Should you be hedging your offshore investments?

Should you be hedging your offshore investments?

Amidst the turbulence of global financial markets this year, one of the most notable things has been the inexorable strengthening of the US dollar (USD) against every other global currency. The corollary of the strong USD has been a relatively weak Australian dollar (AUD).

One of the great lessons of the COVID Crash in 2020 for anyone investing in overseas assets was the more than 40 per cent difference that investing in a hedged version made to returns over the following year.

Hedging is like a form of insurance where a manager neutralises the so-called ‘currency effect’ of the AUD rising, or becoming more expensive, relative to other currencies, so that the investment’s return only reflects the change in its underlying value.

For example, buying USD20,000 worth of US shares when the AUD is buying 65 US cents, will cost A$30,769 (20,000/0.65).

If the share price rises by 10 per cent over the next year and the currency remains unchanged, the investment will be worth A$33,846 (22,000/0.65).

However, if instead the AUD appreciates by 20 per cent, to 78 cents, the investment would only be worth A$28,205 (22,000/0.78). The currency effect has more than wiped out the benefits of the higher share price.

Buying a hedged version of the investment in the first place takes the currency effect out of the equation, so the return would equal the change in the underlying investment, in this case 10 per cent, regardless of what the AUD does.

Why not hedge all the time?

Given that example, it might sound sensible to simply buy a hedged version of any overseas investment and not worry about what happens to the Little Aussie Battler. But there are times when the heightened volatility of the AUD can work to your advantage and being unhedged can help returns.

For example, buying USD20,000 worth of hedged US shares when the AUD is trading at 75 US cents would cost you A$26,667 (20,000/0.75). If the shares fell in value by 10 per cent, the investment would be worth A$24,000 (18,000/0.75).

However, if the AUD exchange rate had fallen to 65 US cents over the same period, the value of the investment will have gone up to A$27,692 (18,000/0.65). Given the AUD is seen as more risky than the USD, and in a downturn investors often rush to safe haven assets like the USD, this scenario is not unrealistic.

Is the AUD cheap enough to hedge now?

Unfortunately, there is no scientific formula to work out whether the AUD is cheap versus other currencies. Last year, research was released that examined more than 50,000 currency forecasts from 136 different institutions over a 15-year period that concluded the forecasts were worse than what you could achieve from random predictions, in other words guessing.

Dan Miles, the Chief Investment Officer at Innova Asset Management, which uses a lot of quantitative (maths based) analysis to determine asset allocation and portfolio construction, says, “Historically, because the Aussie dollar has been seen as a risky currency compared to the US dollar, it’s done a pretty good job of helping to insulate investors against share market volatility. So our policy has been to remain unhedged unless the exchange rate gets to extremes.”

What is ‘extreme’? Miles admits there is no effective mathematical rule to apply but observes that the currency has averaged USD0.76 over the past 30 years, and got to as low as USD0.61 in the GFC and USD0.57 in the COVID crisis. At levels of around USD0.64, he believes it is defendable to be 50 per cent hedged.

Hedge your bets on hedging

Smart investors that are already holding overseas shares that are entirely unhedged, even at a loss, could consider switching to a hedged version for a portion of the holding if there is one available.

However, something else to bear in mind is that whilst the AUD has fallen against the USD this year, it has strengthened against the euro, yen and pound. Before deciding to hedge an investment it might pay to check what its currency exposures are.

Chart 1: the AUD has fallen against the USD, but strengthened against the euro and pound, USD index (+20.4%), AUD (-15.4%), euro (-16.4%) and pound (-20.1%)

Alternatively, another option is to buy a currency ETF as a kind of insurance overlay. For example, the BetaShares Strong Australian Dollar Fund (AUDS) is designed to increase by more than 2 per cent if the Australian dollar rises against the US dollar by 1 per cent. Their Strong US Dollar Fund does the opposite.

Finally, for long-term investors the third option is to do nothing. There is research that argues the long-term effects of currency fluctuations are negligible because it tends to gyrate around the average. So those times the AUD appears cheap simply offset those when it appears expensive.

If you would like to discuss whether hedging would be right for you, please get in touch.