SPONSORED CONTENT| Australian super funds are increasingly exposed to currency risk, as local competition for property, infrastructure and debt force them to look internationally for private assets.
With currency hedging moving to the forefront as asset owners increase their exposure to unlisted assets, a Investment Magazine roundtable discussed the challenges of investing in private markets and hedging those assets back into Australian dollars.
Two different strategies can be adopted when institutional investors hedge against exchange rates moving against them. Investors can either hedge individual assets or hedge currency at the portfolio level.
Here, participants on the roundtable were split. The Future Fund – which has a large private markets program with most of the assets held offshore – manages currency at the total portfolio level.
“We have relatively high levels of portfolio illiquidity and, as a consequence of that and our approach to currency management, relatively high levels of liquidity risk in general,” said Nigel Wilkin-Smith, the Future Fund’s director of portfolio construction. But he said the fund can’t fully hedge the portfolio as that wouldn’t be effective or even possible from a liquidity risk management standpoint.
“There are clear interaction effects between the management of short-term liquidity, flexibility, risk exposure and currency,” he said. “So, we need to think holistically about what an acceptable range of exposure is for each of these risks.”
“We receive an FX exposure from our underlying physical (or funded) portfolio and we complete that to our desired developed markets and emerging markets foreign exchange exposures as required.”
Hedging approach
The $170 billion AustralianSuper – tipped to grow to $250 billion over the next three to five years – is one of the few superannuation funds globally that hedges currency from the bottom-up. “We look at the security level and full exposure at the top,” said Joris Hillmann, the head of capital markets. “Some assets we hedge direct but most of the hedging is at the portfolio level.” On the currency side, Australian Super hedges 100 per cent of its portfolio but also manages active foreign exposure through an overlay strategy. “Within that {overlay strategy} we manage active tilts,” he said.
David Baré, director of institutional solutions, global markets, at the Commonwealth Bank of Australia, said hedging doesn’t necessarily need to be costly. He said term basis was an interesting concept where typically the currency basis is an upward sloping curve. “The longer you go out up until about 10 years or so, and recently beyond 10 years, you can earn a decent rolldown on that currency basis trade.
“When you’ve got a core amount of offshore investment, instead of rolling for three months, you could substitute out some of that three-month hedge, put it as a 10-year hedge, and pick up that currency basis,” he said. “Then your FX position is still hedged in the same way but you’re earning more on the basis.”
Ability to hedge
Richard Kerr, head of treasury services at IFM Investors, hedges infrastructure assets with uncollateralised long-dated FX forwards out five or six years if possible. Kerr said IFM would go out 20 years if it could. “Importantly, banks are wearing the liquidity risk,” he said. “One potential problem with long term FX forwards is that you’ve got a lot of embedded interest rate and credit risk in there. Only FX options can negate duration and hedge settlement liquidity risk,” he said.
Kerr conceded that hedging flexibility such as terming out the forwards may not be possible with a private equity asset that has a long-term realisation date. “This presumes that your offshore asset has some sort of cashflow,” he said. And that may not be the case. So, the FX forwards are termed out to match what we call “cashflow-at-risk.” Kerr pointed out though that infrastructure equity pays some sort of coupon or dividend, which can be ploughed back in to meet the hedge settlement.
Because of its scale, the $167 billion Future Fund can’t manage its FX exposure solely through the use of cross-currency swaps and basis trades. “So, we’ve accepted the trade-off that while we’re a long horizon investor, we predominantly use fairly short-dated currency forwards to manage FX risk in our portfolio,” said Wilkin-Smith. “Given the liquidity and tenor of the underlying hedging instruments that does give us some flexibility, but we do need to manage the contingent liquidity risk of that approach. We are also exposed to the duration mismatch between assets and liabilities, but we’ve factored in that risk and accepted the trade-offs.”
The Future Fund can also use options to hedge flexibility risks at times when portfolio flexibility is lower than desired. Wilkin-Smith said that the Future Fund was not in a position to sell underlying offshore illiquid assets to rebalance FX exposures, so the private markets program tends to increase beyond targeted levels when the Australian dollar weakens more than anticipated.
