To hedge or not to hedge

It's time to consider the currency impact on your international portfolio.

Summary: When the Australian dollar is historically strong or weak, it’s easier to decide whether or not to hedge international investments. At present, with the dollar trading halfway between recent extremes, it’s worth considering the currency effect as well as tax and cost effectiveness, simplicity and diversification.

Key take-out: As investors, we don’t have to take an all or nothing position. A 70/30 unhedged to hedged ratio makes sense.

Key beneficiaries: General investors. Category: Shares.

The reasons for diversifying offshore are generally well known. The Australian market is only around 2 per cent of the world’s share markets by value and is dominated by miners and banks while global markets offer exposure to many other sectors and businesses. Once the decision has been taken to invest overseas a second important question is posed – should the currency position be hedged or not?

The difference between a ‘currency hedged’ or ‘currency unhedged’ portfolio lies in the impact that currency movements have on the portfolio value. In a currency unhedged portfolio, investment values will be impacted by both currency movements and the movement in value of the underlying investments, while a currency hedged portfolio is only impacted by the movement in value of the underlying investments.

When the currency is historically strong or weak

There may be times when investors feel a reasonable degree of certainty about where the Australian dollar sits relative to historical values, and this will influence their strategy. For example, in the period when the dollar was trading above parity during 2012 investors who considered this to be an approximation of the top of the range, and who were considering investing overseas, would have chosen to leave their international investments unhedged, as this would generate an additional return for investors as the dollar fell. 

An investor who, in February 2009, though that at less than US65 cents the dollar was historically weak would have chosen the opposite strategy – hedging their overseas investments – so that increases in the Australian dollar did not reduce returns.

Actual returns

It is interesting to see how this has played out in reality. Vanguard has two international share index funds that will have almost identical holdings, with one currency hedged and one currency unhedged. All the difference in returns between the two portfolios will be from the difference in currency strategy.

Over the past three years to the end of February 2015 the Australian dollar has fallen from around $US1.05 to $US0.78. Theoretically this should provide a superior return for an unhedged portfolio. The Vanguard portfolios demonstrate this with the unhedged portfolio providing an impressive 26.79 per cent per annum (to the end of February 2015) compared to the hedged portfolio – which provided a still relatively attractive 19.57 per cent per annum. The benefit from choosing the right hedging strategy was a significant 7 per cent per annum.

Six years ago the Australian dollar was around US65 cents. This was around the time when share markets around the world bottomed during the Global Financial Crisis period (February 2009). Theoretically, a currency hedged portfolio should have outperformed as the Australian dollar increased in value – and that proved to be the case. Over this period the return from the currency hedged Vanguard portfolio was 20.66 per cent pa, compared to 13.90 per cent pa for the unhedged strategy.

Middle of the range currency issues

This discussion of strategies around hedging when the dollar is at extreme ranges does not provide a great deal of insight into what to do at the moment, with the dollar pretty much halfway between recent extremes. It leads to the possibility that investors might choose to ‘sit on the fence’ somewhat, with a portion of their portfolio hedged, and a portion unhedged.

In thinking about a currency hedging strategy when future currency movements are uncertain, there is an argument to consider having slightly more of your international exposure unhedged for a number of reasons including simplicity, tax and cost effectiveness, greater diversification and ‘banana republic’ insurance.

Simplicity

Choosing currency hedged or unhedged options is often quite easy for someone investing through a managed investment; they make that choice and let the manager implement it. For an individual investor there is a greater range of derivatives that they can use to hedge their currency risk if they choose, however this takes time and effort to research and implement. Leaving direct international exposure unhedged has the attraction of being a simpler option.

Tax and cost effectiveness

Choosing to hedge your currency exposure, whether investing through a fund manager who does it for you or doing it directly yourself, has some costs. Perhaps the most significant cost, however, is the extra tax that might have to be paid as a result of the currency hedging strategy – for example, if the hedging strategy has been successful, and has created extra taxable income for your investments.

Vanguard is one of the few fund managers who report their fund returns after tax – something that provides some insight into the relative tax efficiency of an unhedged international share strategy compared to a hedged one. Over the past seven years the hedged and unhedged Vanguard international funds have provided very similar before tax returns, 8.22 per cent pa (hedged) and 7.91 per cent per annum (unhedged – to the end of February 2015). After tax on distributions at the highest personal tax rate, the hedged fund return drops from 8.22 per cent to 5.44 per cent per annum, whereas the unhedged fund return drops from 7.91 per cent to 7.01 per cent. An unhedged strategy is potentially more tax efficient.

Diversification

A key argument for overseas investing is diversification – providing a different source of returns for your portfolio. The level of diversification (how similar or different returns are over times) is measured by the ‘correlations’ between asset classes. If asset classes have a correlation of one, then they move in exactly the same way. The smaller the number, the less correlated returns are between assets – and the greater the diversification effect of using less correlated assets.

The ASX published research that showed the correlation between Australian shares and international shares was 0.47, while the correlation between Australian shares and currency hedged international shares was 0.79. Put simply – there is a greater difference in the returns from Australian and unhedged international shares, which means better diversification in a portfolio.

Banana republic insurance

I tend to think of overseas investments as partly being insurance against something going badly wrong in the Australian economy – including a collapse of the Australian share market and dollar. In that extreme – and I hope unlikely event – investors will be happier having chosen to hold their international investments without currency hedging, so that they hold investments in other currencies.

Conclusion

To hedge or not to hedge is not an easy question – particularly if you don’t have a firm view on future currency movements, and if the Australian dollar is trading in a ‘middle of the range’ position as it is now. As investors, we don’t have to take an all or nothing position. My feeling is that the lower costs, taxes and greater diversification from holding unhedged international shares makes sense for the majority of the international section of a portfolio. A 70/30 unhedged to hedged ratio makes sense taking into account these figures. Interestingly, figures show the international share exposure in all APRA regulated superannuation funds was allocated along these lines – with 22% of portfolios invested in international shares, of which 7% of portfolio values was in currency hedged international shares, with the remaining 15% of portfolio values in unhedged international shares.


Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. 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.