Hedge forex within your pension pot

THE reasons for currency hedging with a portfolio are fairly straightforward. Any purchase of an international asset requires the equivalent investment in the foreign currency in which that asset is denominated. According to Mark Hogg, director of forex product development at RBC Dexia: “FX risk is an investment risk like any other and needs to be carefully managed. Choosing not to manage the embedded currency risk in foreign currency holdings is an active investment decision in itself.”

Though hedging is important in any portfolio, it can be especially important within a pension fund. Given that asset allocation within a pension fund is more orientated to fixed income over equity, with the investor moving towards a lower risk approach, currency hedging becomes crucial. In addition, there is a small positive correlation between domestic fixed income and currency (whereas between domestic equity and currency the correlation appears close to zero), and so currency becomes less of a diversifying investment, making hedging even more important.

Some managers may favour naturally hedged assets. However, while individual assets may be naturally hedged, the portfolio of assets denominated in each currency is not.
According to active currency managers Adrian Lee & Partners, currency exposure is inherent to an international investment and ought to be managed, and portfolio managers should not simply consider it as a hidden investment. Due to the separate nature of currency from assets, investors can unbundle currency from assets and look at the main policy issues that would be looked at for a separate asset class.

This is where currency overlay can be particularly useful. Currency overlay refers to the management of currency exposures in an asset portfolio, by a separate firm or by a department separate from the currency manager. Rather than simply hedging against currency movements, an overlay manager replaces the currency positions usually made by an underlying asset manager with a specialised and deliberate currency investment position. The idea is that, rather than currency positions being a secondary consideration to asset choice, the investor is left with the best currency positions from the currency specialist and the best asset decisions from the asset manager.

According to Mark Hogg: “It can often depend upon the relative contribution of currency risk to overall portfolio risk and return. For example, if investing in foreign currency bonds then the return volatility of the currency component can far outweigh the risk on the investments themselves.” Hogg adds: “If one considers too that bonds are often a defensive play for many investors and furthermore the currency risk component of the portfolio returns may have no expected return, then you have to be asking the question, why am I not managing the risk?”