Currency hedging – ODI makes the right call every time

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“A long term investment is a short-term investment that failed” – one of the many investment wisdoms that is still relevant particularly for defined benefit pension schemes. When it comes to currency hedging, is it better to get it right in the short-term or in the long-term?

When geo-political risks heighten, currencies tend to become more volatile. We indeed observed that following the result of the UK referendum back in June 2016 when Sterling depreciated against the US Dollar by over 12%. Looking at a slightly longer time horizon, US dollar appreciated against Sterling by 30% since 2014 when the exchange rate was once as high as 1.7 to as low as 1.2 just after the referendum. Any pension schemes that were holding overseas investments without hedging their currencies would have made a gain in addition to the equity gains by a further 30%. The perfect picture I always like to paint for my clients when it comes to currency hedging (and to save them time having to draw lots of lines themselves) is the V-shaped currency hedging ‘strategy’.

Graph of USD vs GBP since 2014

V-shaped currency hedging 'strategy'V-shaped currency hedging ‘strategy’

  • Rule number 1: the exchange rate movements need to exhibit a V-shaped pattern for the strategy to work!
  • Rule number 2: Leave the exposure unhedged as the line goes down – this allows you to capture all the gains as the foreign currency strengthens
  • Rule number 3: Hedge the currency exactly at the tip of the V – avoid all the losses as the line goes back up when the foreign currency weakens again

Sterling has experienced one of the most volatile periods since the result of the referendum, and as I write, more surprises are still to come. Sterling has become headline news on a daily basis. While the focus has been about whether it will be a hard Brexit, in which case, sterling will be in free-fall; or we’ll get a deal and sterling will strengthen. So, should I hedge, or should I not?

Perhaps time to introduce you to the real strategy I adopt every time, and so far, no clients have ever suffered a loss – the Objective Driven Investment strategy. An ODI strategy is one which takes into account the investor’s objectives whilst applying economic and investment solutions to solve a particular challenge or a series of challenges. For a defined benefit pension scheme, their objectives and challenges are multi-faceted, ranging from their absolute funding levels, volatility of the current and future funding levels, how much resource the sponsoring employer has to take risks, need for income and how the trustees and sponsoring company are set up to make decisions on financial matters.

So how would one make decisions on currency hedging by adopting an ODI strategy? When the dollar-sterling exchange rate was at 1.2, we put one of the clients to the test.

They were fully-funded on a self-sufficient basis with a strong employer backing them. From their investment beliefs, they have always expressed a strong view that they want only moderate returns, but favour control and stability on their funding outcomes. Despite some strong views coming from the trustee board of the belief that sterling will continue to weaken in the long term and therefore taking an unhedged position would have been financially beneficial, the decision was to hedge currency exposure as far as practicable.

The rationale: their objective is to be fully funded on a self-sufficient basis (which they are) and it was unnecessary to take further risks which they did not feel would reward them sufficiently given the highly unpredictable nature of geo-political events. They chose not to bet. If sterling were to go up, down or sideways, they can still sleep at night.

And it was completely consistent with their objectives. They have not forgotten their principles. Whichever way sterling goes from here, the client wins. Objectives met. Mission accomplished.

That is why I believe Objective Driven Investment is so important. In an industry where it is easy to push ‘out-of-the-box’ investment solutions which may well be cost-effective from the point of view of a provider, but it costs our clients dearly in terms of investment and funding outcomes. Strict ‘house views’ in an attempt to get all investors to invest in the same way without taking their circumstance into account means there is only a single economic answer for clients. This is not helped by a world where passive investing is in favour.

So should we be long-term or short-term investors when it comes to currency? Stick to your objectives and it won’t matter whether it’s the long or short term. You will be right either way.

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