At Their Own Peril, SWFs Continue to Ignore Currency Turmoil

February 12, 2015 by Craig Mellow

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Sovereign Wealth Funds haven’t shown much interest in hedging their foreign exchange risk. Some currency traders want to change that.

Currency swings are a big concern for global investors, as shown by the Swiss National Bank ’s move last month to unpeg the franc from the euro. Profits that a dollar-based fund earns on smart purchases of European or Japanese stocks can be wiped out by a fall in the euro or yen. And bond investments, with their low nominal returns, are more vulnerable still.

Fully 85 percent of the risk for an international fixed-income portfolio stems from currency movements, according to Mark Astley, chief executive of London-based currency trader Millennium Global Investments. For equities that figure is 25 percent in developed markets and up to 50 percent in emerging markets, where swings in the national coin are more volatile.

The currency danger has recently gripped markets’ attention as the U.S. dollar has risen sharply over the past six months. The greenback has gained 19 percent against the euro since August 1. Its climb against the yen is more remarkable still, the dollar rising by some 50 percent over the past 30 months. Japan’s benchmark Nikkei 225 stock index has roughly doubled during that time, meaning the currency drop would have wiped out all an investor’s profit in dollar terms.

Induced Pain

Statistics like these are spurring increased interest in the arcane arts of currency hedging among many kinds of investors, but not apparently sovereign wealth funds. State-owned investors claim to be in the markets for the long term, and for now assume currency fluctuations will even out over time. "These are investors who tend to think currency works out in the long run," says Rod Ringrow, London-based head of sovereign wealth funds sector solutions at State Street Corp. "They tend to think about strategic allocations between asset classes, rather than between geographies."

Several big sovereign wealth funds are already showing the effects from the dollar’s surge, at least on paper, because the local currencies they use to count their assets have slid on a relative basis. The Russian Federation’s National Wealth Fund , which is surprisingly one of the world’s most open in disclosing its size, shrank 10 percent in dollar terms, from $88 billion to $80 billion, between August 2014 and January 2015, even though its assets increased 25 percent in ruble terms.

Value of Russia's National Wealth Fund in Russian Rubles & U.S. Dollars, 2013–’14

Source: Ministry of Finance of the Russian Federation; Sovereign Wealth Center.

That kind of gaping divergence is often driven by commodity price swings, and not just for Russia. The world’s biggest fund, Norway’s Government Pension Fund Global (GPFG), had 5,478 billion kroner on June 30, equal to $893 billion at the time. Since then, kroner has fallen 18.8 percent against the dollar because of declining prices for oil and gas, Norway’s dominant export. Though the portfolio has grown to 6,579 billion kroner as of early February, its worth in dollars is now $860 billion. That’s a $30 billion-plus haircut in dollar terms.

Value of Norway’s Government Pension Fund Global in Norwegian Krone & U.S. Dollars, 2013–’14

Source: Norges Bank Investment Management; Sovereign Wealth Center

The dynamic works the other way too of course. The Australian dollar, for example, rose 55 percent against the U.S. dollar from early 2009 to mid-2011, benefiting from rebounding Chinese demand for Australian commodities including coal, iron ore and agricultural products after the financial crisis. The strengthening currency meant that while the nation’s Future Fund grew by 30 percent in Australian dollar terms between March 31, 2009 and June 30, 2011 to A$75 billion, its assets under management more than doubled in U.S. dollar terms to $81 billion. However, with the softening of China’s economy in recent months, the Australian dollar has declined more than 18 percent against its U.S. counterpart since June 30, 2014, eroding the value of the nation’s sovereign fund.

Value of Australia's Future Fund in Australian Dollars & U.S. Dollars, 2008–’14

Source: Future Fund; Sovereign Wealth Center

But commodity prices do not have to be a determining factor. Singapore’s two sovereign wealth funds, GIC , which Sovereign Wealth Center estimated to have $315 billion in assets at the end of 2013, and Temasek Holdings , with $177.2 billion as of end-March 2014, have also felt the whip of currency-induced pain, as the Singapore dollar slipped 9.9 percent against the U.S. prototype over the past seven months.

