NAB Survey Highlights Growing Internalisation at Fund Managers

As well as highlighting a greater focus on currency amongst managers, the NAB 2019 Superannuation FX Survey also highlights changing FX business structures at funds with a growing number taking more care over their execution policies.

The survey confirms the 2017 survey’s finding that currency risk is an important consideration in their investment decisions in 2019. All respondents noted that currency decisions were either ‘important’ (83%) or ‘marginally important’ (17%), this reflects the change in the last survey, in 2015, some funds believed that currency was ‘marginally not important’ (11%) and ‘not important’ (8%) however the persistence of 0% of respondents perceiving currency
as ‘marginally not important’ or ‘not important’ in both 2017 to 2019 is a re- assuring theme, the bank says.

There was a big decline in terms of ‘fund trustee’ and ‘investment committee’ influence on a fund’s investment decisions. Instead, funds have directed their attention towards ‘internal investment strategy teams’ (30%) and ‘internal teams with consultant (25%). Additionally, a handful of funds are influenced by ‘internal teams’ in conjunction with ‘investment committees’ (9%).

When asked who sets strategic currency hedging policy, it was notable to see the growth in respondents selecting ‘Other’ from 36% in 2017 to 49% in 2019. When asked about what ‘Other’ denoted, the majority of funds responded with ‘internal teams’ or ‘internal teams with consultants’. The increase in this group as a key influencer in setting the hedge policy is entirely consistent with a broader trend across the industry of building investment team capability, although it should be noted that it is the larger funds that have that bias towards ‘internal teams’.

The 2019 survey suggests that the influence of consultants remains high but in many cases their role is in conjunction with ‘internal teams’. Consultants are still having a significant role in currency decisions particularly for smaller funds.

Funds are looking more often at their currency risk, but are still not adjusting currency policy on a more frequent basis

It is also evident that funds are reviewing currency risk on a more regular basis, with an increase in ‘other’ (40% in 2019 versus 30% in 2017) and a decrease in monthly (8%). While ‘other’ could mean a variety of frequencies, interview respondents indicated those in this category were generally reviewing currency risk more frequently than monthly.

That noted, as far as revising their currency policy, however, funds continue to review it annually, meaning that while the frequency of reviewing currency risk rises, the frequency in reviewing currency policy has decreased.

Counterparty Focus

Superannuation funds are increasingly looking at the domicile of their hedge counterparty (52% of respondents), however this is mainly for tax reasons for, in accordance with an Australian Tax Office ruling, funds need to understand whether their FX hedging gains are Australian sourced for the purposes of calculating their “foreign income tax offset” cap in any given year.

Credit rating also remains an important influence for counterparty selection with 58% of funds that have reviewed their FX counterparties in the last two years saying credit rating was the key influence in any changes made. Other drivers of change in FX counterparties included price competitiveness and overall service offering.

Whilst a large proportion of superannuation funds are not currently set up for collateral management should this be necessary for physically delivered FX Forwards, the proportion of total funds without this capacity has dropped from 80 % in 2017 to 49% in 2019. Unsurprisingly, it is the larger funds which have made progress in preparation for possible changes in the future. This may be in part due to some of the regulatory changes seen away from Australia that seek to reduce systemic risk associated with OTC derivatives such as European Market Infrastructure Regulation (EMIR).

Furthermore, 60% of all funds believe this is an important issue to address in the next two years, indicating a large proportion of the industry believe physically settled FX forwards may be in scope for variation margin requirements.

It was noteworthy that funds remain very comfortable that any change in collateral or margin requirements will not change their liquidity needs for FX hedging, NAB says.

Opportunities for efficiencies seen by funds in a Word Cloud

Another focus regarding counterparty activity is that funds are now more focused on ensuring full transparency of the execution costs of hedging. This was evident in the 2017 results where 73% of funds reported that they were considering or had already decided to implement some form of transaction cost analysis (TCA) for FX execution, but has firmed up to 78% of respondents with a stronger bias to the larger funds. Nearly two thirds of all respondents expect their bank or overlay manager to provide this analysis with a small increase in the number of respondents signalling they would pay for independent TCA.

Funds have also signalled very strongly they expect their specialist hedge provider(s) to have algorithmic/ electronic execution capabilities. Whether this is seen as mitigating operational risk or allowing better access to liquidity it is consistent with a broader trend across FX markets generally.

In or Out?

Insourcing FX management is frequently mentioned as a growing trend in the industry but for many funds there is a preference to outsource all the operational risks of their hedging programme. Perhaps surprisingly, NAB says, there was a strong message from funds that they have no immediate plans to change their current approach to currency management. In the latest survey, 87% of funds said they had no immediate plans to change their approach, up from 80% in 2017. Only 9% of respondents indicated they had plans to insource currency management, which was a slight drop from 11% in 2017.

The survey data also uncovered a very small group of funds who indicated they had plans to outsource their currency hedging. The nature of the respondents were typically smaller sized funds. The general feedback from these funds was that their currency exposure was of sufficient materiality that it warranted the use of a specialist manager rather than investing in currency hedged products, NAB says.

A majority (79%) of funds indicated they were using an external currency overlay manager, this is little changed from 74% in 2017 and below the peak of 81% in 2013. The highest representation of overlay managers was seen in industry funds, very closely followed by corporate funds.

With the decline in Australian dollar volatility, and the rise in internal teams playing a more influential role in currency decisions, NAB says it is noteworthy to see an increase in the number of funds employing an active currency manager. This has increased from 10% of funds in 2017 to 22% in 2019. Nonetheless, it adds this is typically being done in conjunction with a passive strategy (by close to 90% of funds) or an indexed enhanced strategy with the aim of risk mitigation and opportunistic alpha.

Risk or Alpha?

Funds implementing an active strategy generally noted that managing portfolio risk was more important than seeking out opportunistic alpha (79% of funds) although this is lower than in 2017 (100% of funds). Given the current geo- political environment, respondents were apathetic towards viewing currency as an alpha driver, NAB says.

When asked to provide feedback on why they do not employ an active manager, there was a strong response from funds that currency risk is part of the diversification benefits (63% in 2019 vs 28% in 2017). The majority of funds signalled they believe currency management is a ‘zero sum game’ when it comes to managing an investment portfolio.

Colin Lambert

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