Welcome to Finance and Fury. Is it worth it to hedge currency exposures on international investment?

  1. If anyone invests internationally, one major question beyond where to invest is whether you hedge your currency exposure or not
  2. But what does hedging mean, and how can it help or hurt your investment returns on international investments?
  3. To start with, it is important to remember that when you are purchasing an international investment, you are doing so in that countries denomination – so if you buy shares listed in the US, you need to do so in USD, if you are buying shares listed in the UK, you need to do so in the pound, if you are buying Vietnamese shares, you will need some Dongs – get your mind out of the gutter – but you get the picture – You can’t buy Microsoft shares using AUD – but you can convert your Australian dollars to USD and then purchase these assets –

Disclaimer – The information in this episode is general in nature only

To look at the functionality of hedging – An easy example is to look at the purchase of direct shares vs structured investments

  1. If you purchase shares international directly with a broker – say through SelfWealth, or Commsec, or any broker – you will be buying that share in the domination of the country of origin with no hedging present – you will convert your currency to purchase this asset – these investments will not be hedged
  2. However – you can purchase investment vehicles, such as managed funds or ETFs that do the hedging for you
  3. How hedging works – it is a process of removing the risk of currency movements –
    1. Hedging occurs in many forms – Companies that have exposure to foreign markets such as BHP trying to lock in a currency price to sell resources to a Chinese company in 18 months’ time today – managed funds and ETFs also hedge currency risk using forward contracts – but they mostly hedge their risk with currency swap forward contracts
    2. A currency forward contract, also simply called a currency forward – allows the purchaser of the contract to lock in the price they pay for a currency
      1. In essence, the exchange rate is set in place by this contract for a specific period of time – Say a manager wants to lock in the current exchange rate between two currencies for an ongoing basis – they would buy a forward contract on one or more currencies
      2. These contracts can be purchased for every major currency – it can get more difficult for highly volatile or less used currencies – where the contracts can be very expensive
    3. The contract protects the value of the portfolio if exchange rates make the currency less valuable this preserves the value of your share price
      1. On the other hand, if the exchange rate becomes more valuable, the forward contract isn’t needed, and the money to buy it was wasted.
      2. So, there is a cost to buying forward contracts. Funds that use currency hedging believe that the cost of hedging will pay off over time – or simply offer this to investors who believe this is the case
    4. A hedged portfolio incurs more costs but can protect your investment in the event of a sharp decline in a currency’s value.
    5. With ETFs or Managed Funds, you can normally get an option for a hedge or unhedged version of the same investments – such as vanguard index funds, or most other major investment managers –
      1. In the naming of these investments, it should say if these investments are hedged or not – if they don’t say that they are hedged, then the assumption may be that they are unhedged but this is not necessarily the case
      2. The fund may still preserve the right to hedge if they deem it necessary on the investments they are purchasing – double check the mandate in the PDS

How does hedged or unhedged affects returns – this can actually do so in a rather dramatic fashion, depending on the currency in question compared to the AUD

  1. How returns work in theory – Returns from an international investment that is unhedged come in two forms – the underlying returns of the investment that you have purchased plus the currency movements in relation to your domestic currency
  2. Looking at some examples –
    1. Say for example you purchase some Apple shares – if apple increases in price by 10% over a 12-month period, if the AUD to USD remains at parity over this time period, then your returns would be 10%
    2. However, if the AUD to USD currency conversion rate changes, then your total return will be more or less than the nominal price change of Apple – dependent on the exchange rate
    3. Say the AUD and USD are sitting at a parity of $1 to $1 – something that you have to go back to 2011 to 2012 to see – regardless, say this is the case when you initially invest – by the end of the first year the AUD is sitting at $0.8 to $1 USD – so the AUD has depreciated in value – well you were on the right side of the currency movement – as it now takes $1.25 AUD to purchase $1 USD – Therefore your total returns have been around 35% – as not only did apple shares increase by 10%, the exchange rate increased by 25%
    4. The reverse can also be true – say the investment increased by 10% – but the currency depreciated by 25%, then your return would be -15% instead, even though the investments went up in value, the currency did not
  3. This is where you can have the two exact investment managers – holding the same underlying holdings but one will differ to the other in their investment performance dependant on their hedging positions –
  4. To illustrate this point further – lets look at Vanguard’s international Share Index fund – comparing the hedged and unhedged versions and their returns – remember this fund has the same underlying allocation – all that is different is the hedging positions
    1. Hedged – 10y at 10.12%, 5y at 5.42%, 3y at 4.11% and 1y at -17.37%
    2. Unhedged – 10y at 13.69%, 5y at 9.73%, 3y at 6.39% and 1y at -9.72%
  5. Vast difference here – over a 10-year period, say you invested $10k – difference of $26k vs $36k – additional 37% in value from nothing more than the currency changes to the USD to AUD over the past decade

Is it worthwhile to hedge – This is an important question, and doesn’t have a definitive yes or no answer depending on where Australia is in our economic cycle to other nations