Future Liabilities

A resurgent U.S. dollar entails a different sort of challenge for the Middle Eastern sovereign wealth funds, such as the Abu Dhabi Investment Authority , the Kuwait Investment Authority and Qatar Investment Authority , whose government owners peg their currencies to it. Their concern is sinking returns on non-dollar investments in Europe, Japan and emerging markets. Given the relatively limited transparency of these funds, such currency-related losses are impossible to quantify, but they could be substantial.

While sovereign wealth funds may not be overly forthcoming about the finer points of their portfolio management, their advisers and money managers unanimously report that they are remaining calm, sticking to long-term strategies formulated before the dollar took off and skeptical of hedging their currency risks.

Such even-keeled attitudes seem to rest on two assumptions. The first is that, unlike say pension funds, which also invest for the long haul, sovereign wealth funds typically have no fixed liabilities. That is to say there is no current or future requirement for paying out cash in their home currency, so they can wait for decades for currency swings to even out in the marketplace. "Given that large wealth funds tend to be without defined future liabilities, they tend to be strategic rather than tactical about investment," says Nick Tolchard, who heads Atlanta-based asset manager Invesco’s services to sovereign wealth funds. "I have not seen returns in other currencies as an issue yet."

"We Are All Dead"

The second reason for sovereign wealth funds not to be overly concerned about currency fluctuations is that they are much less closely scrutinized than many other institutional investors, who need to provide frequent performance data for regulators, investors or outside stakeholders, both in absolute terms and relative to various benchmarks. State-owned funds by definition usually have a single stakeholder: their governments.

As a result, advisers say that sovereign wealth funds have less need to fiddle with short-term variables like currency risk to satisfy outside observers. Most state-owned savings funds are more concerned with improving long-term returns by using fewer outside asset managers, Tolchard says. "They are looking at external management, which may come with a 150 basis-point fee, and thinking about how much they can move internally," he says. In that budget-conscious climate, there is little interest in engaging a new class of outside currency experts.

Markets offer reasons to question those prevailing sovereign wealth fund assumptions on currencies, though. Even if fluctuations do even out in the long run, that can be a pretty long time. And as the economist and investor John Maynard Keynes put it: "In the long run, we are all dead." Far from bouncing up and down ephemerally around some theoretical equilibrium point, world currency relationships are subject to prolonged and substantial swings.

Stagnation and Deflation

From 2001 the euro rose more or less continuously against the dollar for nine years, from a trough of $0.82 to a peak of $1.60. The yen had a generally uninterrupted bull run against the dollar between 2007 and 2012, gaining some 60 percent during that time. It has lost all those gains over the past two and a half years. The most striking evidence that currency relationships do not always revert to a mean may be the U.K. pound, which, not adjusting for inflation, was worth $5.00 a century ago, and about $1.50 today.

Sovereign wealth funds’ investment horizons may be long, but they are not infinite, despite their protestations to the contrary. A 2014 Invesco survey found that "partial liability sovereigns," which have no pressing needs to sell assets, held securities for an average of 8.6 years. Given that time frame, the potential risks and rewards from long-term currency trends are definitely not trivial.

Many analysts believe the dollar is just starting on a new upward trajectory that could last years. The U.S. has emerged from the financial crisis much stronger than other major developed economies, which are battling against a fresh onslaught of stagnation and deflation.

The U.S.’s trade deficit, which tends to weaken a national currency, has shrunk by half since the mid-2000s, as increased domestic oil production kept imports steady while exports boomed. Most importantly, the Federal Reserve is expected to raise interest rates during 2015 for the first time in years, while European and Japanese central banks keep them depressed in the hope of spurring a bit of growth.

Abenomics Policy

Higher interest rates generally act as a magnet for the home currency as bond buyers around the world flock to the higher returns offered by implication. "Combine the expected Fed tightening, the shale revolution, and sclerosis in Europe, and the upward movement of the dollar looks more strategic than cyclical," Millennium Global’s Astley says.

