Step Into Liquid

From aiCIO Magazine: The solution to the FX issue historically has been the standard three-month forward contract. Some funds execute this strategy internally; others outsource it.

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Forget the normal hubs of finance—the most geographically concentrated locale for asset-owning capital might well be Melbourne, Australia. Over one square kilometer in the city’s downtown core, you can meet more billion-dollar asset owners than there are hours in a day. The problem, however, is that, while decisions for many of the country’s superannuation funds are made here, the capital often is deployed far afield—which, in an epoch of highly volatile exchange rates, makes managing to Australian dollar-denominated liabilities especially difficult.

The solution to the FX issue historically has been the standard three-month forward contract. Some funds execute this strategy internally; others outsource it. Before the GFC (“global financial crisis,” the ubiquitous moniker used here), fund management teams often put minimal thought into their hedges once implemented, preferring to focus on the increasingly sophisticated investments that were beginning to populate their portfolios. (State Street Global Services Head of Sales for Australia, Greg O’Sullivan, refers to this hedging paradigm as a “set-and-forget” strategy.) However, like the metaphorical butterfly flapping its wings in Beijing and causing rain in New York, instituting these hedging programs at a time when the currency quickly crashed and then rallied had a detrimental effect on numerous funds. To keep a hedge in place takes capital; a financial panic—both globally and within the super system, where participants moving en masse to cash can cause a de facto run on the fund—is one time when capital is scarce. “They needed liquidity,” says Phil Gardner, Head of Distribution for Goldman Sachs Asset Management in Australia. “They were getting calls from their custodians, saying, ‘We need x% of the portfolio by next week to cover your hedge,’ and so a small minority had to stretch for that liquidity.” Adds O’Sullivan’s colleague Ian Martin, Head of SSgA S.E Asia and Pacific and Head of Global Markets Australia & New Zealand: “It was a pretty momentous time. The funds sold what they could sell—liquid assets, which were cash assets and equities—and this pushed the domestic equity market down further.”

The result: Mirroring American endowments (although without the severity of the catalyst), super funds are now focused on liquidity management. “Speaking broadly, the GFC has brought to life the idea that funds need to dynamically manage their currency exposures,” says O’Sullivan. Other outcomes, according to him and Martin, include more stress testing, a greater appetite for outsourcing, and carrying more cash. “The forward spreads in September and October 2008 were immense,” Martin adds. “The cost of hedging was so high that funds now focus a lot more on how much cash they have available—above and beyond the 9% a year that flows into the system.” (The mandatory 9% soon may become 12%, more for retirement income than investment purposes.) Still, concerns exist. As one major fund CIO put it, “If any fund claims they know entirely what they’re doing with FX, they’re lying.”

This issue extends far beyond the resource-rich lands of Australia. With many capital pools increasing in size (and few are doing so faster than the Australian superannuation funds) and thus likely to outstrip home-market capacity (yes, even American investors will invest more externally), more portfolios will be exposed to currency fluctuations. As they are, funds would be well advised to learn from Australia’s recent travails: Hedge your currency exposure, but be prepared for what that hedge will do. —Kip McDaniel