Hedging's little extra

PORTFOLIO POINT: Australians investing offshore earn precious extra income if they choose to hedge away their currency exchange rate risk. This applies not just to fixed interest but also to equities, property and even gold and other commodities.
Australians invest more than $50 billion in overseas equities and, according to Morningstar figures for retail managed funds, 86% of this is invested using unhedged Australian dollars. Over the past several years this has been a costly positioning as the Australian dollar has strengthened against most other currencies, thereby depressing returns from otherwise stronger performing overseas markets. What might be surprising is that even in 2011 – when the Australian dollar coincidentally started and finished the year worth $US1.02, 65 UK pence and about 78 euro cents – currency-hedged overseas investments enjoyed an average extra 3% income return. Very few Australian investors realise that not only does it not cost to hedge your currency risk, but those who do so earn precious extra income. This is thanks to the Reserve Bank keeping our benchmark interest rates high and is a retail form of the popular institutional investor "carry trade". Let me explain how this benefit works and raise several intriguing implications this has for your portfolio.

Read this before you go any further '¦

Currency hedging 101

Earlier I suggested (see Buy the World) there were two reasons to invest offshore: first, to invest in industries not well represented in our relatively narrow stockmarket; and second, to protect your standard of living and purchasing power in case of a collapse in the Australian dollar. Now perhaps there is a third reason: to earn extra income when you hedge part of your currency exposure.

Currency hedging works to insulate you from the effects of changing currency when you take your money offshore to invest in the likes of Apple, Exxon, General Electric and Nestle. Many, although not all, managed funds offer funds in both unhedged and full currency hedged flavours. For instance, Vanguard Australia will give you the returns from investing in the world’s stockmarkets, excluding Australia, in both unhedged and hedged versions.

Without hedging, if the Australian dollar strengthens, you’re worse off when you bring your money home, although if the dollar weakens you’re better off. But if you invest using a currency-hedged fund, currency effects are eliminated and you just earn the income and capital gain returns that offshore investors earn in their local markets. I, and others, generally recommended hedging about half your offshore exposure to smooth out returns. But clearly this is not current practice, as many investors are expecting the Australian dollar to stop losing in the current high-stakes “World Currency Devaluation Games”.

Because of lower interest rates elsewhere in the world, Australian investors are actually paid to hedge their currency exposure (see shaded box for additional explanation). At the moment this can add up to 3-4% extra income return to your portfolio. The opposite is true if you are a foreign investor in Australia, which is another reason some are steering clear of our sharemarket.

Currency hedging is a common practice in international fixed interest investing. Through currency hedging, an Australian bond investor currently earns about 6% combined income investing in US government 10 year Treasury bonds, despite them yielding a lowly 2% in the US. This is 50% more than can be earned locally investing in Australian government 10 year bonds yielding 4.1%. Yes, high finance can be baffling.

Earning hedging income through offshore equity investing

This same extra income is also available to investors in other asset classes. The table below shows the 2011 annual total return from investing in various hedged and unhedged equity index funds offered by Vanguard Australia. Most times, changes in currency would cause the unhedged and hedged fund returns to differ dramatically, masking this income effect. However, during 2011 the Australian dollar started and finished the year largely at the same level against other major currencies. This allows us to see an extra 2.5% to 4.6% performance difference mainly from currency hedging. As hedging is a black box activity executed through rolling forward contracts with multiple country counterparties, income among these different funds will vary with different country mix.

-2011 Annual total return (%) from Vanguard equity index funds
Asset Class	Hedged fund	Unhedged fund	Difference
International Shares ex-Australia	-2	-5.3	3.3
International Small Company Shares	-6.1	-8.6	2.5
Global Infrastructure	5.9	1.3	4.6
International Property	1.9	-0.4	2.5
Total % return (dividend and hedging income plus capital gain/loss) from various hedged and unhedged Vanguard index funds for calendar 2011.

What this means to you is that while Australian interest rates are out of step with other countries, you can earn extra income when choosing to invest offshore using a currency hedged fund. The extra hedging income doubles the usual lower yield on international shares to a more generous figure of about 6% for Australian shares. Most investors elsewhere in the world would be jealous of that income!

Of course if you want to profit from an eventual (?) falling Australia dollar, perhaps not all of your currency exposure should be hedged. Also note that with currency hedged funds, paid distributions can be lumpy (for instance, when extra monies are paid out to you to compensate for an appreciated dollar) and even withheld (for instance, if you earned excessive capital gain from a falling Australian dollar and need to make good the hedging counterparty). Swings in currency will affect your distribution, but not your ability to earn this underlying income.

You’ll need to invest in an unlisted managed fund as equity exchange traded funds (ETFs) don’t come in hedged versions, often because they are simply reinvesting your money into an offshore unhedged fund. You should also double check the hedging policy of any fund to assess whether it hedges all the time or only when it tactically wants to. To truly DIY hedge, you’ll need to learn to trade currency futures.

Be paid to hold gold and speculate in oil and other commodities?

This effect can be applied to asset classes other than fixed interest, shares and property. Interestingly for your portfolio, it can also be applied to commodities. Where in other countries speculators don’t receive income from holding commodities, Australians can do so by investing in US-dollar hedged Aussie dollars. For gold bugs, this makes us once again a lucky country.

Australian ETF supplier Betashares manufactures ASX-listed funds that mimic the price in US dollars of gold (ASX symbol: QAU), oil (OOO), various agricultural commodities (QAG) and a diverse basket of commodities (QCB). Because of hedging income these funds currently generate an additional return from hedging/interest income. At the moment this is about 4% before fees of about 0.5% to 0.7%. This income is built into the unit price of the ETF and used to buy more commodities before being paid out annually in July if appropriate (that is, if this income wasn’t consumed in the case of a falling Australian dollar).

The chart below from Betashares shows the price of gold in both US and Australian dollars over a recent period. It suggests that Australians investing in gold using local dollars, for instance through the older and more popular GOLD ETF, may not benefit as much from price rises if they had invested in US dollars. The nice thing about the current Australia/US interest rate differential is that you’ll also be paid about 3-4% of income for doing so – a rate not too dissimilar to the net rent from Australian residential property.

This extra income return might make you change your mind about speculating in, or diversifying your portfolio, with otherwise non-income producing commodities. Earlier I commented (see How to prepare for inflation) on the inflation-fighting potential of both "hard" and "soft" commodities but lamented about their nil income opportunity/holding cost. Expected income might also make your accountant happy if he or she is uncomfortable claiming a capital gains deduction in the absence of income generation from unhedged commodity speculation.

For those investors still uncertain about investing in gold, the oft-repeated correlation between the Australian dollar and gold price means it is far less necessary for you to do so than for investors in non-resource intensive countries in Europe and the US. Perhaps you could say Australia’s currency is gold!

If you are concerned about local equities suffering from resource price contraction, anaemic bank lending and others being hurt by the high Australian dollar, then you might look to increase your investments offshore. If doing so, consider having some of this exposure currency hedged to enjoy the extra income that delivers. In the case of a flat market, earning income any way you can makes sense to me.

Doug Turek is the principal adviser of executive and family wealth advisory firm Professional Wealth.

Financial products mentioned here are referenced for education purposes and don’t constitute an investment recommendation. Please undertake your own research before investing.