Forex freefall

The collapse of the Australian dollar against the greenback in the past three months has exacerbated the funding pressures being placed on Australia's superannation funds. Rachel Alembakis reports

Liquidity risk is a major concern for the A$1 trillion ($680 billion) Australian superannuation industry, which manages the country's retirement assets. After a year of negative returns for the sector, and with individual members shifting from relatively aggressive investment options into more defensive, cash-based investment schemes, superannuation fund managers are keen to make sure they have adequate reserves. That is increasingly difficult, due to the growing illiquidity of assets previously considered liquid.

The average median, balanced option in a superannuation fund lost 4.75% in September and fell 11.59% in the year to September 30, according to research firm Superratings. The Sydney-based company defines a balanced option as one "with exposure to growth-style assets" of 60-76% and says around 80% of Australians in major superannuation funds use the balanced option.

As members switch their superannuation allocations from higher-risk options into cash, the Australian Prudential Regulatory Authority (Apra) - one of two bodies that regulate super funds - sent out letters to all such funds asking them to provide additional information to satisfy concerns about the adequacy of their cash reserves. Apra was concerned despite continuing cash inflows from employers, which contribute 9% of employees' salaries to superannuation.

So far, no superannuation fund has failed to meet its cash obligations. And, while the number of people switching from higher risk/return options to more defensive options doubled in 2008, the rate of switching prior to 2008 was low to begin with, say industry participants. "A lot of funds have seen switching increase, and the rate is double what it was last year. But for some funds this means going from 1% to 2% (of their total proportion of members), and for others it means going from 2% to 4%, so it's a relatively low number," says Fiona Reynolds, Melbourne-based chief executive of the Australian Institute of Superannuation Trustees, which represents not-for-profit superannuation funds.

But a further issue is the dramatic shift in value of the Australian dollar, which was trading at near parity to the US dollar in late 2007, at nearly $0.85 at the start of October and had fallen to around $0.60 by the end of that month. As of January 19, it stood at around $0.68. This swift depreciation has resulted in cash calls from superannuation funds with overlay programmes.

"We've seen client after client trying to extract cash to pay for currency hedges," says Lloyd Alty, head of currencies at Macquarie Funds in Sydney. "There have been large falls on the currency and, depending on the hedging strategy, that could be a significant cost to the superannuation fund." This is a hot topic among the funds Alty has spoken to, he says, as they try to work out if they have the right strategy to deal with the liquidity or the risk going forward, should the Australian dollar keep falling.

The impact is widespread, particularly as Australian superannuation funds are diversified across domestic and international investments. According to statistics published in December by the Sydney-based Association of Superannuation Funds of Australia, the average default option in a superannuation fund had a 23.7% weighting towards international shares and a 6.7% allocation to international fixed-income assets. The statistics were based on Apra statistics measured to the end of June 2007.

Superannuation funds that hold international assets are likely to have done an element of hedging, says Ian Martin, Sydney-based head of State Street Global Markets for Australia and New Zealand. "Given that the Australian dollar has devalued by around 30%, they will have to deal with significant cashflow implications as the hedges mature," he says. "If you've got an international equity manager with a relatively high level of currency hedging for their international portfolio, they're having to deal with the significant liquidity implications of large losses on their currency hedges."

As a result of currency swings, super-annuation funds that hedge their overseas exposures have seen unprecedented calls to cover their hedged positions. While supers stress that the fall in hedged positions are balanced in the ledger book by a corresponding rise in value for non-Australian-dollar-denominated investments, funds are still having to source extra cash to pay off their hedged positions.

AustralianSuper, an A$28 billion superannuation fund in Melbourne, did experience cash calls on its hedged positions, although chief investment officer Mark Delaney would not specify their size. He says the fund met the margin calls on hedge positions using cash reserves. Underlying managers for mandates, such as global bonds and global infrastructure will hedge their currency positions themselves, and AustralianSuper uses State Street to hedge some direct exposures at a fund level, adds Delaney.