QIC global infrastructure principal, Carolyn Martin, spoke about the importance of understanding client mandates, underlying investment cashflows as well as focussing on asset valuations. She said as part of its portfolio management QIC manages foreign currency movements for assets that are denominated in a currency that differs to the underlying investment vehicle.”
“So, you’re hedging your investment per se,” she said. Those investments are independently valued in their local currency. The portfolio hedges are then adjusted considering these valuation movements. She added that the hedging was conducted at a fund level, typically on an uncollateralised basis and for longer term tenors. This was however dependent on the views on the hedging and currency markets at that time.
“The difference to other asset classes is that infrastructure assets are illiquid and typically very long-dated, so we generally seek to implement hedging on a longer-term basis to reflect the investment valuations and term of the fund,” Martin said.
“So, much more so than some, we’re really thinking about the overall portfolio construction, considering the tenor of the assets, liquidity of the fund and actual cashflows from the underlying assets over time.”
Liquidity risk
Liquidity risk is a top issue for all funds that can lead to “quite a significant risk” said the roundtable’s facilitator, Alex Proimos from Conexus Financial.
“We’ve had this massive increase in appetite for unlisted assets from super funds,” added CBA’s director of investor client management, Scott Russell, before pointing out that investors could sell listed assets to realise liquidity back in 2008. “We’ve had a change in the regulatory environment and many funds are now fully collateralised,” he said.
With the introduction of Prudential Standard 226, hedging typically requires short-term cash liquidity in the form of either variation margin or for settlement of FX forward rolls that are typically excluded from variation margin.
“Still, if people aren’t going into these hedges with their eyes wide open, that risk is going to be more profound,” Russell warned. “The risks of dealing with the pro-cyclical line with the Aussie currency and the risks of currency hedging in that long horizon illiquid assets are not fully appreciated.”
Hillmann also cited the need to manage liquidity alongside the hedging program “I think it’s a fine line between how much illiquidity you want and how much liquidity you think you need, and then do a lot of stress testing on top of that,” he said.
Classifying risk
The roundtable also discussed how to classify the risk dynamics of these unlisted assets appropriately. “So, what I’m saying there is what’s growth, what’s defensive, you know, how do you know a toll road is riskier than an airport and the currency dynamics around that?” said Adam Karaelis, senior analyst at Vision Super.
The Future Fund’s Wilkin-Smith said there were different views across the investment team on valuing investments and expected returns. “Everyone has their own frameworks,” he said. “The property team will think about cap rates, the Infrastructure team will think about discount rates and Equities team will think of real discount rates.
“There are different valuation frameworks and methodologies. Idiosyncratic risk always seems very pronounced from the bottom-up, but we believe that systematic risks will dominate the risk profile of the total portfolio. Our investment process encourages the investment team to bring forward their best opportunities regardless of sector and then applies a standardised lens to make the best investment decisions for the whole portfolio.”
Stress test
Every day Australia’s sovereign wealth fund imposes a very conservative crash test on its portfolios to ensure they have adequate short-term liquidity. “We have to have enough at-call liquidity to meet that crash test every single day,” said Wilkin-Smith, adding that they stress test current counterparty arrangements as well as hypothetical counterparty arrangements the sovereign wealth fund may have in the future.
“Moreover, we also have the concept of portfolio flexibility,” he said. “You know, how much of the current portfolio can we transform into at-call liquidity over a two to six-month period to reposition it and take advantage of new opportunities or to preserve value. I mean, in the case of the Future Fund we don’t have inflows and we don’t expect outflows until 2027, so we’re in a different position to superannuation funds and other asset owners in Australia.”
Vision Super hasn’t owned much private equity or unlisted assets since the global financial crisis after the downturn exposed a number of shortcomings in the portfolio.
Karaelis said they were sticking to “plain vanilla” investments after not fully appreciating the dynamics of hedging unlisted investments and getting caught on the wrong side of a currency hedge. “For example, when we wanted liquidity from fixed income mandates, we found there were problems with getting the funds returned so we could allocate them to other markets – a usual strategy when markets go bad,” he said.
“People got really badly burnt by because they didn’t sufficiently understand the liquidity risk of the liquid hedge over assets that turned out to be correlated to their base currency,” added IFM’s Kerr.
