Hedging your bets with ETFs

The recent widely anticipated RBA decision to cut the official cash rate to the historically low 2 per cent per annum sends some important messages to Australian share investors. Our economy is out of sync with the recovery now underway in the US, and is trending towards the sluggish European economies where their negative interest rates are a reaction to danger of deflation. Our share market is now seen by many as being expensive and risky, reinforcing that global investments should be a bigger part of investment portfolios. To access US growth, local investors have for the past couple of years been buying ETFs and active fund managers like Magellan (who can pick stocks on merit, irrespective of their country of domicile). Local investors who do so need to be aware of the impact that currency fluctuations will have on their offshore investments, and understand the opportunities available through the growing range of international ETFs with embedded currency hedging.

Currency wars?

There's another aspect to low interest rates that's not widely spoken about. The official line from central banks is that low rates help stimulate domestic economies by reducing their costs of production and living. The knock on effect is that low rates also help spur share market growth (that's a demonstrable effect in our local economy).

The “hidden” effect of low rates is that they drive the value of the local currency down, making exports more competitive and adding another growth driver to economic recovery.

Slashing currency values was the weapon of choice in the Great Depression, and economic co-operation since then has included strong measures to prevent currency “wars,” so the currency linkage isn't highlighted as a prime reason for rate reduction. But that doesn't mean that we aren't in the midst of significant currency jockeying among global powers – and Australian investors need to be aware of this as they increase their global share market exposure.

Currencies are likely to continue to fluctuate wildly for some time yet, and central banks around the world will continue to use interest rates to manipulate this to maximise the competitiveness of their domestic industries.

How do currency values impact on share prices?

International share funds and ETFs invest in the shares of overseas markets and when they do so, they pay for them in the currency of that market. As the relativity between the Australian dollar and the other currency changes, even if the price of the shares hasn't moved, the value of the investment in A$ will change.

Consider the example of buying $A10,000 worth of an ASX-listed ETF which invests in a US share index (by buying US shares), at a time when the A$ and US$ have exactly the same value. In that example the local investor would get $US10,000 worth of ETF units.

If the A$ rises in value by 10 per cent against the US$ then, even if the value of the underlying share index is unchanged, the local investor will receive $A9090 if they sell their ASX-listed ETF.

Or, if the A$ falls in value by 10 per cent against the US$ then, even if the value of the underlying share index is unchanged, the local investor will receive $A11,000 if they sell their ASX-listed ETF.*

The A$ has fallen significantly against the US$ as the RBA cuts rates, and as our terms of trade falls as the commodity supercycle comes to an end. That trend will continue as the US Federal Reserve raises interest rates in line with the US economic recovery, but the A$ may remain stronger against eurozone currencies and the yen as their rates and economic growth remain lower than ours.

Does it matter?

Thinking about changing currency values is important for at least three reasons:

1. Neutralising currency risk means that you are only exposed to changes in the value of the global assets that you invest in – making for a “pure” play on those assets
2. On the other hand, investment professionals typically like to take on currency risk, as they feel that it adds to the diversification provided by investing offshore
3. Diversification is an elusive concept and in times of market stress where the US$ behaves as a reserve currency (rising strongly against all other currencies), hedged assets can lose value quickly.

What does the evidence show?

Of course, asset prices don't stay constant so the simple example given above (where only currencies fluctuate) doesn't play out in the real world. By looking at the relative performance of ETFs offered over global indices or assets with and without currency hedging, we can see that in some scenarios hedging has clearly made a difference and in others the effect has been muted by other factors.

In Figure 1 we see the difference between the two versions of the State Street SPDRS ETF issued in Australia and linked to the global S&P Developed World (ex Australia) Large/Mid Cap Index. This index covers 1788 stocks from more than 15 global markets and is available in unhedged (ASX code: WXOZ) and hedged format (ASX code: WXHZ).

Figure 1 shows that since inception in Australia the performance of the two versions has fluctuated but over the total period in question the overall performance is virtually identical. That's not overly surprising given that the currencies of the large number of countries in the index have not all moved in the same direction, such that gains in some may have been offset by falls in others.

Figure 1: WXHG price performance vs WXOZ. Source: ASX

So for investors wanting to remove currency exposure as a risk to their portfolio, especially where there is a cyclical trend in place (such as between the A$ and US$) and who also wish to neutralise the risk of currency volatility in times of market stress, hedged international ETFs offer interesting opportunities.

What's available?

Most ETF providers offer international ETFs with and without currency exposure. Apart from the ETFs mentioned above, I Shares offer hedged versions of some of their most popular ETFs including in respect of their low cost S&P 500 ETF (ASX code IVV, hedged version ASX code IHVV) and their global 100 ETF (ASX code IOO, hedged version IHOO). Management costs range from the very low (0.13 per cent per annum for IHVV) through to 0.46 per cent for IHOO and 0.48 per cent for WXHG.

Full details of these ETFs are available at the issuer's websites. Typically the currency risk is hedged by using FX forward contracts which are rolled over as they mature (often monthly). This creates additional risks associated with forward markets, where forward prices are either at a discount or premium to current (or spot) prices. Without dwelling on the intricacies of this, the impact typically is to add some tracking error between the underlying index and the hedged version of the ETF.

Assuming the FX forward counterparty is credit worthy and will be able to pay to the ETF provider as needed (typically the hedge provider is a registered bank but care needs to be taken in this regard!), the overall impact of the hedging will be to change the performance of the hedged ETF by 1 to 2 per cent per annum compared to the underlying index it tracks. For the peace of mind offered by hedged ETFs this may not be a significant issue for investors. ETF issuers provide charts and tables which can be used to assess the impact of hedging activities on actual ETF performance.

What else can investors do?

Investors in global funds like Magellan will be aware that many fund managers are concerned about the prospects of the US share market falling, primarily driven by US interest rates trending higher. The basis of these concerns is the view that US share prices are overly high because of the low equity risk premium that prevails when interest rates are low. As rates rise, the equity risk premium also rises and that translates into lower share prices (unless corporate earnings grow strongly enough to allow the equity risk premium to catch up).

As a result some fund managers (like Magellan) have decreased their exposure to the US share market and are holding increasing levels of cash (in its most recent report Magellan disclosed that it now holds 15 per cent of its Global Equity Strategy fund in cash.

That may be prudent as a defensive measure but it confronts investment thinking in two ways:

1. Holding increased levels of cash has damaged the overall performance of the Magellan Global Fund which has only outperformed its index benchmark (MSCI World Total Return) by 1.24 per cent per annum over the last three years (down from 7.57 per cent per annum outperformance over the last seven years);
2. Critics of funds that increase cash during market weakness say that individual investors can and should manage the overall risk in their portfolio, rather than having the fund manager do that for them.

For investors that want to increase cash holdings in their international portfolio, it may be interesting to do so by holding $US denominated cash or holding US dollars. BetaShares is the issuer of an ETF (ASX code: USD) which holds US dollars and which can provide exposure to the US$ as it appreciates against the A$ (hence adding some currency hedging to the portfolio) and also allowing for investors to tailor their overall global share market exposure to suit their specific circumstances.

The combination of the transparency and low cost of ETFs, with the growing range of ETFs available to assist with managing currency risks, continue to expand the tools available to Australian investors looking to diversify their overall share investments (see In defence of ETFs, May 6). Holding currency hedged ETFs should be periodically reviewed to ensure ongoing suitability.

Dr Tony Rumble provides asset consulting services to financial product providers and educational services to BetaShares Capital Limited, an ETF provider. The author does not receive any pecuniary benefit from the products reviewed. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.

*An earlier version of this article had transposed the A$ and US$ figures.