Pension funds at risk from currency fluctuations

State Street Global Advisors (SSgA), the investment management arm of New York-based State Street Corporation, has warned UK institutional investors they are overexposed to carry trades and to currency-fluctuation risk in their portfolios.

UK defined-benefit pension funds' exposure to international equities rose from 21.8% at the end of 1996 to 31.0% in December 2006, increasing pension funds’ exposure to adverse currency movements, according to WM, State Street's data arm.

The UK defined benefit market grew from £130 billion to £201 billion over the period; international equity exposure grew from £28.3 billion to £62.3 billion.

Colin Crownover, head of currency management at SSgA, explained that the volatility in currency markets decreased less than it did in equity and bond markets, lulling investors into a false sense of security. He said: “Given the 42% increase in non-UK equity investments over the past 10 years, pension funds need to ensure they manage their downside currency risk effectively, or risk being caught out when markets move adversely.”

Crownover added that the carry trade posed a particular risk: “If investors start to unwind their carry positions, those schemes that have not hedged effectively against currency movements could experience a significant decline in the value of their assets.”

Pension schemes could also be at risk if the Chinese or US economies were to slow down, increasing risk of global deflation and in turn a lower US dollar and the potential for disorderly exchange rate movements, Crownover said.