Contact: Ian Howell, (01962) 847540; email: [email protected]

1 Summary

1.1 The Panel last considered the impact of currencies on the Fund's investments at its meeting on 25 May 2007. It decided not to apply a passive currency overlay to hedge the Fund's exposure to overseas currencies back to UK sterling. In addition, the Panel agreed that active currency management should be considered as an asset class for inclusion in the Fund's alternative investments portfolio managed by Bramdean.

1.2 This report reviews the options for currency management in the light of further research by the Fund's alternative investments adviser, Bramdean. The Fund's independent adviser has also raised concerns about whether the current approach is appropriate for all the Fund's assets.

1.3 The report concludes that the Panel's current policy is still valid for the Fund's overseas assets that are actively traded in liquid markets such as the global equities portfolios but that there are grounds for applying a passive currency overlay to the Fund's less liquid overseas assets such as the European indirect property portfolio and the alternative investments portfolio.

2 Recommendations

a) That passive currency overlay should not be applied to the Fund's listed equity and bonds portfolios.

b) That Bramdean Asset Management be asked to include currency management within their portfolio of alternative investments.

c) That Bramdean Asset Management be asked to select one or more currency manager to apply a passive currency overlay to the Fund's currency exposure from the European indirect property portfolio and the alternative investments portfolio, including the Governance for Owners European Focus Fund, and as appropriate to undertake active currency management.

d) That the County Treasurer, in consultation with the independent adviser, be authorised to agree recommendations from Bramdean Asset Management on the appointment of currency managers within the alternative investments portfolio.

3 Background

3.1 The Fund's portfolios of global equities, global bonds, European property funds and alternative investments are held in a range of overseas currencies as illustrated in Table 1 below. It shows the currency breakdown of the total Fund, including the UK portfolios, at 31 March 2008.

3.2 A full list of the 20 currencies in which the Fund is invested is attached at Appendix 1.

3.3 Over 92% of the Fund was invested in the four main currencies, UK sterling, Euro, US dollar and Japanese yen. The next largest currency was the Swiss franc at 1.8% of the Fund.

4 Currency risks

4.1 In total, 31% of the Fund was invested in overseas currencies at 31 March 2008 and this brings an additional risk to the Fund from currency fluctuations, in addition to the risk associated with the underlying investments.

4.2 The Fund's liabilities to its members are all denominated in sterling and it can be argued that it is an unnecessary risk to hold part of the Fund's assets in other currencies. In recent times, sterling has been strong against the US dollar but weak against the Euro and the Yen. If sterling were to recover against the Euro, for example, the Fund's Euro denominated assets would be worth less in sterling terms. On the other hand, a weakening of sterling against the US dollar would be to the Fund's advantage.

5 Currency management by the Fund's existing managers

5.1 The Fund's three global equities managers, Aberdeen, AllianceBernstein and Newton, all manage their currency exposures to some degree as a means of obtaining or maintaining their performance returns. AllianceBernstein are the most active, with Aberdeen and Newton only hedging their currency exposure if they liked an individual company but not its currency.

5.2 The global bonds portfolio managed by Western is hedged to sterling, in line with the Lehman Bros Bonds Index which is used as the basis for Western's performance target.

5.3 Goodman's portfolio of indirect European property funds is held in Euros and no action is currently taken to hedge the currency exposure. Similarly, the alternative investments portfolio managed by Bramdean is partly held in US dollars and Euros. The Governance for Owners European Focus Fund, which is outside Bramdean's portfolio, is also held in Euros.

6 Options

6.1 Currency managers can provide a passive currency overlay service to hedge the Fund's currency exposure back to sterling. In addition, they can take active currency positions in an attempt to make money by predicting future currency movements.

6.2 The Panel could apply a passive currency overlay to hedge all the Fund's currency exposure back to sterling. However, this would be inconsistent with the Panel's decision in 2007 to appoint active global equity managers, Aberdeen, AllianceBernstein and Newton, with mandates that allow them to use currency management as a means of outperforming. They take into account currency factors as part of their assessment of individual stocks. Unlike the European property portfolio and the private equity holdings, for example, the liquidity of quoted equity markets allows the managers to make short-term tactical adjustments to their holdings if necessary. The global bonds portfolio managed by Western is already hedged back to sterling.

