To hedge, or not to hedge?

Nicki Bourlioufas | 13 Jul 2012

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Nicki Bourlioufas is a Morningstar contributor.


While a rising Australian dollar may erode returns from international investments, experts say investors shouldn't be quick to hedge their currency exposure as it limits downside risk in falling equity markets.

A rising Australian dollar erodes returns for international investors when assets are converted into local currency. So, for example, if the Australian dollar rises 10 per cent, the value of offshore investments falls by 10 per cent.

For investors in offshore assets, such currency movements represent losses or gains on their portfolios depending on which way the currency moves.

"If you are taking a tactical view on the currency, then if you think the Australian dollar will continue to rise, then you'd hedge your investments. If you think it will fall, then you wouldn't hedge," says Tim Murphy, co-head of fund research at Morningstar.

"But most investors don't take a tactical view on the currency," he says.

Murphy says for most Australian investors, it makes sense to have some unhedged currency exposure to international assets in their portfolio, as it can limit downside risk.

"The most important issue to consider is the fact that being unhedged in international equities reduces risk in an investor's portfolio," he says.

"That's because the Australian dollar is globally viewed as a risk-on currency, which means that when equity markets rise, the Australian dollar tends to rise also. But when markets pull back, the Australian dollar falls.

"So, if offshore markets are selling off, you get a return pick-up from the currency exposure as the fall in the Australian dollar offsets the fall in offshore equity values. That's typically what has happened and that is what we think will continue to be the experience in the future."

For investors in offshore assets, the decision about whether to hedge is increasingly being left to them rather than fund managers.

"There's been an increasing trend for fund managers to launch hedged options on unhedged international equity funds, putting the onus back on the investor or their advisor to make the decision on hedging," Murphy says.

A common route being taken by investors is to buy into both hedged and unhedged international managed funds.

"It's common for investors to take a bet each way and have some exposure to hedged and unhedged investments," Murphy says.

The time frame of an investment may also play a role in the hedging decision. If, for example, you're investing for the short term and you think the local currency will rise over that period, then hedging makes sense.

"If you've only got a short-term window, then taking some currency exposure off the table may reduce the risk of your investment."

But there is a cost to hedging and you can expect to add an additional fee of 5 to 10 basis points to the cost of an unhedged version, Murphy says.

In terms of fixed interest, most international funds are hedged "as the inverse correlation between the Australian dollar and equities isn't true for fixed interest," says Murphy.

"Additionally, if you think about why someone would invest in fixed interest in the first place (they are conservative or income-seeking), it makes little sense to add currency risk to that exposure."

For retail investors in international exchange-traded funds (ETFs), the issue of hedging is typically addressed by product providers.

iShares, which offers 19 international ETFs on the Australian Securities Exchange (ASX), says the strong Australian dollar has made its ETFs popular because it has made accessing offshore investments cheaper.

iShares has almost $1 billion invested across its range of 19 international ETFs, which are unhedged to keep the products simple.

"Demand for iShares international ETF products spiked when the Australian dollar hit parity in October 2010, and since then, has remained strong," says Mark Oliver, head of iShares Australia.

"The potential for the Australian dollar to weaken from its current high levels is keeping investors interested, as any weakening in the local currency would magnify capital gains for investors," he says.

Other ETFs available to Australian investors may he hedged. BetaShares has launched four ETFs that track commodities, one based on physical gold and three that track futures prices of agriculture, oil and broad commodities.

As commodities are typically traded in US dollars, the ETFs are hedged back into Australian dollars, "so currency fluctuations won't affect your returns," says Drew Corbett, head of investment strategy at BetaShares.

"Investors get exposure to commodities without taking on any currency risk."

The question of hedging comes at a time when many economists expect the Australian dollar to maintain its level above parity.

Westpac Bank, for example, expects the currency to dip below parity during the September 2012 quarter, but to rise back above parity to $1.02 by the year's end.

The bank then expects a run to $1.06 by the March 2013 quarter. So, for international investors, international assets may get cheaper still.

This report appeared on 2020 Morningstar Australasia Pty Limited

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