What to consider when currency hedging

What to consider when currency hedging

International equities ETFs are a popular option with Australian investors, attracting $6 billion in the last three years, but what should you consider when courting this asset class?

In the past three years, international equities ETFs available on the ASX have attracted ~$6 billion from Australian investors, with net inflows into this category growing 40 per cent year-on-year since 2013. As part of continued product innovation in the Australian industry, a number of ‘currency hedged’ ETFs have been launched. Here are three things to consider about currency hedging over equities investments:

1. Total Return = Equities Return + Currency Return

 

Many investors may not appreciate that as they allocate more of their portfolios to international equities, especially on an unhedged basis, they are typically taking on additional asset exposure in the form of foreign currency. For an unhedged investor this means converting their Australian dollars into foreign currency and buying the foreign denominated equities. This secondary exposure can amplify returns when the foreign currency is rising relative to the Australian dollar but can also weigh on returns that would otherwise be expected when the foreign currency falls relative to the Australian dollar.

2. Currency exposure can add to the volatility of your portfolio

While it’s not always the case with every currency pair, investors taking on a secondary exposure in the form of foreign currency are generally adding risk to their international equities portfolio.

Modern portfolio theory tells us that asset weightings should be selected in order to maximise expected risk adjusted returns of the portfolio. In other words, for currency risk to be a reasonable addition to an international equities portfolio, that currency exposure would need to be negatively correlated to equity market returns or you would need to reasonably expect an added return for exposing yourself to additional risk from currency fluctuations.

This would be the case where you have a favourable opinion on the potential direction of the currencies. However, if you don’t have a particular view on where the foreign currency is moving relative to the Australian dollar, hedging may allow you to reduce your portfolio risk while maintaining the expected return from the underlying equities.

3. Australian investors often ‘get paid’ to hedge foreign currency 

The practical costs of implementing the hedge have long been the key argument against the benefits of currency hedging. The main component of the cost of hedging essentially comes from the interest rate differential between the hedged foreign currency and the domestic currency. This, however, is a two-way street. Put simply, in a situation where the domestic currency has higher short-term interest rates than the overseas currency, a beneficial relationship is created and the ‘positive carry’ between the two currencies provides a return benefit for the hedged exposure. If the fund’s currency hedge results in a profit, the positive carry benefit will have the effect of increasing the amount of profit. If the fund’s currency hedge results in a loss, the positive carry benefit will have the effect of reducing the amount of loss. So where Australian interest rates are the higher of the pair, Australian investors hedging their offshore exposures will effectively get paid to hedge.

For example, currently the Australian cash rate is at 1.50 per cent p.a. While it is at historic lows, it still remains notably higher than, say, the European central bank rate which is negative. The difference between the interest rates means the currency hedged WisdomTree European equities fund, for example, is presently generating around a ~2.30 per cent p.a. carry benefit for investors (of course, the carry benefit can vary over time with changes in interest rates and may even reverse).

Conclusion

Despite recent trends, many Australian investors remain underexposed to international equities. As investors begin to take note of the opportunities and diversification benefits of investing offshore, it’s important they consider the effect currency fluctuations will have on their returns. With hedged investment now a simple and cost effective option through recent developments in the exchange traded fund market, Australian investors now have the ability to ensure their exposure appropriately reflects their view.

Investors with a positive view on the relative directions of the respective currencies can take their exposure unhedged via a number of exchange traded funds. However, investors without a specific opinion on the currencies can find themselves having made an unnecessary ‘gamble’ on an uncertain outcome by taking their exposure unhedged, and can also be giving up a positive carry benefit in the process (at least in the current interest rate environment).

In these situations (where investors have a positive view on the underlying market but are unsure on the currencies), they can now easily get a ‘pure’ exposure to the underlying equities without the attached currency risk through a currency hedged exchange traded fund.

Adam O’Connor, distribution manager, BetaShares

 

What to consider when currency hedging
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