Despite the immense importance of the foreign exchange exposure for global investors, the generally accepted approach to currency hedging at euro-based pension funds is too generic, sometimes – counterproductive and often driven by inaccurate assumptions.
Pension funds in the Netherlands and elsewhere in Europe implement a foreign currency (FX) hedging policy with an aim of limiting the risk (measured in terms of volatility) of the investment returns and consequently, the funding ratio. A typical hedging policy consists of multiple ad-hoc rules by asset class and may include for instance a hedging ratio of say X (usually below 100)% for JPY, USD, HKD and GBP equity (and similar) exposures and 100% of developed market and USD- denominated emerging market bonds. In this issue of Risk Wire we assess whether such ad-hoc rules can be improved by examining a large number of wholistic hedging policies for all asset categories in combination, and for the balance sheet of the fund (including liabilities). The question to be answered is whether the current typical policy can be improved by either limiting the costs of hedging at the same risk level or by achieving a lower volatility at the same cost.
The goal of the currency hedging policy is to strike a balance between:
- limiting the volatility of the assets and the funding ratio
- limiting the drawdowns in extreme circumstances and
- limiting the cost of currency hedging.
LINKS have carried out an empirical study based on actual monthly returns of the underlying asset classes, using a realistic portfolio rebalancing policy and multiple hedging policies. Our analysis
- hedging the total US dollar exposure at a significantly lower level than the typical current policies would deliver better results given the period of analysis. The optimal hedging ratio of US dollar for the full period examined (2005-2018) is close to 20%.
- currencies other than US dollar may be hedged up to 100%, however, the only currency that has a meaningful impact on a typical pension fund portfolio if hedged at 100% is the British pound.
- at the balance-sheet (funding ratio) level, the hedging requirement of US dollar exposure is even lower, as liabilities become a partial natural hedge against the US dollar If the analysis period is expanded or assumptions changed, the optimal hedging ratio for US dollar may increase to as high as 40-50% driven by costs and number of extreme events in the period. We have not found circumstances in which higher hedging ratios for US dollar are beneficial for a fund’s return or volatility.
The complexity of hedging the US dollar is entirely due to its safe haven status. The conclusions in this report are valid only if the safe haven status of USD is retained. Any major macroeconomic or geo-political shift precipitating change in the safety perceptions of US dollar will require revisiting the conclusions of this study.