Summary and Key Messages
publicly traded South African company, constraining it to a passive management strategy. GEPF is not authorized at present to invest internationally, and recognizes that it has a suboptimal portfolio in view of regulatory constraints. One option to address this issue would be to quantify the opportunity costs of these constraints and highlight them to key policy makers, in addition to the gradual approach to liberalization suggested by Iglesias in the following paragraph. Vlaar suggests that domestic regulators seek to limit international investments in order to sustain development of domestic capital markets; Iglesias points to broader motivations, including the need to finance public deficits, concerns about impact on the domestic currency’s value, the existence of currency controls for other investors, political opposition, lack of supervision capacity, and lack of experience with international investing. Iglesias suggests the optimal regulatory approach in such situations may be to develop a gradual strategy to liberalize international investments, authorize transactions in preselected markets, establish rigorous reporting requirements, and coordinate with domestic monetary authorities.
Development of a sound and comprehensive currency hedging policy, explicitly approved by the governing board, is recommended as soon as international investments become a significant proportion of a pension fund’s portfolio Trovik suggests that pension funds should focus on a global hedge ratio for their overall portfolio (domestic and international); separate hedge ratios for individual asset classes should be avoided. Due to some diversification benefits from currencies, a 100 percent hedge ratio is rarely optimal. Using the example of a pension fund whose home currency is the Korean won, Trovik concludes that the optimal hedge ratio is quite low (or even zero) when the allocation to foreign markets is less than 20 percent of the overall portfolio, although he cautions against generalizations, as each case is different. Wysocka, on the other hand, states definitively that in the experience of the Mountain Pacific Group, a formal currency hedging policy becomes necessary only when international equity assets exceed 20 percent of the overall portfolio. Vlaar, Trovik, and Wysocka agree that developing optimal hedge ratios should take into account the costs and liquidity implications of currency hedging. The cost of currency hedging is generally higher for pension funds whose home currency is pegged or where domestic foreign exchange markets are not well developed. In such cases, broadly diversified exposure to a basket of currencies may be the next-best option. Iglesias points out, however, that in Chile, the market for currency hedging instruments has developed rapidly in response to increasing demand, which may 20