Little has changed and everything has changed when it comes to Australian superfunds and how they manage their foreign exchange (FX) exposure – or so it appears from the findings of NAB’s 2017 Superannuation FX Hedging survey.

While they continue to rely on FX forwards when they hedge, and the majority still use overlay currency managers, there are other signs that the past two years has been a time of refocusing for funds, as they move from hedge ratio decisions to more structural changes in the hedge process.

This comes during a period of low FX returns and even lower market volatility. At the same time, funds are adapting to a rapidly evolving environment, with shifting member needs, more regulation, pressure to grow or merge and rapid technological change.

Strength in strategy

There’s been a distinct shift in how superfunds view currency exposure from a strategic point of view. Back in 2001, when NAB’s FX hedging survey first began, 91 percent of respondents were managing their currency at an asset class level. Today, nearly half of them (48 percent) are choosing to set their hedges at a whole-of-fund level, while another 15 percent are opting for a member investment choice (MIC) level – unheard of 15 years ago.

This MIC strategy means funds can hedge according to the risk profile nominated by their members, using a lower hedge ratio for a high growth choice compared to a conservative choice for instance.

A dynamic approach to international shares

Yet while funds are hedging according to what their members have chosen, they are in large part (75 percent) enacting this via particular assets classes, the most common being international equities.

There is further evidence here of funds’ increasing flexibility and adaptability – and perhaps a change in overall strategy. According to the survey, 43 percent of funds are opting for a dynamic hedge ratio as opposed to a set range in relation to international equities.  This is up from 17 percent in 2015 and 4 percent in 2005.

At the same time, there’s been a rise in funds ‘tilting’ around the hedge – 74 percent compared with 54 percent in 2015.

Size matters

When it comes to choosing who will hedge, there are other signs of changes afoot. According to the survey, 11 percent of funds are considering insourcing this function (compared to just 5 percent in 2015) while 9 percent have plans to outsource it (also up from 5 percent in 2015).

Both changes may be connected to superfunds that are outgrowing their current way of functioning. Those planning to outsource, for instance, could possibly be newly merged superfunds that are now big enough to consider taking on their own currency hedging. Those intent on insourcing, on the other hand, could perhaps be smaller funds who are close to reaching a size where external help is warranted. Certainly it will be interesting to see what happens next here.

The push and pull of policy

There’s no doubt that regulatory changes are giving rise to new practices. A massive 73 percent of respondents said they were implementing – or were considering implementing – a transaction cost analysis (TCA) framework around their FX hedging, thanks to the introduction of ASIC’s Regulatory Guide 97 which targets the disclosure of fees and costs.

Choosing the right framework is by no means easy though. It’s little wonder then that almost three quarters of respondents (76 percent) are looking for a bank/manager to provide a TCA service. Just 9 percent of those surveyed have plans to build their own.

Other regulatory changes are having more subtle impacts. According to the survey, over half the respondents (54 percent) are now considering the domicile of the counterparty in FX forwards. This is understandable given a counterparty’s domicile may now influence the tax paid on any gains.

The rise of emerging markets

There’s no clear evidence that the new collateral and variation margin regulations are changing practices however. This appears to hold for emerging markets in particular – 96 percent said the new rules had no impact on how they managed their exposure there.

In fact emerging markets have been a dominant theme of 2017, enjoying a groundswell of investment. Yet this hasn’t been met by a similar level of hedging. In equities, 79 percent chose not to hedge their exposure while 52 percent chose not to hedge their fixed income exposure.

There may be good reason for this. The past couple of years saw a dramatic sell-off of emerging market currencies and plunging prices were the inevitable result. Consequently, currency gains may be a key component in expected emerging market asset gains.

Playing it safe

There’s little prospect of currency alpha in the current environment however. Low FX returns and even lower market volatility explains why funds are keen on passive managers just now and why all hedges are being used as a risk-management tool.