International shares: To hedge or not to hedge?

Hedging is a form of currencies insurance policy, but there are downsides.

Summary: Eureka Report speaks to local investment strategists about when to hedge, and when not to hedge, when investing in international equities. 

Key take-out: The decision to hedge can make a big difference to the value of the underling investment. To inform the decision, investors should consider the risk profile of the asset they are buying, the direction of relevant currency markets, and their personal investment timeframe. 

It’s long been debated, whether to hedge or not to hedge, in an equities sense of the term.

Australians are slowly but surely increasing their exposure to international stocks, but every foray into offshore markets contains a hidden danger – foreign-exchange currency risk.

The daily gyrations of the share market move stocks up and down as a matter of course, but then there’s the added layer with offshore stocks when the rises and falls of our dollar causes market values to change, even when an international share price stands still.

Eureka Report spoke to a few well-known investment strategists to determine if you should, or shouldn’t, hedge your international investments.

Put simply, hedging generally involves using options or futures contracts to offset the risk of adverse currency movements. But rather than doing it yourself, these days there are many managed fund offerings that provide inbuilt currency hedging.

Giselle Roux (pictured below), chief investment officer at Escala Partners, says there’s no simple answer on hedging, but she gives investors some tips.

Roux believes investors holding predominantly Australian equities, with only a small allocation offshore, would benefit from an unhedged international portfolio.

Traditionally, it’s riskier to be unhedged, because an unhedged portfolio is subject to higher volatility. This offers the potential for higher returns, which has been the case except in the years immediately following the GFC in Australia.

To make the point, the latest returns from managed superannuation funds in Australia released this week showed international shares were up 1.6 per cent on a hedged basis during May. However, in line with the Australian dollar’s fall over the same period, unhedged investors enjoyed a much higher 2.8 per cent return.

The falling Aussie

Unhedged overseas equities typically perform better with a falling Australian dollar.

For example, a US company bought for $US100 a share becomes more expensive to purchase when the Australian dollar falls.

So, as the Australian dollar exchange rate with the US has fallen sharply since 2011 from above parity to current levels, sitting on unhedged positions has been a very good place to be for those that bought US shares early on.

“As an investor with most of your portfolio in Australia, you already have an implicitly strong bet on the Australian dollar, which as a general rule is typically strong when economic growth is strong and the equity market is performing,” says Roux.

“Having an international, unhedged exposure will buffer against the risk of something going wrong in the local part of your portfolio.”

Take an investor who achieved a 20 per cent return on their US stocks last year, while at the same time their home currency lost 10 per cent of its value. Being unhedged would have worked in their favour, with their net return enhanced on converting their profits into local currency.

But Roux understands some investors might want to go deeper than that before making their decision.

“You can make it a little more complex by looking at how your portfolio is exposed to interest rate movements, for example,” says Roux.

“Rising interest rates mean the dollar is going to go up, and if you have a lot of exposure to commodities, if commodity prices are strong, then the dollar also goes up.”

Where’s the value?

When the Australian dollar was above parity, Roux says it then made clear sense to take an unhedged position.

“Similarly, most people would take the opposite view [to hedge] if the currency were to fall meaningfully below 60c,” says Roux.

The general market consensus for Australian dollar ‘fair value’ right now is between US73-76c. The dollar tends to move up on positive-sounding news, which could be anything from the Reserve Bank not cutting interest rates to strong labour market data. The opposite tends to occur on poor Chinese or commodities data.

AMP chief economist Shane Oliver says to expect the Australian dollar to fall below US70c by the end of the year. He says a downtrend would likely resume on weaker commodity prices, a narrowing interest rate differential in favour of the Australian dollar, and investors reversing long positions.

The Australian dollar is also globally viewed as a ‘risk-on’ currency, which means a drop in overseas equities markets would probably drive even more of a pullback in the Australian dollar.

“We are a growth-oriented economy, and when growth weakens we tend to move quite quickly,” says Roux. “But our currency has been quite stable for the better part of 12 months. This is despite the ASX not outperforming like other markets, which have been running on different themes to our financial and resource weighting.”

It’s all relative

Like with any investment, returns depend on your timeline and it’s also important to remember that almost everything is cyclical.

An unhedged or hedged investor can naturally achieve similar outcomes, depending on when holdings are bought and sold.

“Technically speaking, the correlation of unhedged equities to the Australian market is 0.56 if you take a 10-year view, and over five years it’s only 0.41,” explains Roux.

“But if you take a longer-term view, your hedged versus unhedged performance isn’t always too dissimilar. Hedged returns for five years is 0.68, and 10 years is 0.8.”

On that return differential, Vanguard Australia investment analyst Scott Pappas says the recent historical data can help investors make better financial decisions.

When selecting a fund manager, for example, investors could know to check if the firm has performed well because of currency positions or actual stock market decisions.

In addition to looking at the correlation between currency and equity, Pappas says it’s important to understand the risk profile of a given asset before making a hedging decision. As such, he typically recommends hedging bonds, but doesn’t believe it’s as clear cut with equities.

Pappas won’t take a stance on the Australian dollar. This largely comes back to the fact that despite ‘fair value’ Australian dollar estimates, there’s no hard and fast rule governing the currency. He essentially thinks it’s wiser to wager on a strong investment than trying to gamble on currencies too.

“If you add high volatility currency to a low volatility investment, like long-term bonds, you are defeating the purpose of investing in that low-risk asset,” says Pappas.

“We are of the view that looking at currencies alone is a risky way to make the decision. Over the long-term, you expect equities to go up, but it’s hard to make the same assessment on currencies.”