Michel Thomas is investment director at PensPlan Invest

Italy's PensPlan Plurifonds, the €80m open-pension fund based in Trentino-South Tyrol, takes a case-by-case approach to currency hedging. "At PensPlan, we do hedge part of a portfolio when we are worried about the potential weakness or loss of the currency in which we have invested versus our base currency - the euro," says Michel Thomas, investment director at PensPlan Invest, the investment arm of the foundation Centrum PensPlan, which has assets of €254m.

"We have done this now for about four years because we felt we had the technical ability to partially protect a portfolio, principally against dollar weakness," he adds.

Taking out a full hedge is not seen as the right way to go. "In general, we would never hedge a portfolio 100%, but in increments to 33%," says Thomas. "If we perceive that the currency in which we are invested is really going to collapse, then we could increase the hedge ratio further."

This would then be done by selling the dollar forward on a three-month basis, he says, closing the position once the loss in the currency and the gain in the forward had materialised.

And so far PensPlan's hedging tactics seem to have worked well. Thomas says: "Our success ratio has been well above 50%, so we are pleased with this portfolio tactic."

The theory of mean reversion probably does hold true for foreign exchange rates, he says, but today's pension funds cannot afford to ignore short-term risks. "It is probably right to say that these movements correct each other, but nowadays, pension funds are under performance pressure as well, and have to show that they take currency risk and loss avoidance seriously," he says.

In any case, the cost of hedging was not necessarily high. Thomas says: "In practice, currency hedging with forwards is not expensive, and the cost can be recovered from the gain realised by the operation, when it is successful," says Thomas. "In fact the cost is already in the forwards used to do the hedge."

As well as these hedging tactics, PensPlan has put an overlay in place. "We have also started a currency overlay programme with Rothschild, using a quant model that in this case starts selling dollars when 10 different models deteriorate," he says.

"It has been quite a successful method of operating," he says, pointing out that the overlay programme is paid for on a commission basis.

"We believe that currency hedging adds value," he says, not least because it puts a healthy pressure on an investment team to fine-tune decisions.

Overall, however, the primary benefit for a pension fund in having a currency hedge in place is the modest improvement it can expect in performance - and the main drawback is the extra administration it could involve.

 

Justus van Halewijn, head of investment strategy research, Blue Sky Group

Fiduciary manager Blue Sky Group hedges all the world's major currencies for its pensions clients, which include the pension funds of Netherlands airline KLM.

"We hedge the main currencies - the US dollar, Japanese yen and pound sterling - on a yearly basis from a strategic point of view," says Justus van Halewijn, head of investment strategy research. The group manages more than €12bn of assets, and most of its clients' pensions liabilities are denominated in euros.

Although Blue Sky Group now operates the portfolios of all its clients on a fully-hedged basis, the individual funds adopted currency hedging at different times.

Hedging against foreign exchange fluctuations may not be imperative for pension funds, but there are definite advantages to doing so, he says. "It's not necessary in a strict sense, but we think it's a good thing because it reduces short-term volatility," he says, adding that the few basis points the exercise costs are justifiable.

"For a limited cost you can reduce your exposure to this short-term volatility. We don't want to have these fluctuations, though we realise that over 30 years or so, it won't make a large difference."

Blue Sky Group subscribes to the view that over a long period of time, all currencies revert to the same exchange rates, but also believes that the short-term picture matters.

"Hedging reduces volatility; it's a risk, and we don't want to take risks that go unrewarded," says Van Halewijn.

"Currency levels can diverge from each other widely for many years - it is not just a few weeks we're talking about."

The group conducted research in an asset-liability management (ALM) context into whether it was better - in the Netherlands - to hedge foreign investments or not, says Van
Halewijn. It was obvious that the ALM properties of the portfolio improved when the unrewarded currency volatility was reduced, he says.

This insight led to discussions with trustees and ultimately to the decision to become fully hedged. But equally, a decision was taken not to use currency management as a way of enhancing investment returns.

 

Jean-Pierre Steiner, CEO of Nestlé Capital Advisers, Nestlé

Currency may be a zero-sum game in the long term, but given today's accounting standards, pension funds can ill afford to leave their exposure unhedged, according to Jean-Pierre Steiner, CEO of Nestlé Capital Advisers, the new Nestlé subsidiary that manages the group's many pension funds.

"The argument that corporate pension funds can be long-term investors is no longer really true," says Steiner. "For corporate pension funds, at least, any surplus or deficit is carried on the corporate balance sheet," he points out.

"Their long-term horizon has been shortened by accounting standards, and therefore currency fluctuations come through as a source of volatility for the company," he says. "It would be ideal if pension funds could retain their long-term horizon, but those with a defined benefit scheme have to watch out for the effects on the company."

It is a different story for pension schemes run on a defined contribution basis, although these schemes still have to consider the effect of short-term risks for members.

Steiner says the majority of the pension funds he is responsible for do hedge their foreign currency exposure. "Currency creates a lot of volatility that is probably not rewarded - depending on the theory one believes in," he says. Altogether, the Nestlé pension funds hold assets of around CHF30bn (€18.1bn).

"Of course, a certain degree of currency exposure does contribute to diversification; depending on the base currency, we could tolerate 15% to 30% exposure, but not more than that," says Steiner.

Whether currency hedging is expensive or not depends on the base currency, says Steiner. "It depends obviously on the interest rate differential," he says.

The cost can be high when the base currency is a low-interest rate, such as the Japanese yen, he says, but those investors hedging back to sterling, for instance, often earn a premium.

As well as hedging its foreign exchange exposure, Nestlé also uses a currency management overlay to add alpha.

Steiner says: "The objective of the currency overlay is to add alpha; you can see that as a way of reducing the cost of hedging."

 

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