Time to protect against currency risk or not?
The success of a hedging strategy depends on getting the direction of a currency right.
To hedge or not to hedge, that is the question in the minds of some strategists as the Australian dollar continues its climb.
The dollar could climb as high as US80c in coming months, according to some forecasts, as markets shrug off the covid impact and the local currency follows iron ore prices higher.
The dollar is at two-year highs of about US73 cents, but Westpac sees it at US75 cents by the year’s end and at US80 cents by the end of 2021. That’s a sharp rise from US70 cents in January 2020 and its year low of around US58c in March after the share market correction.
The increase in commodity prices, particularly iron ore, over recent months, has pushed the dollar higher, according to the Reserve Bank of Australia (RBA).
In addition, the substantial policy stimulus from the US Federal Reserve in response to COVID-19 has led to a weaker US dollar, propping up the local currency. The chart below shows the recent sharp uptick in the Australian dollar against the US dollar, euro and yen in 2020, a trend firmly in place since its March low.
With the Australian dollar potentially headed even higher, some investors might want to hedge their offshore investments to avoid losing gains on international investments. For each 10 per cent rise in the Australian dollar, the value of offshore investments falls by 10 per cent when converted to local currency.
But is now a good time to hedge or is it too late? Miguel Castillo, portfolio manager at American Century Investments, says the success of a currency hedging strategy depends on getting the direction of a currency right.
“If there is a good chance that the currency will appreciate, hedging the currency risk from offshore investments would mitigate loss of capital,” says Castillo.
“In global fixed income at American Century Investments, we see potential for some appreciation of Australian dollar, but to a lesser extent than consensus as part of a cyclical rebound in growth orchestrated over the next 18 months. Investors with a high degree of sensitivity to the value of the local currency should consider some hedging,” he says.
Drew Meredith, managing director at financial planning firm Wattle Partners, says if a time has ever warranted an active hedging policy, like that used by many “active” global equity managers, it is now.
“Hedging at this point removes the risk of losses should the Australian continue to recover on the back of stronger commodity prices, despite a comparatively weak economy,” says Meredith.
“When the Australian dollar has been below the long-term average (around US65 cents) we seek hedging wherever possible and when it is trading well above this for an extended period of time, we look to reduce hedging,” he says.
“This strategy worked as recently as much, with some unhedged versus hedged products delivering 15 per cent better returns for those willing to make the call. At US70 cents, the discussion is more difficult, but even more so with the backdrop of COVID-19.”
Most actively managed funds charge around 5 to 10 basis points extra for hedged versions and ETFs similarly, 5 to 10 basis points.
“Importantly, this becomes more expensive the greater the number of currencies and as it expands into emerging markets,” says Meredith.
Adds Castillo: “In cases where the currency to be hedged is less liquid or access is limited by the government, the cost of hedging goes up and that could translate into a slightly higher management fee.”
Over the long run, economists say that currency risks even out—what goes up, must come down—and currency volatility is smoothed out. As a result, there could be less reason to hedge currency movements over the long term as compared to short-term investments as you could be cutting yourself off from the benefits when the Australian dollar falls.
The currency is volatile too, and predicting its direction is fraught with difficulty, says Simon Doyle, Schroders, head of fixed income & multi-asset, who invests globally.
“Forecasts of US80 cents today are likely to be no more reliable than forecasts of US50c made six months ago. What’s more predictable in the case of the Australian dollar is that it tends to rise when global share markets are rising and decline when they’re falling,” says Doyle, referring to the Australian dollar’s fall to US58 cents in March after share markets plunged, but a strong corresponding rebound.
“For most investors, this would suggest holding their global equity investments in a mix of both hedged and unhedged portfolio formats as trying to time the turning points in both equity and currency markets will be fraught with risk. This approach has the benefit of participation in rising share markets, but it provides some protection when markets are falling,” says Doyle.
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