging markets equity allocations, accounting for £2.9 billion of the fund, as well as parts of its £600 million alternatives portfolio.

“Until recently we didn't have alternatives (in the portfolio),” said Mr. Sharman. “We are currently reducing our equity allocation and increasing our exposure to alternatives.” Mr. Waldron said that allocation covers the spectrum of alternatives, including hedge funds, and “could include infrastructure” - although it has no allocation to the asset class right now. n