Currency hedging

Currency hedging: What to do?

Investing in global equity markets delivers diversification benefits for Australian investors who are typically overweight domestic equities and therefore heavily exposed to banks and miners. The global equity universe provides broad investment opportunities in sectors typically under-represented in Australia such as information technology which is 23 per cent of the S&P 500 but only 1 per cent of the ASX 200.

But investing internationally introduces currency risk into portfolios.

The value of a global share denominated in a foreign currency is determined not just by the share price but also the exchange rate between the foreign currency and an investor’s local currency. For instance, the Vanguard International Shares Index Fund delivered a return of 4.6% for the six months to June 30, 2017 but because the Australian dollar rallied from $US0.72 to $US0.77 during that period, the hedged variant of this fund delivered 9.19%. The differential between the performance of both funds continues to widen with the exchange rate at end-August at $US0.80.

Given this trend, it’s understandably tempting for investors to switch their global investments to hedged options. However, currency hedging should be viewed from the perspective of risk management rather than return enhancement. 

While the short-term performance of ClearView’s implemented model portfolios have been hurt by the rising Australian dollar given the global equity portion of our models is unhedged, we strongly believe the risks associated with hedged investments are higher than unhedged for a number of reasons.

Firstly, the Australian dollar is globally viewed as a risk-on highly-cyclical currency driven by global growth dynamics. This means that when equity markets rise, the Australian dollar tends to rise. When commodity prices are increasing, the dollar tends to rally but falls when markets pull back. 

Currently, a synchronised global recovery is underway fuelled by improving wage growth in the US, stabilisation of China’s economy and increasing corporate earnings in Europe and Japan. As a result, financial markets believe stimulus is no longer required.

Equity markets are rallying, particularly cyclical shares like mining and resources companies. This coupled with global growth has triggered the substantial strengthening of the Australian dollar. 

However there are concerns about the sustainability of this rally. It may be sustainable in emerging economies throughout Asia and Europe but it’s difficult to believe a US-driven recovery will last.

The US cyclically adjusted price-to-earnings (PE) ratio is at its second highest in history reflecting extreme overvaluation. Current valuations are second only to the tech boom. 

The difference is that the tech boom (bubble) was driven by an investment thematic while today’s ‘bubble’ has been driven by the quantitative easing strategy of central banks. This injection of capital into the economy has sent investors flocking to riskier assets in a bid to earn a return above cash, driving up the value of stocks. 

If this bubble was to burst hard and fast, a la the tech bust, every country would be adversely affected given the US is the largest global economy.

On the home front, another bubble is emerging caused by the Reserve Bank of Australia’s quantitative easing strategy. In some capital cities, namely Sydney and Melbourne, there are concerns record low interest rates have created a housing bubble. 

Usually during periods when a country’s local currency is climbing too high too fast, the central bank will cut rates to cool the market down. However, the RBA is currently unable to respond in such a way. On the flipside, it can’t circumvent a bubble by raising rates either as this will likely cause the Australian dollar to rally further.  

Furthermore, it’s difficult to believe a commodity driven recovery will last. Iron ore is in structural oversupply and inventories stored in Chinese ports are at historically high levels. With China’s economy rebalancing away from resource intensive construction in favour of services and consumption, the longer term demand for steel is expected to be flat at best. 

The key drivers of the inflated Australian dollar are elevated commodity prices, a US economy that’s priced for perfection and a hamstrung RBA. These short-term trends are not unsustainable which is why an unhedged strategy remains strong. When offshore markets (particularly the US) start to fall, unhedged investments are expected to earn a higher return than hedged investments because the fall in the Australian dollar is offset by the fall in offshore equity values.

While it’s never easy to watch a client’s relative returns stumble, the Kay Review published in 2012 suggests that acting on short-term trends rarely results in a positive impact on long-term investment performance. In fact, it commonly results in investors buying high and selling low or what’s popularly described as catching falling knives. The falling knife in this case is a sharp correction in US shares. If history is anything to go by, long term portfolio positioning is paramount to withstand a crippling global event. 

Additionally, there has been an increasing trend for fund managers to release unhedged and hedged variants of their international equity funds, forcing financial advisers to make a call on hedging. To address this, advisers may consider investing in a professionally-managed fund that makes currency decisions on behalf of investors.

Jessica Schlosser is an investment analyst at ClearView.