  1. Obviously, the correct call over the last decade has been to be in unhedged versus the USA – but this is something that really only hindsight could be certain of
    1. From 2002 to 2012 we appreciated compared to the USD, except for a did in 2009 with the GFC – but the currency rose from around 0.55 AUD to 1 USD to $1.1 AUD to USD at the peak – if you were unhedged in this period, you would have suffered a negative return from a currency movement alone
    2. Regardless of this timing – if you are investing in overseas assets – it is important to consider the value that can be added or subtracted from a hedged position
  2. Looking at a pair between USD and AUD – Australian dollar currently hitting 30-month lows, there are a number of investors switching from unhedged and adding currency hedged exposures to portfolios.
    1. The Australian dollar fell earlier this month to US62c, its lowest level since April 2020, continuing a downward trend since April 2022.
    2. For context, the 5-year average is US72c and the 20-year average is US80c
  3. Forecasting currency is very hard in the short term – almost impossible to be accurate, as what impacts currency ranges from temperature, exports, national debt levels to interest rates – in essence it is supply and demand of the currency which is influenced by many many different factors
    1. At the movement – the USD is considered to be a safe harbour and in high demand – but if confidence in the USD starts to fail, then the currency exchange may start to wane
    2. In comparison – The Australian dollar is seen as a risk-on currency, largely tied to the global growth outlook. Australia is a resource heavy nation, reliant on exports of commodities such as iron-ore, which see more demand when production is high and therefore more demand for Australian dollars to purchase it
    3. But in times of economic turmoil – the US dollar has surged on “safe haven” buying following market concerns about falling share markets, increasing US interest rates and fears of global economic recession
      1. This sort of fall in the AUD to USD can boost returns for investors in unhedged international equities. The increase in foreign currency value has actually helped cushion the equity falls in these markets

Looking at the predictions for the AUD – Australia has a floating exchange rate, which means that AUD’s exchange rate is determined by the demand for and supply of AUD in the foreign exchange market – So what may affect Supply and demand

  1. Interest rates – driver of both supply and demand of currencies in foreign exchange markets due to the differential interest rates between nations – If Australian interest rates increase relative to interest rates in the US, Europe or Japan, Australian assets that pay interest (such as government bonds) become more attractive to foreign investors – This leads to increased demand for Australian dollars – Given that other nations are increasing rates – this decreases the outlook for the AUD apricating
    1. This theory is called the International Fisher Effect (IFE) – stating that the expected disparity between the exchange rate of two currencies is approximately equal to the difference between their countries’ nominal interest rates.
  2. Trade and Exports – driver of demand for a nation’s currency – The higher the exports, generally associated with appreciation in its currency – if a country is importing more than it exports, demand for the currency can be lower
    1. The AUD is commonly referred to as a commodity currency because of Australia’s large share of commodities such as iron ore, natural gas and agricultural products in its exports – so the more the world demands our goods, the higher the demand for the AUD becomes
    2. The higher commodity prices are, can also incentivises exporters to invest in expanding their production capacity, leading to further capital being invested in AUD
  3. Inflation – Prevalent inflation rates and prices of goods and services affect foreign exchange rates in cyclic adjustments based on demand. For example, higher prices for goods and services in Australia relative to the same goods and services in another nation will make Australian goods and services less attractive.
    1. As an example – Putting it all together – during the mining investment boom, a very large increase in commodity prices from the mid-2000s through to 2013 led to large inflows of foreign investment to help expand the production capacity in Australia’s resources sector – we also had low inflation and higher interest rates compared to countries like the USA – so the Australian dollar appreciated significantly during this period, reaching a record high of A$1.10 against the US dollar in 2011
  4. Looking at forecasts – Many Economists currently hold a bearish view in their Australian dollar forecast – this is mainly due to the outlook that we are a commodity currency, and commodity prices may start to decline – hence making us vulnerable to commodity pricing
    1. General consensus sits at around 0.66 by March 2023 and at worst at 0.59 in one year, around October 2023. 
  5. Take all of this with a grain of salt – Note that analysts and algorithm-based Australian dollar forecasts can be wrong – and it often is – no completely accurate way to forecast exchange rates – best you can do is guess what it will be based around factors in 6 to 12 months – but those factors of supply and demand will change over that time period, affecting the predictions
  6. Either way – whilst the price forecasts may not be correct, the direction of the AUD to USD has a general negative consensus due to the exporting pricing predictions

Summary – Role of hedging is like insurance for an investment – aims to protect against the impact of currency movements so that returns are only reflected by the change in the underlying investments change in value and not the currency

  1. but like any insurance, you pay a premium – But unlike insurance – this may result in a worse outcome for an investment return if you are on the wrong side of a hedged position
  2. Whether an investor chooses to currency hedge may depend on the timeframe of their investment and outlooks to a currencies position – Over the long run, hedging may be less important as currency risks typically even out and exposure to currencies such as the US dollar can actually help dampen market volatility. As a result, there could be less reason to hedge against currency movements over the longer term as compared to a shorter-term investment.
  3. If taking a shorter-term tactical view, then switching to or adding currency hedged exposures may be beneficial to offset the potential impact of a rising Australian dollar – the issue is trying to time this movement
  4. With markets likely to remain volatile in 2023, the US dollar could potentially strengthen further, which could see the Australian dollar fall towards US60c or below. It is likely that in order to see a reversal we may need to see a recovery in global growth combined with a pivot from the Fed
  5. However, for investors with a view that the Australian dollar is at its lower bound, considering currency hedge exposures may be beneficial
  6. A way out of this is to diversify – purchase a ratio just in case you are on the wrong side of the trade

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