Currency’s made headlines for the last decade with the spectacular rise and fall of the Canadian dollar. Once lowly, the loonie has, in recent years, hit and then briefly exceeded parity with the U.S. dollar. Good times for Canada’s cross-border shoppers.

But, depending on whom you talk to, the rise and fall of the dollar has been both a blessing and a curse. Yes, it’s been tough on Canadians who rely on imported goods and services, but the loonie’s recent woes have actually been a boon for anyone holding U.S. assets.

Which is why Canadian pensions should place currency front and centre when assessing risk to plan assets. But some experts say Canadian plan sponsors are still on the fence when it comes to hedging their currency. And, in times of economic uncertainty and market volatility, that could be a problem.

Currency risk for Canadian plans is significant, says Jeff Blanco, vice-president and portfolio manager, currency, with Aurion Capital Management. “Currency volatility has increased significantly since hitting historic lows in August of last year, and, right now, currency is one of the biggest factors for pension plans in Canada.” Blanco says returns from currency exposure are far larger than the underlying asset returns. Hedged returns for the S&P 500 (total return) were -2.9% as of the end of August 2015, compared with a gain of 10.5% for unhedged investors. So currency is having a significant impact on investment portfolios, and that’s something plan sponsors can’t ignore.

That’s especially true as Canadian plans add more global assets across their portfolios. Global pension assets now stretch beyond stocks into bonds, real estate and other alternatives. Back in 2000, the average Canadian plan had just 8% allocated to global equities—now that number is closer to 15%, reports the Pension Investment Association of Canada. And that doesn’t include expansion into emerging markets, global fixed income and other alternatives such as infrastructure, real estate or private equity.

So it’s important to understand that, when it comes to currency volatility, not all asset classes are created equal. Plan sponsors ignore that at their peril, notes Don Raymond, chief investment officer at Alignvest Management Corp. He says investors should think of currency in terms of risk and ask themselves whether hedged returns are riskier or less risky than unhedged returns. And plan sponsors must ask that question across all the underlying asset classes in their plans. Since the loonie can be positively correlated with foreign equities, Raymond says, currency hedging may actually increase risk.

“For global equities, you might be better off unhedged, especially when hedging costs are factored in,” he explains. “But bonds are a different story—hedging the currency of a foreign bond reduces risk. Left unhedged, the currency bet could be larger than the bond part of the risk.”

Emerging market equities are, likewise, a different beast. Besides risk and cost considerations, Raymond says there’s also potential long-term return associated with exposure to emerging market currencies, since economic and productivity growth in the issuing countries, and improved trade terms, develop over time.

To Hedge or Not to Hedge

So, how are plan sponsors approaching the hedging question?

It’s all over the map, says Ela Karahasanoglu, vice-president, currency and asset allocation, with CIBC Asset Management Inc. Some choose to hedge their currency dynamically, she says, as opposed to setting a hedge and sticking with it. Dynamic hedging allows plan sponsors to monitor currency movements across the portfolio and to react accordingly as currencies and markets fluctuate.

However, that tends to be the approach of larger, more sophisticated Canadian plans. Still others take a passive approach, with no hedging strategy in place. Then there are those sitting on the fence: those plans with a static fifty-fifty approach to currency hedging. They hedge 50% of the portfolio and leave the rest passive.

“There is no science behind that approach,” says Karahasanoglu, who admits it tends to please trustees who don’t want to risk being 100% wrong at any given time.

The top 8 most tradeable currencies

1. U.S. Dollar (USD)
2. European Euro (EUR)
3. Japanese Yen (JPY)
4. British Pound (GBP)
5. Swiss Franc (CHF)
6. Canadian Dollar (CAD)
7. Australian/New Zealand
Dollar (AUD/NZD)
8. South African Rand (ZAR)


The variation in approaches to currency hedging across plans is surprising when you consider its potential impact on performance. Canadian pension plans have dramatically increased exposures to foreign assets since the elimination of the foreign property rule in 2005. “When you think that, in the average plan today, 50% to 70% of the portfolio is not Canadian dollar-denominated, currency is a huge driver of both returns and volatility,” she says.

