Managing risk is a priority for many local authority schemes in an increasingly volatile world. As we’ve shown previously, we believe the LGPS can more effectively diversify equity risk in today’s markets by adding allocations to global credit and global real assets, rather than UK government bonds.

However, the move towards more globally-diversified portfolios means that currency management is an increasingly important factor for local authority schemes to consider. In particular, our long-term expectation is that the US dollar will depreciate against other currencies, including sterling. With this in mind, we look at the challenges posed by a depreciating dollar and show how effective hedging can minimise currency leakage and maximise the return potential of globally diversified portfolios.

Towards global portfolios

The move by local authority schemes towards globally-diversified portfolios is already well established in equities. At the turn of the century, UK equities made up three quarters of LGPS equity allocations. By 2010, UK equity exposure had fallen to half of the overall equity allocation, while today the UK makes up less than 25% of total equity exposure in LGPS portfolios.

LGPS bond exposure is already following the same globalised trend and we expect that real assets will follow suit as schemes increasingly come to see the broader range of opportunities provided by global real estate markets compared to the domestic UK market.

Minimising currency risk

Global diversification brings several benefits, but it also introduces currency risk to LGPS portfolios. Currency management is a particular challenge in the current environment, with the US dollar — which has strengthened significantly in recent years against the pound and further through the COVID-19 crisis —expected to fall in value in our Long-Term Capital Market Assumptions, in line with long-term real exchange rates. A weakening dollar would act as a material drag on sterling returns if dollar-exposure is left unhedged.

The US dollar looks overvalued on a trade-weighted basis

Source: J.P. Morgan Asset Management 2020 Long-Term Capital Market Assumptions; estimates as of September 2018 and September 2019.

Based on our 2020 Long-Term Capital Market Assumptions, we expect that the aggregate LGPS portfolio could expect to earn around an extra half a percentage point in annual returns by fully hedging currency exposure in global equities compared to an unhedged allocation, with only a relatively small uptick in overall volatility.

Impact on LGPS of hedging currency returns for global equities

Source: PIRC Local Authority Pension Performance Analytics Annual Review, J.P. Morgan Asset Management.  Asset allocation data as of 31 March 2019. Expected return assumptions as at 31 March 2020 and 30 September 2019.  Historic drawdown statistics based on 1 July 2006 – 30 June 2019, in accordance with calibration window for long-term capital markets assumptions. 1 PIRC = Pensions & Investment Research Consultants Ltd.

However, the dollar’s traditional role as a safe haven in periods of market uncertainty can leave fully hedged portfolios exposed to greater drawdowns in a market downturn. While we have reason to believe that the dollar’s safe haven qualities may have been eroded, our research suggests that a thoughtful approach to currency management should be applied in global portfolios to balance the risk of long-term depreciation with the safe haven characteristics of the dollar. 

Our recent thematic paper, “Rethinking Safe Havens”, looks at the changing role of safe haven assets in more detail, including the US dollar and currency management.

Further information

If you would like to discuss currency management in more detail, please don’t hesitate to contact your usual J.P. Morgan Asset Management representative.