Triggering Article 50 – should defaults currency hedge?

To hedge or not to hedge? Predictions of political and economic volatility as the Government triggers Article 50 means currency markets are entering choppy waters. John Greenwood finds pension advisers and providers hedging their bets

Ever since the surprise Leave victory sent sterling tumbling and most equity funds soaring, the question of whether to hedge against currency fluctuations has been thrust to centre stage. Annoyingly for the investment purists, doing the right thing on currency has not paid off over the last 12 months. While defaults that hedge will give greater certainty of return, they will also have lost out from the currency aftershock of the surprise Brexit result – those that didn’t bother will have enjoyed a healthy uptick.

You won’t have to look far to find examples of hedged funds that have done better than their unhedged counterpart, and vice versa. And of course sterling could go back the other way, wiping out gains enjoyed through dollar-denominated earnings. So with experts predicting an intense period of political and economic sterling as the UK formally starts the process of exiting the European Union, how should those overseeing workplace pensions be addressing currency risk.

For Mercer UK DC & wellness principal Steve Budge, the Government’s approach to Brexit will be key. “The issue for markets is whether we will get a hard Brexit and another fall in sterling or a more gentle approach.

“You also have to remember that it is not just about Brexit. The US had looked positive, but now, since Donald Trump’s failure to get his healthcare reforms through, there is uncertainty over there, which is impacting the dollar. Markets have had a good run on the basis of him introducing reforms, but are they now going to pull back? Then there are the questions about where the Euro goes. The news from the Netherlands was positive, but there are other issues as well. But uncertainty remains. The long-term view is that we are not too excited about equities anyway, given the excellent returns they have delivered recently. So we are thinking should we be looking at reviewing assets allocation, to bring in different assets.”
Spence and Partners head of investment consultancy Simon Cohen believes currency hedging had been off the agenda for most schemes until the Brexit result changed things. “Putting currency hedging in place is a tactical approach. Default fund strategies are evolving and many use diversified growth funds. Theoretically these are being managed so currency hedging should be happening to a degree there.”
Like Budge, he points out there is plenty more than Brexit that can impact our currency.
“We are not so worried about the French election – we are fairly relaxed that Le Pen won’t win. But we are more concerned about Italy and we are already seeing the United States being pulled down because Trump could not get his reforms through Congress.”

Life offices appear to be taking a relaxed view on hedging of equities in the current environment.
Scottish Widows head of fund development and analysis Iain McGowan says: “The pension portfolios that form the underlying investment of Scottish Widows’ pension defaults are designed as long term investments and as such, we avoid short term tactical changes. The asset allocation of the portfolios is reviewed annually, with adjustments made as required to ensure the asset allocation is effective and the portfolios remain within their risk categories.

“Our recent review, in the last few weeks, concluded that the portfolios are best served for the long term by making no changes to currency exposure, specifically that they should remain unhedged on equities and hedged on corporate bonds.”

Aegon investment director Nick Dixon says: “Aegon’s default fund is globally diversified. Broadly it is three quarters equity and one quarter bonds, and it holds a mix of UK and overseas investments. In the nine months following the Brexit vote, the fund’s international exposure strengthened returns as sterling fell and UK investors benefited from the elevated value in pounds of overseas earnings. The upcoming EU exit means UK equities are likely to be more volatile than overseas markets in the medium term. We will watch how events unfold closely.”

Budge says standalone schemes are firmly divided between those who buy into the concept of hedging and those who don’t, even after the events of the last 12 months. “If you are unhedged, you have to ask whether you want to change things going forward. Currency can go either way and we think sterling is more likely to go up so you may want to be protective on the upside rather than worrying about sterling falling too much further. Saying that, we have a lot of clients who are not hedged and they see no value in hedging, even though they have reviewed that position in light of Brexit.”
Cohen thinks the whole currency bounce post-Brexit has highlighted what is effectively just another market risk. He says: “The key point from all of this is that default funds need something that can manage volatility. Currency is just one aspect of volatility. This is a freak event, but so was the credit crunch. Theoretically speaking the optimal hedge ratio is between 50 and 70 per cent, so maybe an answer as to hedge half of the default fund, so that you are not making a strong call either way.”