The loonie’s wild ride underscores the importance of currency risk. “You need to look at everything from a risk/return perspective and understand that you don’t take risk without getting paid for it,” says Tom O’Gorman, senior vice-president and director of fixed income with Franklin Bissett Investment Management.

Fluctuations in the loonie’s value relative to the greenback have been particularly surprising to investors, and the Canadian dollar’s steep rise following the financial crisis was largely due to the strength of the Canadian banking system. It was further spurred by the prevailing view that U.S. Federal Reserve policy relied extensively on “printing money,” O’Gorman explains.

But that’s changed. The U.S. is now recovering, and the Fed is looking to normalize monetary policy. By contrast, a steep fall in energy prices has Canada facing economic headwinds.

Barring some sort of economic miracle, currency volatility isn’t going away any time soon.

Rob Spector, fixed income portfolio manager at MFS, says today’s low-return environment makes it imperative for investors to closely watch currency. As investors reduce expectations for equity market returns and bond yields, notes Spector, “suddenly currency movements take on a bigger part of the total return.”

During times of double-digit stock market returns, he says, investors might not notice a currency bump of 2%, but when those returns are sitting at 5% or 6%, it becomes crucial. “Clearly, we are in a lower-return environment where currency returns could be more dominant in terms of total portfolio returns,” he explains.

James Davis, chief investment officer with OPTrust, says currency could become important in a different way as policymakers look for new economic levers. With extremely low interest rates making it tough for central banks to use rate setting to drive policy, currency markets could become a new stimulus tool for banks trying to boost growth. “At that point, currency management is going to be very important,” he says.

The Effect on Plan Sponsors

All this means sponsors need to evolve from simply hedging currencies to managing them.

Says Davis, “Plan sponsors need to make decisions based on their investment objectives, the macroeconomic landscape and the economic exposures within the portfolio, rather than simply using a blanket hedge ratio.”

ABCs of currency management

Passive hedging – Plan sponsors don’t have a hedge; they let asset values fluctuate in relation to currency moves.

Active hedging – Setting a hedge ratio to mitigate the effects of currency volatility on foreign assets.

Dynamic hedging – As plans branch out into global assets, this method allows managers to react in a more immediate way across the portfolio.

He says a static hedge ratio may no longer be appropriate. “You need to manage currency, and if you do have a hedge ratio, it should be flexible and reflect specific exposures in your portfolio. What’s right for me might not be right for you.”

Raymond agrees the decision to hedge or manage currency is more nuanced. He says plans should differentiate between strategic (long-term) and tactical (short-term) currency management, with the most important focus being the longerhorizon strategic decision. “Many plans blend tactical and strategic decisions, which has the potential to blur accountability for their respective decisions,” he says.

When it comes to understanding and dealing with the changing role of currency in Canadian pension plans, Tom Lappalainen, director, strategic advice, with Russell Investments Canada, says plan sponsors are “coming along in their understanding of how to manage currency risk.”

However, fewer are developing formal policies that address currency risk universally across asset classes. And that’s key. “Plan sponsors need to assess the size of currency risk impact on the organization,” he says. “The next decision is how they view currency and what their policy is.” In some cases, plans may decide to take a more dynamic approach.

While a set hedge ratio might work for some plans, there are clear limits. In particular, dynamic currency management is key, says Karahasanoglu, who advises plan sponsors to avoid a set-it-and-forget-it approach. She reminds plan sponsors of what happened to the euro over the last decade. “Before 2008, the euro was a safe haven currency. But, after the global financial crisis, it started behaving like a risky currency. You need to adjust your hedge ratio as the behaviour of currencies change.”

Caroline Cakebread is a Toronto-based freelance writer.

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Copyright © 2020 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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