Paul O’Connor explains why advisers need to get their heads around currency management.
Traditionally, Australian investors have currency-hedged their offshore defensive assets, for inflation protection in their home currency, while leaving any offshore growth assets unhedged. This approach was based on the economic theory that “floating currencies” should reflect their true relative long-term value, which worked well during the 1980s and 1990s when the global demand for commodities was benign. However, during the past decade, increasing $A volatility has resulted in currency losses on unhedged offshore growth assets, sparking a rethink on the issue. Is it time to start hedging global growth assets?
EQUITIES
Deciding whether or not to currency hedge equities assets ultimately depends on a portfolio’s risk/return aims. The following are some key considerations for investors:
PORTFOLIO VOLATILITY
The $A has historically had a high correlation to global growth assets. An unhedged position tends to lower volatility over the longer term and outperform hedged equities when the dollar falls, but results in returns lagging a hedged equities portfolio when the dollar is rising. Therefore, if lower long-term volatility is an aim, investors should consider unhedged equities.
EXPOSURE TO THE $A
Australian companies’ earnings are affected significantly by the value of the dollar, so typically investors achieve some diversification benefits by spreading a portfolio’s currency exposure. As a result, many Australian investors have used unhedged global equities to diversify their portfolios’ exposure to $A earnings, particularly given the large global macro influences on the dollar, such as commodities and global growth.
INVESTMENT TIMEFRAMES
The effect of $A volatility and hedged/unhedged exposures to global assets appears to have had little influence on investment portfolio returns. While returns from currency-hedged and unhedged global equities have differed over shorter time periods, the risk/return analysis is broadly similar over the longer term. Over the 22 years from January 1988 to June 2010, the MSCI World Net Return Hedged Index (AUD) outperformed the MSCI World Net Return Index (AUD) by more than 1 per cent (7.47 per cent compared with 6.34 per cent). However, from a risk perspective – as measured by standard deviation – the MSCI World Net Return Index (AUD) outperformed the MSCI World Net Return Hedged Index (AUD) by almost 1 per cent (15.02 per cent versus 15.99 per cent).
This may lead some to conclude that there is little difference between hedged and unhedged positions from a risk/return perspective and that unhedged global equities do provide a currency diversification benefit to investors’ portfolios. However, the short-term volatility of unhedged positions can have a dramatic effect, depending on the sensitivity Australian investors have to entry and exit points and their investment timeframe.
For example, consider an investment in unhedged global equities when the $A is valued at 60 cents to the $US. If the underlying global equities return 0 per cent over a five-year period but the $A rises to parity with the $US, then the total loss to the investor would be in excess of 60 per cent.
Hence, we are now seeing a greater focus on the timing of entry and exit points for unhedged global equities portfolios, which typically aim to invest more heavily in global assets when the $A is high and invest more heavily into Australian-based assets when it is low. The corollary to this strategy is to sell global equities when the $A is trading in the low range. Clearly, the shorter the investment timeframe, the greater the risk around unhedged exposures, given the short-term volatility of the $A.
HEDGING AIDS RETURNS
Consideration should be given to the fact that hedging strategies have aided returns in recent years due to Australian investors paying to hedge currency exposure but then receiving income in excess of the hedge cost. In fact, over the past 10 years, currency hedge costs have varied between 0.3 per cent and 0.9 per cent, but income received has at times been in excess of 3 per cent. Therefore, this “return” needs to be considered against the outlook for the $A. If investing for a five-year timeframe, and assuming the cost of hedging doesn’t change, one would need to consider how much the $A would have to fall to leave hedged versus unhedged investors in the same position from a return perspective.
EMERGING MARKETS
An interesting point to note is that emerging market equities and the $A are heavily influenced by global growth and hence are highly correlated, so when global growth falters, both fall in value. Therefore, an unhedged emerging market equities exposure makes sense from a diversification perspective and tends to lower volatility in this asset class.
ACTIVE MANAGEMENT
In theory, active currency management over the global equities exposure in a portfolio could significantly reduce the impact of Australian dollar volatility on returns by actively balancing the exposure to hedged and unhedged global equities pending the dollar valuation. However, in practice, this is extremely difficult to manage due to high short-term volatility and the delays in processing investment switches between hedged and unhedged global equities options on the standard industry platforms. Given the complexities of this style of currency management, the market will generally outsource this function to an active currency-hedged global equities fund.
PROPERTY, ALTERNATIVES
Most global property products available in the Australian marketplace employ a fully-hedged currency strategy in an attempt to align the products more closely with the perceived needs of property investors (that is, capital stability with income). Therefore, if using global property in a portfolio to lower the volatility of the growth assets exposure, investors will typically take a hedged global property exposure. Alternatively, if using global property as a pure growth asset and diversifier to an Australian listed property exposure, an unhedged position might be more appropriate for long-term investors after taking into consideration all the issues raised above. However, very few unhedged global property funds are available in Australia.
