Why currency hedging matters!

BY Adam O'Connor | 28 March 2017
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Last year in my article Currency hedging – 3 things to consider I introduced the concept that exposure to foreign currencies can potentially be an added source of unnecessary risk to your global equities investment when looking at certain currency pairs.

Today I’m going to highlight a few specific international regions and global sectors where taking on this additional currency risk has historically been to the detriment of Australian investors due to the correlation of the underlying equities market to its domestic currency or, in one particular case, the commodity to our own currency.

Japanese Equities

A falling Yen helps the Japanese equity market in two ways. First, it makes Japanese assets cheaper for foreign investors, attracting capital inflows into Japan. Second, and more importantly, it boosts the earnings of Japanese exporters in local currency terms. In fact, it’s estimated that every 10 Yen of sustained currency depreciation adds approximately 8% to listed companies’ earnings (Source: Bloomberg).

The impact of the falling Yen on equities returns can be seen in the chart below, which highlights the historic inverse correlation which has existed between movements in the Yen and movements in the Japanese equity market:

Source: Bloomberg. Past performance is not an indicator of future performance.

European Equities

For precisely the same reasons above regarding Japanese equities, a falling Euro benefits European equities markets and has likewise been highly correlated to equities returns in the past. European equities have traditionally performed best when the Euro has been falling – with an average return of 21% in declining v -5.9% in upward currency trends (source: MSCI EMU in Australian Dollars 1987-2016).

Like Japan above, you can see in the chart below the negative correlation between the pair over the last 12 months:

Source: Bloomberg. Past performance is not an indicator of future performance.

Gold

Looking domestically at our own local currency, the Australian dollar has historically been positively correlated to movements in the gold price – meaning that a rally in the gold price has traditionally been accompanied by a rally in the AUD. For unhedged Australian investors in Gold, which is U.S. dollar denominated, this would have in the past eroded part of the returns that might have otherwise been expected, based on the movements in the gold price on its own, due to a strengthening Australian dollar.

As you can see from the chart below, had a hypothetical Australian investor invested in Gold over the seventeen years since 2000, they would have added ~85% to their investment by investing on a currency hedged basis in USD terms, compared to holding the exposure unhedged in Australian dollars over the same time period.

Source: Bloomberg. Past performance is not an indicator of future performance.

These historical currency relationships suggest, at least, that an investor considering exposure to Japanese equities, European equities or Gold should also think about whether exposure should be on a hedged or unhedged basis.

Exchange traded funds, such as the BetaShares WisdomTree Japan ETF – Currency Hedged (ASX: HJPN) and the BetaShares WisdomTree Europe ETF – Currency Hedged (ASX: HEUR) provide access to the Japanese and European markets respectively, while mitigating exposure to fluctuations between the value of the Yen or Euro respectively and the Australian dollar.

BetaShares also provides the ability to get exposure to both physical gold bullion (ASX: QAU) as well as Global Gold Mining Companies (ASX: MNRS) on a currency hedged basis.

 

5 Comments

  1. robert mcwilliam  |  March 29, 2017

    It seems to me that hedging is useful, but how much extra does the management expense fee rise as a result. The best ETF is obviously the one with lowest management fee.

    1. Ilan Israelstam  |  March 30, 2017

      Hi Robert,
      There is no additional cost over and above the management costs for HEUR and HJPN – it is built into the management fee. For example, there is an alternative unhedged European ETF available (IEU) that costs 0.60% p.a. whereas our European Hedged ETF (HEUR) costs 0.58% p.a. Hope that helps

  2. Carlos Cobelas  |  March 30, 2017

    currency hedging does NOT reduce risks from currency fluctuations. It means one loses out when the Aussie dollar falls but win when the Aussie dollar rises, whereas unhedged funds lose out when the Aussie dollar rises but win when it falls. There is no removal of currency risk, only a reversal of the risks.

    1. Ilan Israelstam  |  March 30, 2017

      Carlos – we understand your perspective. Please note that the rationale behind the currency hedging from the perspective of an Australian investor is to give such an investor an opportunity to take a view on the underlying exposure (e.g. European shares, Gold Bullion, Japanese Shares) without the need to concern themselves with the fluctuations in the currency market. While you are correct there may be an opportunity cost in doing so, we find that most investors we speak to would prefer to make a single decision (e.g. European Shares) rather than a double decision (European Shares and Euro, for example).

      1. Carlos Cobelas  |  April 4, 2017

        that’s not a single decision.
        by hedging the currency you are taking the view that the Aussie dollar will rise or at least remain stable, rather than fall.

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