6.3 This leaves the European indirect property portfolio, the Governance for Owners European Focus Fund and the alternative investments portfolio managed by Bramdean. All three are much less liquid than listed equities and there is a much stronger case for hedging their currency exposure back to sterling. At 31 March 2008, these portfolios were invested in UK sterling, US dollars and Euros, as the Table below shows.

6.4 These amounts will increase as further commitments are made to the alternative investments portfolio and the amounts already committed are drawn down. Eventually, up to £300m might be invested in overseas currencies for these portfolios when they are fully drawn down. The Fund's independent adviser has expressed the view that the currency exposure of these assets should be hedged back to sterling as their managers has no means, or incentive, to protect their value against currency movements.

7 Bramdean's views

7.1 Analysis by Bramdean's former head of research Michael Kinney suggested that currency hedging had no significant impact on long-term returns or volatility of equities. It does reduce volatility of overseas bonds, however, and also improves the correlation between overseas and UK bonds. With only a 5% allocation to global bonds (and that portfolio already hedged to sterling), Bramdean concluded that no action need be taken to apply a passive currency overlay to the Fund.

7.2 With Michael Kinney's departure, Bramdean's focus has moved from this analysis of historical returns to a more instinctive view that holding a large proportion of a UK Pension Fund in unhedged overseas currencies is an undue risk. Nicola Horlick has accepted, however, the analysis in paragraph 6.2 above that hedging the global equity portfolios would be incompatible with the managers' mandates which allow them to use currency management to enhance their returns.

8 Other views

8.1 Emily McGuire from the Fund's actuary, Hewitt, discussed the advantages and disadvantages of different forms of currency management with the County Treasurer in November 2006 and concluded that taking no action on currency hedging was a plausible option in the Fund's particular circumstances. She commented that passive currency management is likely to be low cost but there are risks of large downsides if an active currency manager makes a wrong call. Some commentators have expressed doubts about whether even experienced currency managers can beat the market in the long run.

8.2 The County Treasurer discussed the issue with Hugh Adlington of Rathbone Investment Management in February 2008. As reported to the Panel in November 2007, Rathbones had made an interesting presentation to the Panel's sub-group on alternative investments earlier that month. As a principle, Mr Adlington would hedge currency exposure back to sterling to avoid speculating on currency movements. He commented that some currency managers are able to provide "dynamic hedging" as a half-way house between passive and fully active currency management. This would limit losses but can provide some participation for the Fund in gains.

8.3 The County Treasurer has also sought the views of the Fund's investment managers in February 2008. None expressed strong views that the Fund should hedge its currency exposure, whilst SGAM's Keith Percy argued that it should not as currency movements were one of the factors taken into account by global equity managers in making their stock selection decisions.

9 The way forward

9.1 Bramdean could be asked to allocate part of the alternative investments portfolio to currency management. They would be required to appoint a manager to apply a passive currency overlay to the currency exposure of the European property portfolio and the alternative investments portfolio including Governance for Owners.

9.2 In addition, Bramdean could be authorised to decide whether the currency manager should take active currency positions as Bramdean saw fit. The results of any active currency management would count against Brandean's overall performance target for the alternative investments portfolio. This would place active currency management on an equal footing with the other alternative asset classes within Bramdean's portfolio. The funding required for both passive and active currency management would be met from Bramdean's allocation for alternative investments. Bramdean would be able to decide whether a fully active, "dynamic hedging" or any other approach was appropriate, in the light of prevailing circumstances, and whether it was appropriate to appoint one or more managers to obtain the necessary skills.

9.3 Bramdean have already prepared a research file on potential currency managers. If the Panel agree this approach, Bramdean will nominate their selected manager(s) after any necessary further due diligence work, in a similar way to their recommendations for potential private equity funds.

Section 100D - Local Government Act 1972 - background documents

The following documents discuss facts or matters on which this report, or an important part of it, is based and have been relied upon to a material extent in the preparation of this report.

NB: The list excludes:

None.

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Appendix 1

Hampshire Pension Fund 31 March 2008

Analysed by currency

Note: some overseas equities are not listed on stock exchanges in their local currencies. For example, the Brazilian oil company Petrobras is listed in US dollars.