Allocating funds to international assets has the potential to deliver real benefits to investors. From enabling access to a vastly larger and more varied investment universe, investor benefits include access to the growth potential of industries either underrepresented or unavailable on the Australian market and a reduction of overall portfolio risk through more effective diversification.
Yet international investments expose investors to a new risk: currency fluctuations. In fact, currency movements can be so great and sometimes outweigh raw investment returns, turning a loss into a profit — but it can also turn a profit into a loss.
This prompts the question: to hedge or not to hedge foreign currency exposure?
Managing Currencies Since
Assets Under Management1 1
Dedicated Portfolio Managers
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.
Targeting the right hedging level across a total portfolio is the key to achieving an optimal balance between reducing currency risk and maximising returns. Below are our tips for managing currency risk:
Investing Globally with SPDR® ETFs
Gain diversified international exposure with SPDR ETFs. ETFs can provide investors with the flexibility to select investments that are aligned to their investment strategy, the ability to adjust asset allocations and rebalance portfolios quickly and easily, and the simplicity and transparency of an investment in Australian shares.
ETFs offer a choice of hedged and unhedged investments, giving investors the ability to adjust currency exposure across the portfolio.
We pioneered ETFs as a simple, cost effective means of investing in the performance of market indices, with all the benefits of listed market liquidity.
In 2013 we developed and launched the SPDR S&P® World ex-Australia (Hedged) Fund, which is Australia’s first ETF that provides Australian investors with access to international equities while mitigating currency risk.
The hedged ETF enables investors to diversify their portfolio with exposure to over 1,600 international quities in sectors that are either unavailable or more difficult to access in the Australian marketplace, while minimising the impact of currency changes on the value of their investment.
Understanding ETF Liquidity
One of the main advantages of ETFs is that they offer liquidity from two sources. From the surface, it may be obvious that there is liquidity as defined by the trading volume and bid/ask spread in the secondary market. Beneath this is another source of liquidity in the primary market that may often be missed.
1 State Street Global Advisors, as of March 31, 2019. The currency AUM includes all currency overlays managed by State Street Global Advisors’ currency team. The currency AUM reported by State Street Global Advisors at a firm level reflects the currency overlay from external accounts only and does not reflect internal accounts where State Street Global Advisors manages both the underlying assets and the currency overlay. Diversification does not ensure a profit or guarantee against loss.
2 State Street Global Advisors, MSCI.
3 MSCI World ex Australia Index return (net of WHT) for 2009 was -0.30%.
4 MSCI World ex Australia A$ Hedged Index return (net of WHT) was 26.71% for 2009.
5 MSCI World ex Australia Index return (net of WHT) in local currency return 29.18%.
6 MSCI World ex Australia Index return (net of WHT) in Australian dollar return 48.03%.
Risks associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. Companies with large market capitalisations go in and out of favour based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalisations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalisations. Investments in mid-sized companies may involve greater risks than in those of larger, better known companies, but may be less volatile than investments in smaller companies. Investing in foreign domiciled securities may involve risk of capital loss from unfavourable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Currency Hedging involves taking offsetting positions intended to substantially offset currency losses on the hedged instrument. If the hedging position behaves differently than expected, the volatility of the strategy as a whole may increase and even exceed the volatility of the asset being hedged. There can be no assurance that the Fund’s hedging strategies will be effective.