Australian super funds look to cross-currency basis swaps

With an average unhedged currency exposure of 17% of assets under management, Australian superannuation funds face the risk of significant performance drag from global foreign exchange volatility. The cross-currency basis swap market, however, has created a potential opportunity to hedge this risk and profit at the same time

As Australia increases its ownership of offshore assets across global equities, real estate, infrastructure and other alternative asset classes, foreign exchange has become a major contributor to the investment returns of Australian pension funds. But according to the 2011 Superannuation FX Survey by National Australia Bank (NAB), which polled 49 of the country’s largest super funds with combined AUM of A$523 billion (US$560 billion) representing 79% of the market, forex volatility has hit the sector hard. Unhedged portfolios lost 12.7% in 2010 on adverse currency moves alone, while 100% hedged positions gained 4.5%.

Since mid-2009 the effect is more pronounced, with unhedged positions giving up 30% against gains of 8% for fully hedged positions. The 38% differential represents an opportunity cost to overall portfolio performance of some 3.25% per annum since then, according to NAB.

Against a backdrop of increasing offshore exposure and a focus on relative performance versus their domestic peer group, it should follow that Australian super funds have significant interest in optimising their currency overlay strategies. Outside of the fixed interest sector, however, investment managers say there is little consensus around forex risk management best practice with some funds ignoring it altogether. Troy Rieck, managing director with the Brisbane-based Queensland Investment Corporation (QIC), an institutional investment manager with AUM of A$60 billion, reports a disparate range of operational approaches. “Some funds use their asset managers to run forex hedging strategies, some rely on their custodians, while others choose not to hedge or don’t really think about it at all,” he says.

Furthermore, the tendency of incumbent providers to rely on traditional hedging tools can act as a drain on liquidity with particularly painful consequences. According to the NAB survey, some Australian super funds have around 17% of their portfolios exposed to foreign exchange movements. Based on an average asset allocation across fixed income, equities and alternatives, QIC suggest that 13% of total fund exposures are directly hedged using forex forwards.

Between July and October 2008, the Australian dollar dropped by more than 30% versus the US dollar, leaving funds long the Aussie under bullish hedge positions facing a severe liquidity event. Although the stronger US dollar increased the value of their foreign investments by around 5.1% (30% x 17%), as their deeply out-of-the-money hedge contracts expired, funds faced payouts that far exceeded their strategic cash holdings. QIC suggests that the cash needed to settle underwater hedging obligations could have been as high as 3.9% of total funds under management (30% x 13%) on an industry-wide basis.

With this experience still fresh in their minds, investment managers are getting excited about a forex overlay approach that has been a favoured tool of international bond issuers and fixed income portfolio managers for some time. The strategy employs longer-dated cross-currency basis swap contracts – plain vanilla derivatives contracts quoted on multiple screens – which advocates argue allow funds to better manage liquidity requirements by smoothing out income gains and losses. Moreover, they argue, it is accretive to the overall risk-adjusted portfolio returns.

“The rollover risk arising from forex overlay programmes based on short-dated contracts can be very large, as the past few years have shown. By using longer-dated cross-currency basis swap contracts, funds can improve the liquidity profile of their forex overlay, and get paid for a risk management activity which they have to do anyway,” says QIC’s Reick.

Big Four funding

The opportunity for better risk-adjusted forex overlay performances is driven by market expectations around the offshore funding requirements of Australian financial institutions. Essentially, the more offshore debt issuance announced by Australian banks, the greater the cost of converting that funding back to the domestic currency using cross-currency basis swaps and vice versa. At the same time, the relative issuance activities of international borrowers in the kangaroo (domestic Australian) market can have an offsetting effect, with increased issuance and related supply of the domestic currency acting as a cap on basis swap spreads.

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Australian super funds look to cross-currency basis swaps

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