Croydon Council is considering hedging the currency risk in its pension fund.
Members of the council’s pension committee are exploring the option of a currency hedge for the equity investment part of the portfolio.
The decision carries risks and costs for Croydon. Volatility in global currency markets is significant due to factors including Brexit and unpredicted policy decisions by the current US government.
A report to committee members made it clear: “Heightened volatility in currency exchange rates has a direct impact on the pension fund. This volatility can be managed by employing various hedging techniques. However, these techniques can be expensive, and movements in exchange rates can be beneficial as well as damaging to the fund.
“Past pension committees have discussed the merits and demerits of actively managing this issue on a number of previous occasions but have never executed a currency hedging strategy,” it said.
The report revealed the liabilities of the Croydon pension scheme are denominated in sterling so any exposure to foreign currency through the asset portfolio can lead to an increase in volatility with little or no additional expected excess return.
The review isn’t surprising; according to Mercers – which Croydon commissioned to write a report with advice on its options – three quarters of UK pension schemes are reviewing investment strategy.
What’s changed is the impact of Brexit. Croydon’s team explained: “Since the outcome of the referendum on leaving the EU, sterling has devalued so that UK investors with un-hedged overseas currency exposure have seen material gains from their position. This scenario is likely to continue for some time, dependent on the outcome of the immediate process.”
With a three-month extension of Article 50 now being negotiated, volatility is now set to continue.
Peter Gent, senior investment consultant at Mercer told Room151: “It’s not about calling the market. It’s making sure fund managers understand the risks and have the information in place to deal with them.
“The world is moving at a faster pace and US interest rates are going to change. Sterling has been very weak recently. For some funds they’ve seen an opportunity. However, the thing to remember about the local government pension scheme is that it invests for the long term.”
Not calling the market and being very aware of what could happen if events change is a view also shared by decision-makers in the sector.
Mike Jensen, director of investment at Lancashire County Council, said: “The academic work strongly suggests that for long-term asset holders, currency hedging is unnecessary or inefficient albeit there has to be an acceptance of short-term mark-to-market volatility.”
He adds: “Making one-off hedging decisions across specific market, global or political events is obviously a very short-term market picking event and should be driven – if at all – by risk profile/management rather than ‘market call’. This form of FX hedging, whilst cheap to execute, has de facto an extremely wide range of possible outcomes.”
Croydon’s pension committee is considering the LGIM Developed World ex-Tobacco Fund as its preferred option. It says the fund “fits the criteria set out in the Mercer report for implementing a currency hedge”.
However, a final decision won’t be made until specialist legal advice has been received on the implications.
The committee is clear that it is taking a long view: “In the long run the impact of currency movements will likely be neutral. This strategy is more about eliminating, or whenever possible, mitigating the effects of volatility.”
by Chris Smith
