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.