The CI Pension Fund Forum

With respect to your international portfolios, what techniques do you employ (such as risk budgeting) to determine what impact currency exposure is having on returns and how much risk it is adding?

KR: APG Asset Management (APG-AM) is the asset manager for several Dutch pension funds. For each of these clients, a strategic assessment of t's strategic investment plan, covering a 3-year planning period. On the basis of a MonteCarlo simulation of a vector autoregressive model in which criteria such as median coverage ratio, probability of underfunding, expected future inflation indexation and excess return (absolute and liability-relative) are evaluated, the strategic asset mix and hedges are determined. One of these hedges concerns FX exposure, for which regulatory constraints and constraints on liquidity are taken into account in the simulation.

NW: Our benchmark is 100% hedged back to local currency. The decision to have a 100% hedge reflects the trade-off between the risk of the position and the expected return. The impact of the 100% hedge position is captured in the benchmark's expected risk and return and the returns associated with the currency hedge at both the benchmark level, and through any active management of the position, are fully attributed in our periodic reporting. The benchmark refers to our Reference Portfolio which is a notional portfolio of inexpensive, listed, growth-weighted passive exposures that we believe would achieve the objective of the Fund. Because we deviate from such exposures to add additional value to the Fund (e.g. with unlisted investments), the performance of the Reference Portfolio is therefore a key benchmark for whether we actually do add value to the Fund. That's why we refer to the reference portfolio as 'our benchmark'.

JwvO: With the exception of emerging markets currencies, all currency risk is fully hedged for the investments in the strategic benchmark. Currency exposure in reserve-currencies is added via an overlay account. The expected impact in risk and return is at least monitored at an annual basis. When implementing the currency hedge, our traders have a Var-limit to reduce the risks of implementing. EM-returns are periodically compared with local returns, but due to a lack of data a comparison with hedged returns isn't possible.

How do you view currency investment: as an uncorrelated source of alpha, as a risk mitigation investment (hedging) or as holistic - utilising hedging and alpha mandates?

KR: At APG, currency investment is viewed as holistic, we actively seek attractive currency investments as a source of alpha and hedge a substantial amount of the FX exposure stemming from the countries in which our clients are invested most heavily. In relative terms, the size of APG's hedging activities dwarfs that of APG's currency alpha mandates. At present, the EUR-equivalent of the FX-exposures that are being hedged by APG is close to EUR 90 billion and is roughly equal to one third of the average client's asset base.

NW: For us currencies are not an asset class. Our benchmark currency position, 100% hedged, simply converts all global risk premia that we earn back into our local currency. We choose to have a 100% hedge because we believe there is a systematic return pick up associated with the riskiness of our base currency. Therefore the benchmark decision is a simple statement of our investment beliefs and a reflection of our risk preferences. Currencies can provide scope for active returns and we actively manage the hedge ratio internally depending on our view on the expected returns to local currency versus foreign currencies.

JwvO: A large part of the currency exposure leads to risk without sufficient return. In this case currency investments (hedges) are used to mitigate risk. There is a small allocation to currency strategies to improve the risk/return of the total portfolio.

Klaas Reedijk

"At APG, currency investment is viewed as holistic, we actively seek attractive currency investments as a source of alpha and hedge a substantial amount of the FX exposure stemming from the countries in which our clients are invested most heavily."

How is your currency management process integrated into your asset allocation process - are overlay hedging strategies viewed as a standalone mandate?

KR: The strategic hedges of our clients (currency, interest, inflation) are centrally managed by APG-AM's Allocation & Overlay team. This team is responsible for managing our clients' asset mixes and implementing positions to maintain FX hedges for our clients that e.g. change due to rebalancing the investment portfolio or from rolling positions that are about to expire. Within APG-AM all FX hedge related transactions are executed via APG-AM's Treasury Center, which ensures a cost-efficient implementation and exploits crossing opportunities.

NW: Currency is fully integrated into the asset allocation process. The decision on the benchmark hedge ratio is taken at the same time that we decide on our benchmark asset allocation. We dynamically manage the hedge ratio alongside the dynamic management of our market exposures. Currency management is undertaken internally and is part of the asset allocation process and not viewed as a stand alone mandate.

JwvO: 100% hedge of developed market currencies in our investment funds. A lower hedge ratio for reserve currencies is implemented via an overlay.