Other factors support that view. The dollar is nowhere near its historic highs, according to Russell Silbertson, head of reserve management at London-based Investec Asset Management. Measured by a standard multi-currency basket called the Dollar Index Spot, the U.S. dollar is still 21 percent below its 2001 peak, and 45 percent short of its level in 1985, an all-time high since Washington dropped the gold standard in 1971, he says. Silbertson predicts the U.S. dollar can "comfortably rally another 10 percent."

This situation presents a quandary for large global investors. One intuitive course would be to sell non-dollar assets and buy in the U.S. and countries with dollar-linked currencies. That could be a mistake, Astley says. The monetary conditions that make for weak currencies — low interest rates and heavy borrowing — can be positive for stock markets, not to mention real estate, an investment that sovereign wealth funds are increasingly drawn to. The Standard & Poor’s 500 index of large capitalization U.S. stocks returned 6.1 percent annualized between year-end 2001 and 2007 even as the dollar tumbled. More recently in Japan, the same so-called Abenomics policies of the Liberal Democratic Party government that set the stock market on fire sank the yen.

Smart hedging strategies should leave investors with most of the upside from the stocks, while protecting them from any corresponding currency decline, according to Astley. "It’s a major myth that if I like the asset, I must like the currency," he says. "In fact it is possible to separate the asset decision from the currency decision."

Dynamic Hedging

Hedging need not be expensive, according to James Wood-Collins, CEO of U.K.-based Record Currency Management, which services large institutional investors. The most basic strategy, known as passive hedging, involves buying an offsetting currency forward contract along with any cross-border purchase of securities. If a U.S. fund puts $50 million into Eurozone stocks, for instance, it agrees to sell the equivalent amount of euros back into dollars at today’s exchange rate, typically six or 12 months from now.

Usually investors will hedge 50 percent of their equity exposure, not all of it, Wood-Collins says. But the commission is the same either way: a few basis points in management fees and even less in transaction fees.

Record Currency Management chargessomewhat higher management fees for so-called dynamic hedging programs that change the offsets depending on market movements and analysis, Wood-Collins says. Hedging also raises cash-flow issues, since a year is the maximum term for simpler forward contracts. If, after that time, the euro has gained ground against the dollar, the investor must take the loss then, while likely delaying the gain that may come from selling the underlying stocks.

But the real cost of a hedge is limiting upside in case the foreign currency one invests in rises against one’s own. The risks of making that choice depend on where you sit, literally, even over a very long haul, academic research indicates.


U.S.-dollar-denominated investors, holding an index-balanced portfolio of global stocks between 1972 and 2011, would actually have lost money by hedging according to a 2012 study conducted by London Business School professors Elroy Dimson and Paul Marsh, and published by Credit Suisse. Their annual returns would have fallen from 4.9 percent to 4.2 percent. Investors from 19 other countries in the survey would have gained, boosting returns in home-currency terms from 4.3 percent to 5.0 percent. Behind both results stands the same phenomenon, relative dollar weakness over the 40-year study period.

Not surprisingly, hedging can reduce volatility, particularly for bond holdings, Dimson and Marsh found. A global fixed-income portfolio was 14 percent less volatile for dollar-based investors and 28 percent less volatile for those with other home currencies. "Hedging for global fixed-income is next to a no-brainer," Record Currency Management’s Wood-Collins says. "So much so that many fixed-income managers will just include hedging in their product." But on the whole, long-term funds are better off controlling risk through diversity and not bothering with hedging, the professors decided. "Hedging is on average counterproductive," they concluded.

Counterproductive perhaps, but increasingly popular. U.S. retail investors have flocked to exchange traded funds that provide them with hedged exposure to global equities. Assets in this category of ETFs have grown nearly fivefold since 2011 to more than $30 billion, according to data from Reuters. Dollar-based institutional managers are stopping by Record Currency Management’s office in increasing numbers, looking for tactics to suit an extended run up for the U.S. dollar.

Sovereign wealth funds are so far reluctant to hedge, but Millennium’s Mark Astley says he hopes to change some outlooks with an upcoming trip to the Middle East. "In the first half of 2014, volatility in currency markets hit a 40 year-low, so it was hard to get people excited about hedging," he says. "But the second half was completely transformational. It’s time to refocus the minds of sovereign wealth funds that currency is an issue."

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