However, the superannuation fund's policy is to seek unhedged exposures to foreign currencies. In 2008, it set a target of having 17.5% of total portfolio assets invested in unhedged foreign-currency-denominated assets. Most of those assets were in non-Australian equities, says Delaney.

During the 12 months to the end of December, the MSCI hedged global equities index declined by 39%, while the MSCI unhedged global equities index fell by 25%, he says. "The advantage to us was a 14% difference in return due to the impact of the depreciation of the Australian dollar against the MSCI's basket of currencies," says Delaney. "We were able to benefit from that 14% difference. It gave us an added 2.3% in performance to the total portfolio to reduce the negative effect of declining global equity markets."

In addition, the Australian dollar tends to be highly correlated to the Australian equity market in times of market stress. The correlation is based on the fact that both currency and equity markets are influenced by commodity prices, as Australia is one of the world's biggest commodity producers. For example, miners BHP Billiton and Rio Tinto are both large composites of the Australian Stock Exchange whose fortunes are heavily tied to commodity prices.

And it is clear that, in times of stress, the Australian dollar does go down, says Delaney. "You want diversification in higher risk events, so you leave some positions unhedged," he says. "It's hard to prove, but logically it was a strong proposition: the experience of the past four months has been a vindication."

It's a similar story at other superannuation funds "It's not necessarily that clients are concerned with the currency positions per se, but rather that they're concerned with liquidity implications," says Andrew Harrex, a principal at financial consultancy Mercer in Melbourne.

The issue centres on liquidity, as supers effectively have to pay a large currency bill rather than post currency profits or losses. "Clients either have to sell some of the overseas assets to pay the currency bill (and net it off) or use cash from another asset class to pay the currency loss," says Harrex. "But the question is: where can they get access to cash? It's okay if it's in overseas equities, but what if it's in less liquid investments, like infrastructure or property?"

Brisbane-based QIC Asset Management - the A$70 billion fund manager for clients including A$23 billion Q Super, the super fund for Queensland public sector employees - also saw cash calls for hedged positions in its clients' funds. But, two years ago, QIC had revamped its approach to risk and cross-asset correlation, reorganising its asset management business into alpha sources and beta sources and deploying a third team to manage capital market risks, or omega. It also instituted policy guidelines with its clients that would allow it to access sources of liquidity when cash calls might be under pressure.

As a result of its overhaul, QIC recommended to clients that when there are volatile movements in currency - such as was seen in October - they rebalance their hedged positions more frequently than the industry-standard once a month. This more frequent rebalancing allowed clients to cover positions at a lower cost. "We were able to meet our clients' cash calls," says Troy Rieck, a managing director in the capital markets team at QIC in Brisbane. "This was possibly the biggest benefit of our liquidity planning and forecasting. The size and speed of the movement (in the Australian dollar) caught us all by surprise. There was a crisis in US dollar liquidity in September and October at the same time as the drop in the Australian dollar, which meant that some were not able to roll over their hedges if they waited until the end of the month."

Rieck believes monthly rebalancing leaves funds vulnerable to the currency correlations between Australia and the rest of the world. "We rebalance more frequently, which means we were not left with any end-of-month liquidity crises," he says.

But not all superannuation funds had a policy on liquidity in advance of events in October. Harrex says Mercer picked up "a couple" of new clients during 2008 that did not have such a policy when they first contracted with his firm. "We usually have a debate with clients: 'Do you plan for a two-standard-deviation event, a normal event or a six-standard-deviation event, which arguably you could say we are in right now?'" he says.

In the context of currency fluctuations, a standard-deviation event is one where the value of a currency relative to another currency or a basket of currencies, deviates from the normally distributed modelled mean. In statistical theory, 68% for events are within one standard deviation above or below the average, 95% within two standard deviations and 99.7% within three standard deviations.

Harrex feels funds should be set up ready to handle a two-standard-deviation event. "The next step is to have the governance in place such that the trustees know what steps to take when you reach that level," he says. "From a governance point of view, some fund trustees didn't think that through in the first place."

This article was first published in Asia Risk, February 2009.