Neil Williams

"Currencies can provide scope for active returns and we actively manage the hedge ratio internally depending on our view on the expected returns to local currency versus foreign currencies."

Which alpha strategies have proved most effective? Into which part of the portfolio does it fall - into alternative assets and how much?

NW: We do not have any external currency managers. Some of our external managers may run some currency risk but this is not a meaningful part of their strategies nor of the Fund's overall active risk budget. All currency management is undertaken internally. We dynamically manage the hedge ratio in response to changes in expected returns across different currencies. Expected currency returns reflect our views on the fundamental valuation of currencies, how quickly we expect actual values to revert to fair value as well as the interest rates provided by different currencies. We do not "bucket" our investments into "alternative" or any other type of category. We have a series of strategies in place that provide the framework for taking on active risk in the actual portfolio versus the benchmark and these strategies articulate the types of risk and returns we expect in each strategy.

JwvO: Based on research we believe a combination of strategies works best. Our currency strategies would have a beta or systematic beta character rather than an alpha character.

KR: Since our clients are Dutch pension funds with long-dated liabilities in EUR, it is the client-specific liability-profile that is the driving factor in hedging large non-EUR exposures in our clients' investment portfolios. In implementing our clients' FX hedges risk-return considerations, liquidity and transaction costs influence the way the hedges are executed and the instruments that are employed.

NW: We believe that currencies do diverge from fair value but ultimately mean revert. We believe that we can manage our currency exposures internally to a high standard. We are prepared to take meaningful risk positions on the currency versus the benchmark position.

JwvO: Risk, expected return, costs of hedging (transaction costs/carry), impact on liquidity.

Jan Willem

"We are currently in the process to see whether more FX-exposure through different kinds of currency strategies can enhance the risk/return of our portfolio."

Do you use a simple tactical hedging strategy or prefer a fully-hedged portfolio? On what basis is the selection made and how does the hedge ratio reflect your portfolio and how often is it rebalanced?

KR: Our clients' investment plans contain currency specific hedge ratios (e.g. a 75% hedge ratio for GBP exposure), which follow from the ALM-study to which I referred earlier. At present, APG hedges between 75% and 100% on average of GBP, JPY and USD-exposure. Hedge ratios are thus established for a longer period and can be reset when a new investment plan is being launched. In times of market stress APG may temporarily recommend its clients to deviate from the policy hedge ratios and, depending on the precise circumstances, the hedge ratios could be increased or decreased.

NW: We manage the Fund's currency exposures at the overall portfolio level. In other words, we do not "bucket" our currency exposure by asset class or mandate, we look through the portfolio at the overall currency exposure and manage the exposures back to our target in that way. Our starting position is a 100% hedged local currency exposure and we dynamically manage that exposure - by varying the overall hedge ratio and varying the exposure to specific currencies - at the total portfolio level depending on expected returns.

JwvO: No tactical hedging is used by us. The hedge ratio is fixed, unless market circumstances change substantially.

In general, are you utilising passive hedging strategies with infrequent rolling of the hedge ratio or do you adopt a more dynamically and actively managed approach to the hedging process?

KR: A semi-passive approach is being followed, in which cost-efficient implementation of the strategic FX-hedges is the main focus.

When rolling open positions and / or changing the size of the hedges, APG-AM's Allocation & Overlay team uses a score card approach, in which they carefully balance the impact of such factors as carry, momentum, valuation and sentiment/stress on implementation.

NW: We dynamically manage the hedging process. We utilise a range of products and maturities to best manage our currency exposure having regard to risk, return, liquidity and counter party exposures.

Looking ahead, are you planning on making any significant changes to your current currency management strategy over the near term?

KR: A potential change that is being researched by APG-AM for our clients concerns a 'solvency-neutral' FX-hedge. Instead of using fixed hedge ratios for a couple of currencies, one aggregate hedge ratio could be used.

This would enable our clients to exchange one currency for another in their FX hedge portfolios without violating regulatory solvency requirements. This would effectively result in a more dynamic approach to currency hedging with a larger opportunity set without increasing risk as defined by the Dutch regulatory framework for pension funds.

NW: No major changes are expected although we are always looking to improve the efficiency of our approach to currency management and to exploit areas that we think will add value to the Fund.

JwvO: We are currently in the process to see whether more FX-exposure through different kinds of currency strategies can enhance the risk/return of our portfolio.