Why hedged ETPs are a tough sell for pensions

Square Peg in a Round HoleInflation, currency and interest rates—combined, they’re a triple threat to DB pension funds, which are always on the hunt for ways to guard against their return-busting effects. To hedge or not to hedge is a question often asked by plan sponsors. In reality, however, the costs end to force many into the “not” camp (or toward a partial hedge).

But as plan sponsors become more comfortable with exchange-traded funds, they might want to consider looking at the growing number of hedged products hitting the market.

This article in Pensions & Investments gives a good rundown of some of the top products out there, pointing out that currency-hedged products account for the lion’s share of assets in hedged exchange-traded products (ETPs). With US$12.9 billion in assets across 15 funds, currency-hedged ETPs track indexes that are fully hedged against short-term exchange rate spikes. By far the biggest is the WisdomTree Japan Hedged Equity fund at US$11.1 billion. Investors looking for access to Japanese equities can use it to hedge out exposure to fluctuations between the value of the U.S. dollar and the Japanese yen.

In this growing space, currency-hedged ETPs offer a couple of key attributes that big investors look for—liquidity (they’re tied to the robust and always-moving currency futures and forwards market) and size (institutional investors like to wait for a fund to hit the $1-billion mark before making an allocation, according to one source quoted in the article).

But there is an ever-growing menu of new ETPs that handily hedge other big risks besides currency—volatility and interest rates, for example. Such products address plan sponsors’ key concerns, yes. But are they a good fit in the pension market?

Not really. Most of the newer hedged products, as the article points out, don’t have the size and liquidity most pension investors want to see.

But another much bigger barrier is an essential mismatch between how these off-the-shelf products are built and the very different way that pension funds invest assets. Incorporating them into a pension portfolio involves downright investment gymnastics—adjusting an overlay or shifting assets from a long portfolio and an absolute return allocation.

That’s a lot of manoeuvring just to fit a new product into the mix. And for Canadian plans that already enjoy relatively low fees for active management, it’s going to take a bit of time to get active ETPs into the portfolio mix.

That disconnect between the structure of these ETPs and the reality of a DB pension portfolio is something you hear a lot about. It makes it tough for plan sponsors to use ETPs—and it is a key barrier to growth in the pension space.

What’s the solution? Customization seems to be one workaround that is gaining popularity in the pension space. We’ve already started to see this happen on a small scale (recall what Arizona did last year).

More and more, I think it will be easier for providers and plan sponsors to team up and hit the right mix for a particular plan. After all, if it makes it easier for pension funds to hedge their big risks, why not give ETPs a try? Providers looking to make headway in the pension space could take a page out of Arizona’s book and start to tailor their product menus to meet pension-specific requirements.

This article was originally published on BenefitsCanada.com.