The past two years have seen a fundamental change in the international investment environment for Euro-zone pension funds. In January 1999, currency risk for 11 EU members was eliminated for cross-border investment within the 11, and currency risk for non-euro members was concentrated by the elimination of nine currencies (Belgium and Luxembourg already had a currency union).
At the time of the introduction of the euro, there was a much-vaunted suggestion that pension funds within the euro-11 would adopt a new ‘pan-euro’ strategy, that would redefine international investments in the Euro-zone as ‘domestic’. The extent to which this has in fact come to pass is not clear, although there is no doubt that in the vanguard this strategy has been adopted – with pan-European manager structures to match. For Euro-zone investors, how has this affected their currency exposure strategy?
One approach (mainly Netherlands-based) is to view the entire EU as ‘domestic’. The impact of this is to require the elimination of residual currency risk associated with the non-Euro countries – UK, Switzerland, Sweden, Denmark and Norway. This has prompted a fully hedged strategic benchmark to be applied to these investments (which in the case of UK and Switzerland are substantial allocations).
When this strategy was conceived, in the latter part of 1998, it was widely regarded (within the Euro- zone) as axiomatic that the euro would be a ‘strong’ currency, and that overlay would deliver potential return benefits, as well as risk-reduction. The opposite has been the case – and the (opportunity) cost of these overlay programmes have tested the resolve of these funds. Those with a strong supporting risk-reduction case will (rightly) view the past 18 months as part of the inevitable, and volatile, cycle of currency movements.
The same view – that of prospective euro strength – did prompt some Euro-zone funds in late 1998 to review their currency strategy with respect to non-EU investments, essentially the US and Japan. Some concluded that they wished to reduce or remove their strategic exposure to these currencies, and they implemented currency overlay programmes. A brief survey of our database in this area, however, indicates that the majority chose active briefs over passive.
Switzerland has little overlay; despite the (erroneous) ‘lay’ view that the Swiss franc is a strong currency. However, as Swiss funds ‘modernise’ – ie, adopt the objective benchmark/specialist manager route, they are inevitably coming up against currency exposure as a strategic issue.
A small number have set hedged or partially hedged strategic benchmarks, although again the evidence is that most have opted for active overlay.
In the UK, a tiny minority of funds have hedged or partially hedged benchmarks, and consequently little passive currency overlay. The advent of the euro has not been viewed as a fundamental change in the currency exposures of pension funds, and the persistence of peer-group benchmarks and the still-prevailing view of the pound as a weak currency has contributed to this view.
However, there are signs that the consulting community has recognised that currency exposure has not had a diversifying effect on UK funds, and that the pound has in fact been a strong currency over the past 20 years, not a weak one. This is just now prompting a re-appraisal (or mostly just an appraisal for the first time!) of currency strategic benchmarks, and it is likely that this will lead to a series of changes to partially or fully hedged benchmarks in larger, mature and internationalised funds. Whether this prompts a rash of passive overlay mandates, or of active mandates, depends on how convinced consultants and funds are of the case for active value-added in currency overlay, and whether funds have a high aversion to the cash-outflow that passive overlay can bring.
What is clear in current trends in Europe, however, is that currency overlay is moving from a fringe interest to centre stage, and that the next few years will see a continuous stream of new overlay mandates in Europe, both passive and active.
Neil Record is chairman of Record Treasury Management in Windsor