Some investors choose to hedge their currency exposure when they invest globally. That means, in effect, they want their return to come just from the overseas stocks or bonds they’ve invested in, without having to worry about any rise or fall in the currencies involved.
Rule of thumb
But hedging isn’t free. There will be a charge and this will vary depending on the type you employ and how long it’s in place. The rule of thumb is the longer you want to hedge, the more you’ll have to pay.
There are other risks involved as well. While hedging reduces your vulnerability to currency fluctuations, it also prevents you benefiting from those movements.
There are three approaches. You can fully hedge your investment. Or you can do it partially so that currency shifts have some impact – positive, you hope – on your returns.
Then there’s what the industry calls overhedging. That’s where you take out a position beyond the value of your investment. This is more like a pure currency play and best left to those with a keen grasp of foreign exchange markets.
The strength of the Australian dollar over the past few years has made overseas investments relatively cheap. We’ve been able to snap up foreign assets with the Australian currency near or above parity with the US dollar.
But the question is whether that’s a fundamental change in the long-term exchange rate or an aberration brought on by the resources boom and the relative weakness of the US economy since the global financial crisis.
The head of investment strategy at UBS, George Boubouras doesn’t favour guarding share purchases this way in the current environment (late 2012) although he has a different view on fixed-income assets.
“When it comes to exposure to international equities, when the $A is above parity, we tend to recommend going unhedged,” Boubouras says. “It’s hard to see the [Aussie] matching the appreciation that went on in the past five years.”
In the firing line
Currencies such as those of Canada, South Africa and New Zealand, which have grown through strong commodity prices, could decline along with the local currency, he says.
Also, emerging economies may outpace the developed world, leading to a relative weakening in the $A.
Boubouras says investors shouldn’t necessarily see such a fall as a bad thing. He notes that Australian investors had a few years of good returns in the 1990s in part because of a declining $A.
When to act
The $A would probably have to fall below US85¢ before UBS would recommend hedging, he says.
“Even if it went to $US1.25 – which we don’t see happening, by the way – then we would still leave it unhedged” for equities.
But that’s not the case with fixed income, he says. “There’s much less volatility and lower returns in what are much more defensive assets, so there we do recommend hedging.”
The reason is that people want to know what they can expect from their fixed-income holdings, so this eliminates any forex movements and just leaves the return from the asset.
Dixon Advisory has a targeted approach when it comes to offshore assets. Chief investment officer Kevin Smith says all of its major foreign plays are unhedged, including its US residential property fund.
“Investors need to take a long-term perspective,” Smith says. “We say that’s the case with the US property fund. In five years, we think the $A will be worth less than it is now; in that time, US property could be worth more than it is now. To get the full benefit from both of those things occurring, you need to go unhedged.
“It involves accepting the risk and volatility that goes with that, but you can also reap the benefits.”
Smith says the $A is about 25 per cent overvalued in terms of its purchasing power, prompting Dixon Advisory’s approach.
At least consider
The head of investment strategy at BetaShares, Drew Corbett, says you should at least consider hedging. “There are indications that about 60 per cent of an unhedged overseas fund’s investment performance can be attributed to currency movements – so that’s larger than what’s coming from the underlying investments,” Corbett says.
While there’s nothing wrong with that, people should bear in mind that currency movements can boost or obliterate returns, and investors need to be comfortable with that.
BetaShares hedges all its exchange-traded funds, Corbett says. That enables asset holders to focus on the performance of the investment itself.
No one has a crystal ball showing where currencies are headed, so Corbett says investors need to consider whether the certainty that hedging provides fits with their overall investment strategy.
At some stage, nearly all positions have to be converted back into $A. You also pay your bills and living expenses in the local currency. So, if your liabilities are in $A, it makes sense for your returns to be denominated that way as well, Corbett says.
The head of client dealing at OzForex, Jim Vrondas, says education is important here.
“We try to educate all our retail investors about hedging,” Vrondas says. “There are still many who are not familiar with the concept. But depending on a range of factors, including your risk profile and the duration of the investment, it’s at least worth thinking about.”
A matter of cost
The longer the hedge, the more it tends to cost, Vrondas says. It can also be hard for retail investors to get a forward exchange contract beyond a year, so some people are forced to make annual arrangements.
They then take the profits or crystallise the loss and roll over the proceeds to start the process again if they require a long-term position over, say, 24 or 36 months.
The volatile currency markets in recent years also tend to make hedging more expensive, Vrondas says. He says it has also become more readily available to retail investors as more players have entered the forex market. “While the banks still prefer the big deals, it’s much more possible for retail [customers] to arrange a hedge now,” he says.
The head of analysis and education at CMC Markets, David Land, says people need to know that when they purchase assets overseas, they’re taking a position on that country’s currency.
That’s even more the case if you invest directly in shares, rather than using derivatives,
But Land also points out that the threat to your portfolio may not be too large.
“If you have $10,000 invested and the currency moves by 0.1 per cent, then it will cost you $10. You have to decide if it is worth hedging – that’s a decision each investor has to make for themselves.
“Obviously, the more you have invested, the more exposed you become.”
A hedging tool used in foreign exchange markets is the currency option.
Saxo Capital Markets’ head of sales Stephen Luu says retail investors can also use them. For example, an investor may want to take a currency position on $US100,000 for a month. In this hypothetical case, let’s say the AUD is trading at $US1.02.
The investor could buy what’s called a put option with a strike price of parity, locking in the AUS/USD exchange rate at 1 to 1.
A month later, the AUD may have dropped to $US0.80. But the investor would be able to sell at parity by exercising the option. Otherwise, it might be necessary to sell at the current spot rate.
But be aware that the cost of using options will vary. The longer the time frame, the more expensive the premium.