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The pros and cons of currency hedging

Nicki Bourlioufas  |  22 Jul 2019Text size  Decrease  Increase  |  
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Now could be the time for investors to consider whether hedging offshore investments is the best approach, with expectations the Australian dollar will follow official interest rates lower.

The decision 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 fall helps investors as it magnifies gains when assets are converted into local dollars.

For example, if the Australian dollar falls by 10 per cent, the value of your offshore investments would rise by 10 per cent. The Aussie dollar is currently trading around US70c, but some economists expect it to fall to US65c later this year or early next year, given expectations of further interest rate cuts.

However, any rise in the Australian dollar diminishes returns when assets are converted into the local currency. The Australian dollar is considered pro-cyclical, so it typically goes up when global equity markets are rising and fall when equity markets sell-off.

Weighing your risk appetite

So, should investors have hedged or unhedged investments or some of both? It’s an important question and fund managers are increasingly offering hedged and unhedged versions of the same international managed funds to appeal to investors with different risk appetites.

Aidan Geysen, head of Vangard’s Investment Strategy Group, says currency hedging should be part of a long-term asset allocation decision, made in accordance with an investors’ investment objectives and risk appetite.

"There are a number of different factors to consider when thinking about hedging. High among these is an investor’s risk tolerance given the potential for long periods where the currency moves unfavourably,” says Geysen.

Brett Evans, managing director of Atlas Wealth Management, says someone with a low risk tolerance “may just want to try and stabilise their returns and are happy to offset currency gains with lower returns and higher fees."

“An investor with a higher risk tolerance may use hedging as an investment tool if they are taking a top-down approach to managing assets and [they] foresee currency weakness that they would like to protect against but not change their asset allocation to a particular market or stock,” he says.

Both dollar and opportunity costs

Cost is another key factor, as currency hedging increases your portfolio expenses.

"Developed markets are less expensive to hedge than emerging markets, so investors could consider hedging just the developed markets component of their overseas investments," Geysen say.

Vanguard offers hedged and unhedged versions of most of its developed market international exchange traded funds (ETFs). Hedging typically adds an additional 0.02 per cent to 0.04 per cent to the cost of a Vanguard fund.

While ASX-listed international ETFS are denominated in Australian dollars, the underlying investments are traded in another currency. This means that exchange rate movements will affect the value of ETFs.

Evans says the opportunity cost of hedging is another important consideration for investors.

“Investors may or may not be aware that there is a cost to hedging an investment, both in the intrinsic sense of higher fees as well as the potential of lost returns by getting it wrong,” he says.

If investors opt to hedge their investments and the Australian currency falls, then they will miss out on currency gains once the value of their investment is converted into local currency.

A better way to hedge

A third key consideration is the relationship between the Australian dollar and overseas equities.

In periods of significant market stress, historically the Australian dollar has fallen. During the technology wreck of the last 1990s, the Australian dollar fell to around US50c, and during the global financial crisis, it fell to around US60c.

“The Australian dollar has displayed a positive correlation to overseas equities through most of its post float history [since 1983],” says Geysen.

“Although the Australian dollar has over the long term moved in step with global equities, shorter term timeframes have seen much more variation."

He suggests that hedging a component of foreign currency over the long-term is a lower volatility way of using this approach within a share portfolio, instead of moving in and out of currency hedging positions or having a fully hedged or unhedged position.

"Not all investors will be better off by being exposed to currency fluctuations throughout their investment time horizon.

“The hedging decision is more straightforward in fixed interest portfolios, which benefit more from being fully or substantially hedged than equity portfolios because bonds typically have lower volatility than shares," Geysen says.

If left unchecked, he believes currency volatility can undermine the key defensive characteristics that prompt many investors to invest in bonds and other fixed income vehicles.

 

 

is a Morningstar contributor.

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