The way superannuation funds manage their foreign currency exposures is becoming increasingly important as they invest more overseas and as regulators put their investment decisions under closer scrutiny, writes DREW BRADFORD, NAB Executive General Manager Markets.
Australia is the world’s fourth largest superannuation market, according to OECD data, and has experienced among the highest growth globally over the last 20 years.
The result is that funds are increasingly looking beyond local shores to seek out investment opportunities and better yields in larger overseas markets.
Given the growing importance of FX management to super funds, NAB’s Biennial Super Fund FX Survey into how funds manage their foreign currency exposures – now in its tenth vintage – is of increasing significance, being the only survey of its kind to examine hedging techniques in Australia. The latest survey, released in November and covering 54 super funds responsible for $1.8tn or 80 per cent of the sector’s AUM (ex-SMSFs), reveals that super funds have on average close to 47 per cent of their assets allocated offshore, up from 41 per cent in 2019.
This percentage will only grow, with three out of five fund managers saying they intend to increase their foreign allocations over the next two years. Funds are most likely to increase allocations to listed international equities, followed by unlisted infrastructure and listed property. Alternatives, unlisted property, fixed income and listed infrastructure also rate mentions.
With funds getting close to allocating half of their assets offshore and hedging a significant amount of the resulting currency exposure, we can see how important FX management decisions are when it comes to investment returns.
An increasingly proportion of funds (72 per cent) now look at currency through the same lens used to examine underlying asset exposures, that is, in terms of a desired level of currency exposure, rather than the traditional hedge ratio. A rising share of funds (over 40 per cent in the 2021 survey) also now consider their currency exposure or hedging decisions at the member investment choice level, rather than the asset class or overall fund level.
The Government’s recently-introduced Your Future, Your Super (YFYS) reforms and performance tests are also putting funds’ FX strategies under the spotlight.
Funds say that passing the performance test will be an ongoing priority and therefore quantifying their tolerance for tracking error—or volatility—will be very important. There is and will continue to be much greater scrutiny and monitoring of the impact currency risk is having on their performance relative to APRA’s performance metrics.
They also consider consistency of performance to be more important than having a single good year, and therefore investment teams and fund trustees are likely to place greater scrutiny on whether any significant currency deviations are justified.
APRA’s listed strategic asset allocation benchmark metrics use indices which have fully hedged, partially hedged and unhedged returns, and these will create currency hedge requirements and tracking error that funds will have to incorporate.
Understanding currency deviations under the YFYS performance test will be crucial for investment teams and trustees.
The latest NAB survey reveals how funds navigated the unprecedented volatility in investment markets in the early phases of the global COVID-19 pandemic in 2020. The volatility through March and April shone a spotlight on the imperative of having the governance structures, investment delegations and investment frameworks in place to be able to change asset allocations in a timely manner.
Those with streamlined structures and relatively small decision-making teams fared well, while those with inflexibilities in their processes—including for example an inability to act in currencies outside of the London 4:00pm fix window when most FX transactions are carried out—inevitably fared worse.
Some funds were pleased by their ability to move quickly back into growth asset or sell and/or buy back into the AUD in light of perceived wide valuation gaps, given the speed of the recovery in both equities and the currency in April. For example, one fund mentioned that it bought cheap assets such as equities and sold expensive ones, such as bonds, when US 10-year yields approached 50bps.
Other funds rued their inability or failure to act quickly and missing the boat with regards to the speed of some market rebounds, including the AUD. Some of these funds said they justified their inaction at the time due to fears of a ‘W’ shaped recovery in risky asset prices. Some others were pleased that they—and most of their members—had held the course through the mayhem, so hadn’t sold near the lows only to then miss out on the vigour of the rebound.
Those funds that habitually erred on the side of having more foreign currency exposure and less hedging, so as to minimise the profit and loss impact of ‘risk-off’ scenarios under which AUD typically falls sharply, were initially pleased with how this worked out.
Some 42 per cent of funds said they had increased the frequency of reporting and communication of investment performance to the fund’s investment committee and trustees. Additional stress testing or scenario testing was frequently cited by Funds to ensure investment options met their objectives and from a currency perspective, better supported their liquidity management plan.
The key responsibility of the investment committee is to ensure a fund’s investment options achieve their objective within its liquidity, risk and cost parameters. They typically work very closely with the investment team. This has filtered down in recent years to currency decisions, with investment teams given more responsibility over implementation while the investment committee and board focus on strategic decisions and monitoring the performance and effectiveness of the investment strategy.
This shows up clearly in the question of who has most influence when it comes to setting the strategic currency hedging policy. About two-thirds of funds said the investment team is most influential, with 19 per cent citing the investment committee as having most influence and 17 per cent their asset consultant.
In terms of currency hedging products, the survey revealed that FX forwards continue to occupy a central place in Funds’ hedging strategies.
But funds are also increasingly using FX options. Some 27 per cent of funds said they have used options, significantly higher than in the 2019 survey (just 14 per cent). However, the feedback from some funds was that FX options were used rarely and can be prohibitively expensive.
At the same time, there has been a decline in those funds that also use cross currency and interest rate swaps – 12 per cent in 2021, down from 20 per cent in 2019.
As funds invest more offshore, they are naturally turning their attention more to emerging markets, particularly to Asia.
The NAB survey reveals that many funds (57 per cent) do not hedge any of their emerging market exposure, despite increasing allocations to these investment markets.
Of those respondents who said they did hedge some of their underlying exposure, about three quarters hedge less than 50 per cent of their equity exposure (and typically only 15-25 per cent).
In contrast to emerging markets (EM) equity exposure, most funds with investments in EM fixed income have a relatively high currency hedge ratio, in the 75-100 per cent range.
As funds have become more focused on currency risk management generally and have gradually increased allocations to emerging markets, they are spending more time considering if some of that exposure should be hedged and if so, how they go about hedging it.
To read more about the insights from the survey visit: Super FX Survey 2021 | Business Research and Insights (nab.com.au)