In some years, hedging a portfolio’s exposure to foreign currencies would have boosted returns significantly. For example in 2009, a strong post global financial crisis rebound in global equity markets saw international shares rise by 26% for the year (as measured by the MSCI World ex-Australia Index, before allowing for exchange rate movements).2 But a strong rebound in the Australian dollar meant that an unhedged investor would have done well to break even3 on international shares after allowing for exchange rate movements. As a result, in 2009 hedging would have boosted returns by around 27%.4 Hedging can also detract from returns. In 2013 international shares had another strong year, rising 29%5 (before allowing for exchange rate movements). But a falling Australian dollar turned an impressive 29% return into an astounding 48% gain6 for unhedged Australian investors. In 2013, hedging would have cost over 15% in performance.
Hedging Risky Assets
When you are constructing client portfolios consider the trade-off between the risk and return of hedging. While hedging an international bond portfolio dramatically improves the certainty of returns, the picture is much less clear for risky assets like international shares. History suggests that international shares remain risky whether or not the currency exposure is hedged, and from the late 1990s, leaving currency exposures untouched has tended to reduce the risk of an international share portfolio.
But it’s not all about volatility reduction – potential returns also play a large part in your decisions. While remaining unhedged might reduce volatility in an international share portfolio, greater stability can come at a cost.
In it for the Long Term
We believe that in order to develop a longer term currency strategy designed to enhance returns, it is important to understand where the Australian dollar is trading relative to its long term averages. We normally expect currencies to revert to their long term fair value at some point in the future. While this could take years in some cases, we still expect that reversion to occur, resulting in return opportunities for investors.