Interactive charts test | Insight Investment

Text on screen: Using currency hedging to protect asset values

Text on screen: Francesca Fornasari, Head of Currency

Text on screen: Marketing material. For professional clients and qualified investors only.

Over the past year, the dollar has reversed some of the large gains it made against sterling between 2009 and 2024.

FULL PAGE GRAPHIC – TITLE: The pound is undervalued vs the US dollar

Image on screen:A line chart displays the GBP/USD exchange rate from the 1970s to 2025. Reference lines mark the historical 25th percentile, median and 75th percentile levels. The latest exchange rate is positioned below the median and close to the 25th percentile, indicating that the pound is trading at the weaker end of its historical range against the US dollar.

The key question for LGPS investors is how much further the dollar has to fall. This question is important for many LGPS, as they're still sitting on significant unrealized currency gains from their holdings of overseas assets.

We estimate that these gains are still notable and amount to hundreds of millions of pounds for the average scheme. A further unwind of these unrealized gains could harm the funding levels of LGPS.

Looking ahead, we believe there are significant risks that sterling will continue to outperform. If we're right, investors with unhedged overseas assets are likely to experience a further erosion of their funding levels and risk requiring higher contributions from their members, just at a time where many of the schemes are turning cash flow negative.

FULL PAGE GRAPHIC – TITLE: Estimated losses on £500m overseas assets if USD weakens

Image on screen:A bar chart illustrates the potential impact of a weaker US dollar on a £500 million overseas asset portfolio. Two scenarios are shown. If the GBP/USD exchange rate rises to its estimated fair value of 1.53, the portfolio could experience a currency-related loss of approximately £70 million. If the exchange rate rises further to its historical median value of 1.61, the potential loss increases to approximately £100 million. The chart highlights that a strengthening pound and weakening US dollar could significantly reduce the sterling value of overseas assets.

As such, we believe that ensuring appropriate currency risk management is key for the LGPS community. But which approach to currency management is the most appropriate?

Currency risk management can be implemented in two ways, either through a passive hedge or through a dynamic hedge. In the case of a passive hedge, a constant hedge ratio is applied, while in the case of a dynamic, the hedge ratio is fluctuating over time.

FULL PAGE GRAPHIC – TITLE: Hedging could improve returns while limiting volatility

Passive hedge programs will protect the portfolio when sterling increases, but they will generate negative cash flows if sterling weakens. It is also worth noting that hedged share classes are a form of passive hedging.

They're easy to implement, but beware, as they're often very expensive and inefficient. Indeed, according to our analysis, they can lead to as much as a 100 basis points annualized drag on performance.

In short, passive hedging is effective, but it is not appropriate for all investors, particularly those with cash constraints, and this is the case for LGPS funds that have a rise in allocation to illiquid assets.

For cash flow sensitive investors, dynamic hedging is more appropriate. This more flexible currency risk management introducing currency hedges only when sterling is expected to rise. This allows for both the management of cash flows as well as mitigating regret risk if sterling were to fall instead of rise.

FULL PAGE GRAPHIC – TITLE: The ability to protect returns and reduce volatility

If you would like to discuss how to protect your funding levels and lock in your unrealized capital gains in a cash flow sensitive way, we're here to help. We'd love to talk to you about the most efficient and appropriate way to manage your currency risk.