| Pension fund appetite for active currency mandates on the rise |
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| 14/10/2007 | |
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Currency has been gaining, well, currency among European pension funds. Active currency mandates have increased markedly, especially among UK local authorities. In 2004, bfinance advised one such €23m mandate with Flintshire County Council. By 2006, the number of active mandates increased to three; the largest was a €165m mandate with West Midlands. Year to date, six such mandates have been concluded or are in the pipeline, two of them with corporate pension funds. The largest is a €300m mandate with the West Yorkshire Pension Scheme. The West Midlands Pension Fund awarded three actively-managed pure alpha currency mandates last year, the first time it has ever done so. At the time, Judy Saunders, CIO of the £7.1bn scheme, said: "Our fund does not have a herd approach. We are quite forward thinking in the investments we are prepared to look at. Diversification is an important part of our approach to risk management." West Midlands has also put into place an in-house passively managed overlay currency hedge which is performing as expected. "To date, the performance of our three active managers has been mixed, with two performing well," says Saunders. "However, it is still early days as we are long-term investors." The £700m London Borough of Tower Hamlets pension fund is searching for a specialist currency mandate in addition to a passive currency overlay. Until recently, the fund's global equity mandate contained an element of hedging, but it did not have a separate explicit hedging program in place, says David Lyon, an officer in the finance department of the local authority who advises the fund. Global trend Evidence suggests that local authorities' appetite for active currency mandates has spread beyond the UK. Investors are attracted by the low correlation that currencies offer with equities. The drivers remain diversification and growing allocations in risk budgets to pursue absolute return strategies. Another important catalyst is pension funds' growing exposure to overseas equities, which has prompted some schemes to put into place currency overlay programs. This summer, the €21bn National Pensions Reserve Fund of Ireland (NPRF) invested €80m in the JP Morgan Euro Managed Currency Plus Fund. The fund targets an absolute return of 20%. JP Morgan's investment approach combines quantitative analysis and fundamental insight to exploit movements in the global currency markets. NPRF made its initial investments in currency funds in 2006 and continues to do so in 2007, says Adrian O'Donovan, senior manager at NPRF. NPRF hedges 50% of the foreign currency exposure arising from its non-euro denominated investments on the basis that this provides the most efficient trade-off between risk and return. Emerging markets and commodities, however, are excluded from the currency hedge. This is because a currency view is an integral part of the investment manager's decision to invest in a particular emerging market country, while commodities were incorporated into the fund primarily for diversification purposes, says O'Donovan. "Hedging the foreign currency exposure arising from commodity investments would reduce their diversification power." While the reserve fund's global investment profile exposes it to the risk of large swings in exchange rates, investment in non-euro denominated assets can also serve to reduce risk through the increased diversification that it brings to the fund. The 50% hedge is a passive hedge in that it is not varied in response to market conditions. "It is possible to increase the return on the fund's currency exposure by tactically varying the level of the hedge in the light of short-term market conditions," says O'Donovan. "To achieve this, the NPRF has allocated 1% of the fund to currency funds which seek to profit from short-term opportunities in the foreign exchange markets." Earlier in the year, Sweden's €7.7bn AP7 fund awarded a €640m currency overlay mandate to Lee Overlay Partners. The mandate does not have a specific benchmark. In the United States, CalPERS, has launched an active currency program with a focus on real return (see related article). "Much of what happens regarding allocations will be decided this month at our Asset Allocation/ Liability Workshop which takes place once every three years," says Clark McKinley of CalPERS. "Generally, the trend is to increase allocations to active management." Dutch and divided Not all pension funds are continuing their love affair with currency. Shell's €20bn Dutch pension fund uses forwards to hedge out its currency exposure. The decision to implement a strategic hedge was taken in tandem with a move to a more international equities portfolio. "Our principal reasoning is that currencies are not a source of alpha. They are a source of additional risk and so in order to reduce this risk we hedge the major currency exposures," says Sijb Bartlema, CIO of Shell Asset Management Company in Holland. "If you do an analysis of the return series of equity investments that are hedged and compare them to those that are not, you will find that the hedged return series is less volatile." Shell's Dutch scheme is invested 64% in equities, 30% in bonds and 6% in alternatives. Europe (including UK) accounts for 42% of the equity exposure so that the Dutch fund hedges 58% of its currency exposure in the portfolio. "I have seen investment banks promoting currency as a source of alpha, but that is driven mostly by their marketers," says Bartlema. "There is also a focus on absolute return strategies and a move into alternatives because some investors are concerned about equity valuations. If you read the papers in particular in Holland, you would come to believe that we are in a bear market, whilst we actually have been in a great bull market for the past four years. The vogue of absolute return strategies and LDI stems from the disbelief that equities can deliver the returns that we need, that originated from the 2002-2003 bear market. Some people find it difficult to acknowledge that that pessisimism has proven to be wrong." Among the leading Dutch pensions ABP considers currency an excellent alpha-generator. "It can be argued that the currency market is not the most efficient of markets and premiums can be earned with active management," says Thijs Steger of ABP. "We therefore use absolute return strategies to capture alpha. These strategies are not benchmarked against the actual currency exposure of the total fund. At the same time, the foreign asset portfolio remains fully hedged. We use currency both ways." VB |
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