Hedged vs unhedged: 4 reasons to consider currency hedging global investments
Betashares Chief Economist David is responsible for developing economic insights and portfolio construction strategies for adviser and retail clients. He was previously an economic columnist for The Australian Financial Review and spent several years as a senior economist and interest rate strategist at Bankers Trust and Macquarie Bank. David also held roles at the Commonwealth Treasury and Development (OECD) in Paris, France.
8 minutes reading time
Unlike investing in local shares and property, investors considering exposure to international shares and commodities face the decision of whether to hedge the associated foreign currency exposure.
All else constant, if you are bullish on a global investment exposure but also bullish on the Australian dollar, it makes sense to seek a currency-hedged exposure if available, as otherwise your potential returns will be diminished by a fall in the value of your investment in Australian dollar terms when it comes time to sell and convert back into our local currency. By contrast, if you are bearish on the Australian dollar, it makes sense to consider an unhedged exposure if available.
And of course, for a number of investors, currency hedging can be used as a simple way to remove an additional element of uncertainty in investment returns – and investing in this way means that investors do not have to concern themselves with the impact of often volatile currency fluctuations.
For more detail on how currency moves affect hedged vs unhedged investment returns, please see the technical appendix below.
Hedged vs. unhedged global investments over time
The chart below details the historical returns from global equities on both a hedged and an unhedged basis – along with the value of the $A against a basket of global currencies of countries within the global equity index.
Source: Bloomberg. Past performance is not an indicator of future performance.
As evident, over the past 25 years at least, the $A has experienced marked cycles of appreciation and depreciation around a generally flat underlying trend. As a result, the returns from global equities over this long period have been broadly similar on a hedged and unhedged basis (both around 7.5% p.a.).
On this basis alone, and provided the $A remains in a long-run flat trend against other global currencies, there is not a clear cut long-term case to hedge or leave unhedged broad long-term exposure to global equities.
That said, over medium-term time periods, it’s also evident that the $A can sometimes be either positively or negatively correlated with global equity bull market periods. In the late 1990s – and again since around early 2013 to the present – the $A tended to fall even as global equities rose – boosting returns from the latter in unhedged terms. Between 2001 and 2013, however, the $A tended to rise with the rise in global equities, meaning investors would have been better off with hedged global investment exposures.
What causes these shifting correlations between the $A and global equities?
In essence, as evident in the chart below, it appears to reflect whether the drivers of global economic growth and equity market performance tend to favour relative performance of Australian corporate earnings and equity prices. Technology booms – as in the late 1990s and much of the past decade, have tended to undermine relative Australian equity and currency performance – which in turn has favoured international investing on unhedged terms. By contrast, commodity booms, as evident in the decade after the Dotcom bust, have tended to boost relative Australian equity and currency performance – which has favoured hedging exposure to international equities.
Source: Bloomberg. MSCI ACWI vs. S&P/ASX 200 Index. Past performance is not an indicator of future performance.
Last but not least, a final feature of the $A and global equity relationship is worth pointing out.
Over the very short-run (say over a few months) the correlation between the $A and global equities tends to be positive – as both are considered ‘risk-on’ assets that move together in line with the ebb and flow of short-run global investor sentiment. What’s more, this positive correlation is especially evident during major ‘risk-off’ periods or global equity bear markets.
Risk-on? Why hedging may make particular sense today
The past few months of “risk-on” market behaviour has again demonstrated some of the benefits of hedging at the right times. As seen in the chart below, the U.S. Federal Reserve’s extreme monetary stimulus has helped weaken the $US versus the $A, whilst at the same time helping to push up gold prices.
As a result, a hedged gold bullion exposure, such as through the BetaShares Gold Bullion ETF – Currency Hedged (QAU), has performed a lot better than an unhedged gold exposure.
Source: Bloomberg. Past performance is not indicative of future performance.
The same is true of hedged exposure to global equities, such as via the Nasdaq-100.
In short, in a period when the U.S. Federal Reserve is providing extreme monetary stimulus – which in turn is helping weaken the $US – it could well make sense to hedge exposure to global investments (such as gold and equities) likely to do well in this environment.
