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To hedge or not to hedge?

Nicki Bourlioufas  |  31 Jul 2017Text size  Decrease  Increase  |  

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The rise in the Australian dollar to 80 US cents has surprised many people. Investors who may be exposed to currency movements via offshore investments might be feeling the pain once offshore returns are converted to local currency as currency depreciations will deplete their returns.

 

But that pain is only expected to be temporary and most analysts think the currency is expected to head back towards 70 US cents, though over the short term, it could head a little higher.

The decision about whether to hedge your currency exposure is an important one as movements in the Australian dollar can either erode or add value to your investment. Any drop in the Australian dollar helps investors as it magnifies gains when assets are converted into local dollars.

So, if, for example, the Australian dollar fell by 10 per cent, the value of your offshore investments would rise by 10 per cent.

But currency appreciation can be bad for returns as it will eat into your international returns once they are converted to Australian dollars (as you'll be getting fewer). But with the currency not expected to head over 80 US cents, the experts are saying it isn't time to worry and rush into hedged investments, depending on the investments you make.

The good news is that buying offshore assets becomes cheaper, according to Andrew Lord, a director at wealth management firm Sherbrook Private, who has recently been visiting the US and investing in US assets on behalf of his high net worth clients.

David Sokulsky, chief investment officer of Crestone Wealth Management, says when investing in defensive asset classes such as fixed income, investors typically hedge offshore investments as "you don't want to add volatility to a defensive asset class".

But with shares, "currency movements are considered part of the return you can get from offshore investments". So, for example, if you're invested in US assets and the Australian currency falls, it can boost your return from investing in US equities.

"With the Australian dollar at around 80 US cents, this isn't time to hedge out currency risk unless you think the dollar will go above 80 US cents or to 90 US cents, which we don't think it will. Over the medium term, we think the currency will likely stay where it is or go lower towards 75 US cents We think that it is at the top of its range over the medium term," Sokulsky says.

"So, if you chose to invest in offshore offsets now, you would probably make an unhedged investment to take advantage of any currency depreciation. But if the currency was at or below 65 US cents, then you would hedge your offshore share investments to protect against any currency appreciation," he said.

Sherbrook's Lord says the currency's appreciation is a good thing if you're buying offshore assets.

"To this end, we are taking the position to retain an unhedged position and as the Australian dollar strengthens, we use this to further increase our exposure to specific areas of the US property and corporate credit markets," he says.

"Foreign investment decisions are made more from the perspective of where we don't want to be (Australian shares and bonds), than from where we want to be."

While Lord isn't in the business of predicting currency movements, he isn't so confident that the currency will fall back to 75 US cents any time soon. Instead, the US dollar could keep on falling as real US interest rates drop due to rising inflation, with President Donald Trump's expansionary economic policies spurring on wages growth and prices.

"Australia, despite the slowest wage growth since the 1930s, will possibly raise rates (a 100-basis-point rate increase is expected in 2017) before the US does, which would further strengthen the Australian dollar."

Outside the US, the Australian dollar isn't expected to rise against the euro. Indeed, Sokulsky says the case for being unhedged is even stronger for European investments, with the euro widely expected to strengthen given improving growth prospects in Europe.

"It's a clearer case with the euro investments. There is a very higher probability that the Australian dollar won't go up against the euro. But with the US there is a bit more uncertainty. But at the moment, I wouldn't be hedging against the US or euro, though the argument is less clear cut with US investments."

Sokulsky is upbeat on European markets too. He says they offer better value than US equities which appear fully priced, on which he is therefore neutral.

"We've been overweight European equities for three months now and we still think there is further upside to come ... Politically, the US is facing more uncertainty compared to a few months ago and European valuations are more attractive."

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Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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