The decision whether to hedge one’s currency exposure is important as movements in the Australian dollar can either erode or add value to international investments.
So, if, for example, the Australian dollar falls by 10 per cent, the value of international investments such as US equity managed funds or exchange-traded funds would rise by 10 per cent when converted into local dollars. However, any rise in the Australian dollar diminishes returns when international assets are converted into the local currency. Foreign investments are usually held in the local currency and asset values must be converted into Australian dollars to determine returns.
There has been an increasing trend for fund managers to launch hedged options on unhedged international equity actively managed and exchange-traded funds, putting the onus on the investor or their adviser to make the decision on hedging. Adding to the importance of the decision is that more investors are moving their assets offshore, especially to the US stock market given the impressive gains by the technology sector and FAANG stocks and lately, BAANG stocks, or those linked to gold. So, should investors in managed funds and exchange-traded funds have hedged or unhedged investments or some of both?
One of the most important factors to consider is the type of investment. If you are investing in a defensive asset class like government bonds or other fixed income assets, where capital stability and income are key objectives, then removing the currency volatility is very important. However, if you are investing in equities for growth over the long term, then currency fluctuations are less of an issue and simply an expected part of the investment journey.
It’s also important to understand that the Australian dollar moves with offshore equity markets and in the past we have seen the Australian dollar fall when share markets have dropped and therefore act as an insulator in times of market stress. For this reason, having unhedged international investments in a portfolio can be a very valuable source of returns when needed the most.
For investors who are more sensitive to shorter term volatility, they may prefer to hold hedged investments. A sharp rise in the Australian dollar can generate a big drop in earnings from international assets. Hedging can also play a part for conservative investors who simply don’t want to expose their portfolios to any currency volatility.
A common route being taken by investors is to take a bet each way on the currency and buy into both hedged and unhedged managed international share funds. The more conservative the investor and the lower their tolerance for risk, the higher the ratio of hedged investments versus unhedged investments they would adopt to minimise their currency exposure.
Another important consideration to the hedging decision might be cost. Like insurance policies, hedging will add slightly to the cost of a managed fund, typically between two and five basis points. But like any insurance, that's a potentially small cost compared to returns investors could be protecting if the Australian dollar appreciates. While the outlook is for short-term depreciation over time according to economists, what goes down could eventually come up. That is very true of the Australian dollar. Over time, currency risks balance out, and hedging may not be necessary.
Michael Kodari, CEO of Kodari Securities