Bottom line: Four reasons to consider currency hedging
Against this background, in our view there are four reasons an investor might consider currency hedging, at least on occasion:
- As a medium-term investor, you think the next equity-up cycle will be one in which the $A will also strengthen, perhaps reflecting a shift in global economic drivers from, say, disinflationary technology disruption, to a more inflation/commodity-driven boom (perhaps reflecting ongoing extreme global monetary stimulus).
- As shorter-term investor, you think current risk-on sentiment will persist, which will push both equities and the $A higher – so you want to hedge your favoured global trades (such as gold and the Nasdaq-100) to avoid limiting some of your gains through exchange rate loss.
- As either a short or long-run technical trader, you want to base entry and exit into certain global exposures using specific price level or price performance indicators, and don’t want these signals distorted by currency movements.
- As an investor, you simply have no idea as to which way the $A will move over either the short or long term. In this case, you may choose to simply ‘take currency out of the equation’ by focusing on only hedged exposures, or by splitting your exposures into both hedged and non-hedged positions.
BetaShares’ new currency hedged global exposures
So as to provide investors even greater choice in terms of how they gain exposure to international markets, BetaShares recently launched a range of currency hedged ETFs – HNDQ (providing exposure to the Nasdaq-100 Index), HQLT (providing exposure to global quality companies) and HETH (providing exposure to global ethically-screened companies) – to complement the exposures that are already available on an unhedged basis through the NDQ, QLTY and ETHI ETFs respectively. Each of these currency hedged ETFs obtain their investment exposure by investing into the corresponding unhedged ETF, with foreign currency exposure hedged back to the $A.
These three new products join BetaShares’ long-established range of currency hedged exposures, which includes currency hedged exposure to the $US gold bullion price and to an index of the world’s top global gold miners through the QAU and MNRS ETFs respectively, along with a range of other currency hedged global sectors, regional exposures and commodities.
Investing involves risk. The value of an investment and income distributions can go down as well as up. Before making an investment decision you should consider the relevant Product Disclosure Statement (available at www.betashares.com.au) and your particular circumstances, including your tolerance for risk, and obtain financial advice. An investment in any BetaShares Fund should only be considered as a component of a broader portfolio.
By way of example, to invest in U.S. stocks, investors (either directly or indirectly through their chosen fund manager) must convert their $A into $US in order to make the purchase. When the time comes to sell these investments, the $US proceeds then need to be converted back into $A.
The total return to local investors in $A reflects the combination of both the $US return on stocks held and the change in the $A/$US exchange rate. If the $US value of the stocks rise, for example, but the $A also rises against the $US over this period – the returns in $A terms from the offshore investment will be reduced. By contrast, if the $A falls against the $US over this period, the $A returns from the investment will increased.
So which is better – hedging or not hedging? There really is no one correct answer – it really depends on the investor’s goals and (obviously) any particular currency views they might hold.
By way of example, if the $A is worth US80c and you want to buy $US100 worth of U.S. stocks, it will cost you $A125 ($US100/.80) to make the purchase (ignoring transaction costs).
If the value of these stocks rises to $US150 over a year, your return in $US terms is 50%. If the $A has not changed over this period, you can sell your $US150 investment and convert it back to $A187.5 cash ($US150/.8) and your return in both currency-hedged and unhedged terms will be 50% (($187.5-$125)/$A125). If, however, the $A has appreciated to US90c over this period, your $A return on conversion drops to $A166.67 ($US150/.9), implying an unhedged $A return of only 33%. If the $A had dropped to US70c, however, your unhedged return would be $A214 ($US150/.7) or 71%!
Currency hedging effectively negates much of these currency effects through borrowing US dollars at the time of purchase and using the proceeds to invest in Australian dollars (and adjusting this borrowing over time in line with the $US value of the investment). Apart from transaction costs, hedging in this way also produces either a positive or negative interest income over time depending on whether Australian interest rates are above or below those in the U.S. When Australian interest rates are above U.S. rates (which typically has been the case in recent decades) hedging $US exposure has tended to also produce positive interest income for investors in currency hedged investments, as the interest earned on the invested Australian dollars is greater than the cost of borrowing the US dollars.
David is responsible for developing economic insights and portfolio construction strategies for adviser and retail clients. He was previously an economic columnist for The Australian Financial Review and spent several years as a senior economist and interest rate strategist at Bankers Trust and Macquarie Bank. David also held roles at the Commonwealth Treasury and Development (OECD) in Paris, France.Read more from David.