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Hedged or unhedged: what's best for your ETF

Glenn Freeman  |  02 Sep 2016Text size  Decrease  Increase  |  

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Jonathan Shead, head of portfolio strategists - Asia Pacific, State Street Global Advisors, gives his views on the advantages of using ETFs to boost international exposure.

 

 

Glenn Freeman: I'm Glenn Freeman for Morningstar Australia and I'm joined here today by Jonathan Shead, Head of Portfolio Strategist Asia Pacific for State Street Global Advisors.

Jonathan, thanks for joining us.

Jonathan Shead: My pleasure.

Freeman: Jonathan, how important is currency hedging within the ETF space?

Shead: One of the things we've seen ETFs used for extensively over recent years is gaining exposure to foreign companies, offshore companies.

And that's terrific in that you get exposure to industries and to parts of an economy that we don't have in Australia, but you are also exposed to foreign currency risk. You can't buy a foreign company without also buying that company's currency and that can expose you to currency losses.

So, you might be gaining from a foreign investment holding but losing on the currency side. Hedged ETFs allow you to remove that currency risk from the investment.

Now, of course, sometimes you can make money out of currency as well as lose it. But the terrific thing about hedged ETFs is they give you the flexibility. They give you the choice as to whether you want that foreign currency exposure or not.

Freeman: And what are the market environments that favor hedged ETFs over unhedged and vice versa?

Shead: Well, there are actually two answers to that question. There is a short answer and a long answer.

The short answer is that when the Australian dollar is appreciating in value against foreign currencies, that's a time when you want to hold the Australian dollar, you don't want to hold foreign currencies. That's the environment where a hedged ETF will do well.

A hedged investment of any sort would do better than an unhedged investment. So, the Australian dollar is appreciating, hedged ETFs look good. If the Australian dollar is falling, then unhedged ETFs will do better. That's the shorter-term view.

Over very long periods of time we tended to note that foreign equities tend to do well at the times that the Australian currency is not doing well.

To give you a simple example, if everyone thinks that the world is rosy, that growth in China is going to go through the roof and that the world economy looks in great shape, what tends to happen is global equity markets go up and so does the Australian dollar.

Now, you remember my earlier comment, when the Australian dollar goes up, you tend to lose money from foreign currencies.

It's a long way of saying that very often unhedged ETFs tend to have currency movements that go in the opposite direction to equity market movement. S

o, if you gave me a choice over a long period of time between having a completely unhedged portfolio and a completely hedged portfolio, I would actually choose a completely unhedged portfolio. The problem is that that's a 15-year view and most people have a view that's a little bit shorter than 15 years and so we come back to the first point, which is, on a three to five-year view do you think the Aussie is going to appreciate broadly or do you think it's going to depreciate and that determines your choice.

Freeman: Now, ETFs are just one way that individual investors can access international markets. What are some of the advantages they have over things like managed funds, direct shares and SMAs?

Shead: One of the most powerful features of ETFs broadly is that the pricing you get is live. So, if you take a typical managed fund, the manager will have a cut-off time for your application for you. That cut-off time might be midday, or it might be 2pm in the afternoon. And if you miss that cut-off time, you get the next price.

Most managed funds in Australia strike their prices late that night when markets around the world close. So, if we take an example where your deposit arrives at 3 or 4 o'clock in the afternoon on Tuesday, you don't get Tuesday's price, you get Wednesday's price; but you don't get Wednesday's during the day price, you get the Wednesday's night price in New York or in London or in Paris which means that the gap between when you make your investment and when you actually get your money invested can be 36 hours.

Currency is something people are aware of on an hour-by-hour basis and I think the most powerful thing about currency-hedged ETFs is you can look at where the Australian dollar is trading now and if that's the level you want to get set at, you can get set now.

That's something that you can't really do inside a managed fund. ETFs are also administratively very simple to use. There are other techniques you can use to hedge your currency exposure, things like forwards, but they are a little bit more complex to do.

You need a little bit more expertise to use those kind of instruments. So, ETFs are very easy to use. They are very flexible and you can look at the screen now and get set right now.

Freeman: And Jonathan, how popular are bond ETFs versus their equities equivalent and how are they fairing in the current environment of low bond yields?

Shead: Bond ETFs have taken off more slowly than equity ETFs. Equity ETFs in a sense are at home in an equity market.

In fact, the most natural ETF to have in the Australian equity market is an ETF that owns Australian equities. Extending ETFs in the Australian market that own foreign securities, that took a little bit of doing in the industry.

Similarly, ETFs on the Australian share market that own bonds, which don't trade on the share market, takes a little bit of work doing. So, we found both in terms of the products that have come out in the industry and also how people think about those products and use them, it's taken a little bit longer for bond ETFs to take off.

The broader question about whether in a low yield environment we've seen a flock of investors going towards bond ETFs, I think the ETF market is probably not the best place to gauge those kind of investor trends.

I think investors have been expressing a preference to fixed income across a very wide range of instruments, be it term deposits, be it managed funds or be it ETFs. I don't think that coverage of the bond ETF market is broad enough to discern those trends yet.

Freeman: And just finally, are we currently seeing in the market volatility that money is flowing out of global ETFs into Australian ETFs, or are investors still holding firm?

Shead: I think we're seeing rather than a shift from global to Australian equities, we're seeing a shift in how people actually hold those exposures. So, I think the big story in the last three to five years has been the extent to which people have gained exposure via ETFs instead of via managed funds. I think that's probably been the big shift that we've seen.

Allied to that has been the fact gaining overseas exposure via ETFs has got easier and easier has meant there's probably a large number of investors who didn't previously have much exposure overseas who are now starting to gain that exposure via global ETFs.

Within the domestic market, we've seen global ETFs being used to fill out a portfolio that otherwise holds well-known Australian equities. So, it's really global exposure being brought in by global ETFs I think is the bigger trend we've seen over the last three years rather than any significant capital shift from global equities into Australian equities or the other way around.

Freeman: Thanks very much for joining us, Jonathan.

Shead: My pleasure.

Freeman: I'm Glenn Freeman for Morningstar. Thanks for watching.

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Glenn Freeman is Morningstar's senior editor.

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