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Investing offshore gives you access to a larger and more varied investment universe, with opportunities for growth and income that are simply unavailable in Australia. International investments also expose investors to currency risk.
While hedging can attempt to protect against adverse currency impacts, it can lead to lower returns. And although hedging can be an effective strategy for reducing the volatility of defensive assets, it can actually increase the volatility of returns from growth assets like international shares.
Allocating funds to international assets has the potential to deliver real benefits — especially at a time when key industries are only available for investment offshore. Yet investing offshore also introduces an important new variable to the investment equation: currency.
Currency movements can sometimes outweigh raw investment returns, turning a loss into a profit — or vice versa. As a result, the total return from an overseas investment effectively has two parts:
This prompts the question: should you hedge foreign currency exposure, removing the effects of exchange rate movements altogether? Or should you seek to turn it to your advantage? We present seven essential tips to help answer these questions.
Hedging Your Exposure
In some years, hedging a portfolio’s exposure to foreign currencies would have boosted returns significantly. For example, in 2009, a strong post 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). But a strong rebound in the Australian dollar meant that an unhedged investor would have done well to break even1 on international shares after allowing for exchange rate movements. As a result, in 2009 hedging would have boosted returns by around 27%.2
Hedging can also detract from returns. In 2013 international shares had another strong year, rising 29%3 (before allowing for exchange rate movements). But a falling Australian dollar turned an impressive 29% return into an astounding 48% gain4 for unhedged Australian investors. In 2013, hedging would have cost over 15% in performance.
Source: State Street Global Advisors, MSCI as at 30 June 2020.
Past performance is not a reliable indicator of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect capital gains and losses, income, and the reinvestment of dividends.
TIP 1: Playing short-term currency movements is difficult, even for the experts. Unless you are particularly skilled in foreign exchange, set a long term strategy.
TIP 2: Choose a strategy that suits your base currency. A strategy that suits a US or UK investor may not suit an Australian investor.
Balancing Risk and Return
How, then, do you develop your strategy? The key is to achieve the right balance between the two dimensions of currency strategy: risk and long term returns.
Risk: Most people who invest in international government bonds choose to hedge their currency exposure. That’s because hedging an international bond portfolio dramatically improves the certainty of returns. Unfortunately, the picture is much less clear for risky assets like international shares. History suggests international shares remain risky whether or not you hedge the currency exposure.
Return: While volatility is important, it is not the only element to consider. Potential returns will also play a large part in your investment decisions. While remaining unhedged might reduce volatility in an international share portfolio, greater stability can come at a cost.
TIP 3: Investors commonly hedge 100% of the currency risk for defensive international investments like government bonds. For these assets, history suggests that removing currency fluctuations dramatically improves the stability of returns.
TIP 4: In contrast, Australian-based investors who focus solely on reducing volatility will tend to only hedge a small part, if any, of their international share investments.
Finding Fair Value
For investors seeking to develop a longer term currency strategy designed to enhance returns, understanding where the Australian dollar is trading relative to its long term averages is an important first step. We normally expect currencies to revert to their long term fair value at some point in the future. While it may take years in some cases, we still expect that reversion to occur resulting in return opportunities for investors.
TIP 5: Be aware of whether the Australian dollar is at long term highs or lows when setting a currency strategy. Remember to consider the GBP, EUR and JPY exchange rates as well as the USD —and be aware that ‘long term’ in this case means a decade, not a year.
TIP 6: Be patient. Currencies can move away from fair value for long periods of time, and picking short term currency movements is notoriously difficult. Currencies can move quickly in both directions. Unless you are a foreign exchange expert, avoid rebalancing too often or too quickly in response to currency movements.
Bringing It Together
When experienced institutional investors assess currency risk, they think about its impact at the total portfolio level, not its effect on each asset class. Instead, they aim for a predetermined level of currency exposure across the entire portfolio, then hedge individual asset classes accordingly. Understanding the overall level of foreign currency exposure you want to achieve can be much more important than setting the hedge ratio for each asset class. That brings us to our final essential tip for international investors.
TIP 7: Understand how much foreign currency exposure you have across your entire portfolio. Consider the impact of exchange rate movements at the portfolio level, rather than just within individual asset classes.
*Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect capital gains and losses, income, and the reinvestment of dividends.
1 MSCI World ex Australia Index return (net of WHT) for 2009 was -0.30%.
2MSCI World ex Australia A$ Hedged Index return (net of WHT) was 26.71% for 2009. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect capital gains and losses, income, and the reinvestment of dividends.
3MSCI World ex Australia Index return (net of WHT) in local currency return 29.18%. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect capital gains and losses, income, and the reinvestment of dividends.
4MSCI World ex Australia Index return (net of WHT) in Australian dollar return 48.03%.
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