NAB’s ninth biennial Superannuation FX hedging survey highlights what Ray Attrill, head of FX strategy at the bank, terms “seismic shifts” in how managers of the fourth biggest pension pool in the world, think and handle their currency exposures. “The fact that the majority of managers are now thinking of currency through the same lens as other asset classes – how much currency exposure do they want compared to how they used to think about how much they didn’t want – is synonymous with currency coming of age,” he says. “Managers are now thinking about currency as a diversifier and a form of tail risk hedging, it’s a different operating model for these firms.”
A key finding of the survey indicates that not only are more Australian superannuation funds investing more heavily in offshore assets and therefore have commensurately higher level of currency exposure, but they have switched dramatically in how they hedge currency exposures, with 57% of funds now thinking of currency in terms of a desired foreign currency target rather than the traditional hedge ratio, compared to 28% in the last survey two years ago. For those funds targeting a percentage of foreign currency exposure, the average desired exposure is 24% in 2019.
The 2019 survey reflects the views of 61 respondents representing AUD 1.82 trillion of AUM, which equates to approximately 90% of the Australian Superannuation industry (excluding Self-Managed Funds which were not part of the survey).
Breaking the 40% barrier for the first time in the 19-year history of the survey, 41% of funds invested assets overseas, a finding that is broadly consistent with March data from the Australian Prudential Regulation Authority (APRA). Equally, there was a strong response rate to the question of future international allocation, with 72% of respondents indicating their intention to increase the share of their investments in international assets in the next two years.
The survey reveals a further shift in favour of managing currency exposure at the member investment choice (MIC) level. Just over 30% of respondents say this is now the level at which they manage their currency hedging. This has more than doubled since first being asked in 2017, when the affirmative response rate was a little under 15%.
The lift in hedging at the MIC level is entirely at the expense of hedging at the overall fund level, NAB says. The proportion of funds that hedge at the overall fund level has fallen to 25% in 2019 from 48% in 2017. A slightly larger share of funds manage currency exposure at the asset class level (44%, up from 37% in 2017) but this is still down from the 50%-plus share in prior years’ surveys.
It is the larger funds who have embraced managing FX exposure at the MIC level more readily than smaller funds, with 35% of medium and large sized funds now doing so, up from just over 15% in 2017. The majority (56%) of small funds still manage FX risk at the asset class level, an increase from 2017 (44%).
Funds continue to use developed market currency pairs as a proxy for emerging markets hedging and there is, surprisingly perhaps, a significant decline in the use of NDFs for hedging
A majority (58%) of funds surveyed run some form of currency hedge tilting policy, down from 74% in 2017, with a heavy weighting towards larger funds. A large minority (40%) of funds who tilt say they do so by ±15% around their strategic target, while 60% of funds stated it is a lesser ±10%. It is, however, exclusively retail (50%) and government (29%) funds that fall into the larger ±15% category.
Those funds that retain a traditional hedge ratio, representing 38% of funds surveyed and weighted to smaller funds and retail funds, have on average a target hedge ratio of 28% on total assets, the survey finds. This is a sizeable reduction from the 2017 survey where the average hedge ratio was 39%. “This lower hedge ratio is primarily reflected in international equities as all other asset classes are typically deemed to be 100% hedged,” Attrill says.
The dispersion of target hedge ratios across the funds has increased substantially, ranging from 10% to the mid-40% for international equities in the 2019 survey. This reduction in hedging likely reflects the downtrend in the Australian dollar, from above 80 US cents at the time of the 2017 survey to nearer 70 US cents in 2019, with an expectation the currency could fall further. There was also clear feedback from respondents to the survey that running a higher foreign exposure was seen as a cost-effective way to protect investment portfolios from a deterioration in risk sentiment.
What might be seen as a surprising finding, the survey finds that funds have reduced their hedging activity in emerging markets, in spite of investing more in these markets. It reveals there is no unanimous approach to hedging emerging markets by funds, with a majority (58%) of funds not hedging their emerging market equity exposure, despite increasing allocations to this asset class in recent years. This includes 67% of large funds.
NAB says feedback from the survey suggests that large funds appoint specialist emerging market managers, whereas smaller funds typically allow their international equity managers a limited emerging market exposure within their mandate. Of the 42% of funds that have indicated an element of hedging, 82% are hedging with developed market proxies, while only 18% hedge to the underlying asset exposure – typically the MSCI All Country World Index (ACWI).
Interestingly, just 7% of funds are fully hedging their emerging market equity exposure.
There is a significant contrast when considering emerging market fixed income hedging strategies with 50% of respondents fully hedging their exposure, while 40% of funds indicated this exposure is wholly unhedged. In terms of fund size, it is the medium and larger funds that are primarily fully hedging this exposure. Notable from the results is that no corporate funds are among those who fully hedge.
Similar to emerging market equity, the vast majority (88%, of respondents) who are hedging all or part of their emerging market fixed income are utilising developed market proxies to do so.
Continuing the theme, there was a significant fall in the number of funds using non-deliverable forwards (NDFs) to hedge currency risk, to 7% in 2019 from 18% in 2017, something that is surprising given how recent industry data suggests trading volumes in NDFs have almost doubled in two years. “Despite the broader theme of funds increasing their exposure over time to emerging markets, the survey has not uncovered any quantitative evidence of funds hedging this exposure directly,” Attrill says. “There is a structural change of funds moving from the MSCI World to MSCI ACWI, which includes both developed and emerging markets exposure. The interesting factor here is the potential impact the use of proxies can have on tracking error.”
As to why funds appear to be shying away from NDFs, Attrill is less sure. “It is hard to pin any one factor down in the survey responses,“ he says. “Margining requirements for NDFs and whether funds are set up for collateral management could be one factor, as could the view from some respondents that EM FX is an expensive and illiquid market in which to hedge.”
In terms of products used, when asked about the currency products used by superannuation funds, all respondents stated they use FX forwards as the key element of the product suite. This was unchanged from the last two surveys and underscores the ongoing dominance of FX forwards in all hedging strategies.
There has been a slight pickup in those funds that also utilise cross currency and interest rate swaps; more than 20% in 2019, up from 18% in 2017, which NAB says implies a number of funds are looking at opportunities to improve returns on their FX hedge book. By using Cross Currency Interest Rate (CCIR) swaps, in conjunction with FX forwards and other FX instruments, funds believe this will protect part of their portfolio from further falls in Australian interest rate differentials versus other major currencies, the bank adds.
FX options also featured more in responses from funds with 14% of respondents saying that they have used options as part of their currency hedging program. This was a reasonable increase from 2017 (7%), but still remains well below the highs of 2013 (28%). The feedback from a number of funds was that FX options would feature more in an environment where the Australian dollar was perceived as significantly undervalued or overvalued on a longer-term basis.
A large portion of respondents (70 %) indicated they typically use three-month hedges. In many cases, when the size
of the hedging reaches a material size these hedges may be staggered over multiple dates to smooth cash flows and avoid big rollovers around key event risks such as major economic releases. Most funds indicate that their typical FX hedge tenor is three months. Just over 10% of funds prefer shorter duration hedging (one month rolling forwards) with just under 20% of funds signalling they have hedge tenors for some investments of six months or longer.
“This would seem entirely consistent with superannuation funds investing more in unlisted and alternative asset classes where updated asset values are less frequent and liquidity in the portfolio may be a key consideration,” the bank says. “While there is a balance between managing hedges and associated cash flows, it was clear from the surveys that many of the larger funds have a bias for multiple hedge settlement dates in their programme.”