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Why hedging may make sense

Nicki Bourlioufas  |  02 Apr 2020Text size  Decrease  Increase  |  
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The dramatic fall in the Aussie dollar in March and the chance of an equally sharp bounce-back means some investors may be considering hedging their assets to reduce risk.

The Australian dollar hit a decade-low of around US55 cents on 19 March, as world markets digested the coronavirus pandemic and the imminence of global recession. The currency has since rebounded to 61.5 cents and jumped 7 cents in a single week, highlighting its volatility.

Local currency could gravitate higher over the remainder of the year. This means currency hedging makes sense for offshore investments, says Drew Meredith, managing director at financial planning firm Wattle Partners

“Once the Australian dollar moved under US60 cents, we engaged with every client to switch to hedged wherever possible. The dollar is now below historical averages and represents potential risk to those investing overseas,” says Meredith.

“Having experienced volatility at all-time highs, we would prefer to remove at least one risk (currency) from our portfolios and rely on the recovery of share prices from the underlying businesses."

A rise in the Australian dollar diminishes returns when assets are converted into the local currency. On the other hand, any fall helps investors. If the Australian dollar rose by 10 per cent, the value of your offshore investments would fall by the same margin.

Hedging makes sense if you think the Australian dollar is going to rise. It can also play a part if you're a conservative investor and simply don’t want to expose yourself to any currency volatility.

Many analysts expect the Aussie dollar's value to move around this year, as the coronavirus runs its course and the global economy remains stalled.

Hedging isn't without risks

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Assuming that stock prices have hit their nadir and that the Australian dollar has troughed is the main risk, says Simon Doyle, head of fixed income and multi-asset at Schroders.

While both assumptions may be correct, there may also be further downside as the economic realities of shutting down the global economy hits corporate profitability.

“In this environment further weakness in the Australian dollar is probable and this would help offset any further equity weakness … [I] would not be surprised if it falls below US50 cents before this cycle is over,” says Doyle.

“On the basis that it is difficult for individual investors to really manage their currency exposure a more blended approach might be preferable."

Jun Bei Liu, portfolio manager with Tribeca Investment Partners, says Australia's close economic ties with China mean our dollar has long been used as a barometer for global growth.

“While the world continues to combat Covid-19 through forced shutdown and supressed consumption, the Australian dollar is likely to remain volatile,” says Liu.

She expects a flight to safe haven assets or currencies such as the US dollar, but says the suitability of such approaches depends on how much risk your portfolio can handle.

"Currency movements will make the underlying investment return more volatile; in some cases, it may double or erase the entire investment return,” says Liu.

"If investors don’t have a strong view of the currency direction, then a hedged option would definitely provide smoother returns."

Hedging your hedge

Gemma Weeks from ETF Securities says it's impossible to predict how low the Australian dollar will go. And she agrees with Bei Liu's view that the US dollar probably holds more appeal given the volatility of markets at the moment.

But for investors keen to buy the local dollar she suggests another approach.

“After seeing the Australian dollar swing after market crashes before, many investors will still want to take a hedged position at this time. If so, so why not hedge your hedge?" says Weeks.

"By switching 50 per cent of your position into hedged and leaving 50 per cent unhedged, you're essentially mitigating any currency risk, giving investors the best of both worlds."

Over the long run, experts say that currency risks even out – what goes up, must come down – and currency volatility is smoothed out. But if you do decide to hedge now, there may be a small of between 2 to 10 basis points compared to an unhedged version of the same managed fund.

is a Morningstar contributor.

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