Funds Need to Consider Longer FX Tenors as Allocations to Private Assets Grow

Taking a staggered approach with longer tenors to FX hedging helps mitigate event risk and could help funds that have increased their allocations to private assets manage their liquidity profile, IFM Investors says

In March 2020, during the depths of the COVID-19 pandemic, the Australian dollar fell about 15 per cent against the US dollar, which triggered a series of significant margin calls for superannuation funds and other institutional investors.

On some days, the cumulative size of margin calls to meet foreign currency (FX) settlement obligations reached up to $17 billion, according to data from the Reserve Bank of Australia.

It prompted many funds to review their liquidity management processes, including how they would manage their FX hedging programs going forward.

Historically, most funds have used short-dated FX forwards to hedge their exposures, typically with a maturity of between three and six months. Having such short maturities means these contracts need to be regularly rolled over to keep currency exposures covered.

This approach has worked well for most funds in the past because the majority of their assets were listed and, therefore, had high liquidity levels. But it also exposed them to event risk, according to IFM Investors.

“The key learning from COVID was liquidity management is crucial. With regular, short-dated FX hedge programs that were settling during that March-April period, when the Aussie dollar experienced that large depreciation, funds were having to raise liquidity very quickly,” James Bulfin, Investment Director, Treasury Services at IFM, says in an interview with [i3] Insights.

“And it was at a time when global listed equity markets were also suffering a significant drawdown. So they were selling assets at the worst possible time.

“That had a snowball effect because you had that weight of numbers in the ASX market raising liquidity, which pushed the market lower, which pushed the Aussie dollar lower, and it created more liquidity demands as they went along,” he says.

Creating a program of FX forwards with a longer tenor, preferably between one to two years, and having a portfolio of staggered maturity dates allows funds to manage liquidity in periods of market volatility and mitigate event risk, Bulfin argues.

“If you have a lot of your hedge book maturing within a three to six-month timeframe, there’s a lot of event risk that can happen,” he says.

“And naturally, having 100 per cent of your FX hedge portfolio at risk of rollover creates a large liquidity requirement, which in normal circumstances is fine, but it is in those stress market events where it becomes more challenging.

“Spreading the tenor of your FX hedge profile does smooth out your event risk in a way that you have a smaller notional amount at risk of settlement at a time when the market is stressed,” he says.

The recently published biannual superannuation survey by National Australia Bank shows a gradual move towards extending tenors is already happening. “Funds are placing greater emphasis on liquidity, with ongoing evolution in several facets of FX hedging strategies, including a trend toward longer hedge tenors,” the report said.

But according to the survey, funds have extended their tenor by a few months, rather than moving to one to two-year maturities. Bulfin says funds sometimes resist applying longer tenors because they think that any contract beyond a year will increase collateral requirements.

“There is a misconception in the market that any tenor below one year is uncollateralised, and anything beyond one year needs to post collateral. But that is certainly not the case,” he says.

“APRA’s Prudential Standard CPS 226 exempts physically delivered FX Forwards and FX Swaps from initial margin requirements for superannuation funds, regardless of the tenor.”

Growing Allocations to Private Markets Skews Liquidity Profiles

Many super funds have been increasing their allocation to private markets over the years, driven by diversification benefits, the promise of stable, long-term returns and the ability to put large amounts of capital to work.

The Thinking Ahead Institute showed that pension funds globally had increased their private market exposure from 7 per cent to 26 per cent in the 20 years to 2022. Australian funds have also increased their exposure to private markets, albeit at a slower pace. Domestic funds currently have, on average, 10.9 per cent of total investments in private assets, although some of the larger funds have significantly higher allocations, according to data from Rainmaker.

As private assets are mostly illiquid, the use of short-term FX forwards here could lead to liquidity mismatches, Bulfin says.

“If these assets aren’t regularly producing cash flows, offsetting hedge requirements, then you do take on rollover risk in terms of mark-to-market fluctuations,” he says.

“To manage market fluctuations more smoothly, extending the tenor of your hedge book is certainly a method that we use. Just extending the tenor from three to six months to that one to two-year timeframe would certainly help smooth out the liquid profile,” he says.

The need to match the hedging program with the liquidity profile of unlisted assets is made all the more pertinent by the fact most institutional investors have a higher hedge ratio attached to private asset exposures, often closer to 100 per cent, while in global equities this percentage is much lower, often around 30 per cent.

“With unlisted assets, you really do just want the return of the asset rather than the fluctuation of the currency risk,” he says.

Splitting Out Listed and Unlisted FX Hedges

Most funds manage FX hedging at a total portfolio level, since historically their largest exposure was global equities, but Bulfin argues there are good reasons to split out your listed and unlisted hedges as the overall level of unlisted assets in the portfolio grows.

“It does allow you to manage the liquidity profiles of each asset class more effectively,” he says.

“You could easily run a slightly longer tenor profile for the unlisted asset portfolio, have that carved out by one currency overlay manager, and then you have a shorter tenor portfolio for your global listed equities that is more dynamic.”

Staggering maturity profiles adds further benefits to the portfolio, Bulfin says. One is that the settlement amount is considerably smaller at any one time, but by spreading out your maturity profile, you can also lock in contracts early by rolling them ahead of time.

“We typically roll our portfolio a minimum of nine months ahead of time,” Bulfin says. “And what that does is it creates certainty on cash flow requirements, so you can plan your liquidity needs well ahead of time, rather than a typical program where they may have staggered monthly rolls with quarterly maturities.

“And generally, they roll that only five days out from expiring. So then, if there is a large settlement required, you do have to come up with cash reasonably quickly,” he says.

Posting Large Cash Settlements Forms a Drag on Returns

Another benefit of having a staggered approach of longer tenors is that it helps reduce the amount of capital that needs to be posted for settlements. Having to post large amounts of cash forms a drag on returns, especially during stress events when reinvesting in equity markets could produce significant upsides.

“Once that money is out the door to fund a large drop in the Aussie dollar, that cash has left the portfolio, and it’s not a return-seeker. It’s just there to settle a hedge,” Bulfin says.

“If you can smooth out your liquidity profile so you have less of an FX need in those severe markets, then you can allocate your cash elsewhere to the portfolio. So you could utilise more cash and put it towards return-driving assets, rather than having a higher requirement to short-dated FX hedge programs,” he says.

To read the IFM Investors white paper: “FX Liquidity Strategies for Australian Superannuation Funds”, please click here.

This article was sponsored by IFM Investors. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.

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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.