As we enter 2020, many Australian investors may be looking to diversify their share portfolios by investing in global equities. If you’re one of them, you might have considered currency hedging to avoid the perceived risks associated with currency fluctuations. There are many pros and cons that should be weighed up when deciding to hedge or not to hedge.
Investing overseas not only involves investing in overseas equity markets, but also exposes the investor to currency risk. Commonly referred to as exchange rate risk, this is the impact of the change in the price of one currency with respect to another. This creates an additional profit, or loss, to the equity position.
When currency works against you
Let’s use an example to highlight this risk. You decide to buy 100 Apple shares at a price of US$200 per share when $1AUD = $0.8USD. This trade would be a US$20,000 investment in USD before fees, but for an Australian trader it would be an AU$25,000 investment in AUD ($20,000/0.8).
6 months later, you want to sell your Apple shares. The current share price is US$220. In USD, this trade would generate US$22,000, a US$2000 net profit.
The AUD has strengthened and now $1AUD = $0.9USD. In AUD, this sell trade would generate AU$24,444 (22,000/0.9). This is a net loss of AU$555 on the AU$25,000 you initially invested.
In this case you could hedge by using a derivative to take an opposing position in the USD/AUD currency pair, effectively locking in the original $0.8USD currency value when you sell the stock to remove the impact of its movement on your investments.
It should be noted that if the Australian currency fell in value then your profit in AUD in this example would have risen.
But currency fluctuations can reduce risk too
One of the many benefits of investing in global equities is protection against imported inflation. As opposed to the example above, imported inflation can be caused by a weakening local currency or an increase in foreign prices.
We all know a weaker Aussie dollar can import inflation by making imported goods and overseas holidays more expensive.
Offshore assets can help protect against these risks. If prices of imported goods are rising overseas, the value of any global investments should increase to offset or hedge against these rising prices.
In addition, an investor protects against the depreciation of their currency because their overseas assets are now worth more to them when converted into AUD. In this example the strong US dollar will buy more Aussie dollars when converted.
In falling markets, currency has worked for Australian investors
Historically, for Australians investing in global equities, currency has been our friend.
Over time there has been a strong relationship between the Aussie dollar and global equity markets. With a positive correlation over the last 20 years, the AUD is seen as a ‘risk on’ currency. This means it moves with markets, generally weakening when equity markets fall and strengthening when markets rise.
For a local investor this can be a huge benefit. When global equity markets fall, a weakening AUD will give a boost to the portfolio return on your overseas equities in AUD terms. The 2008/9 financial crisis illustrates this perfectly.
Market moves - 30 June 2008 to 27 February 2009
The chart above demonstrates this for an Australian investing in the US. During this period the domestic market fell -33% and the US market lost -41%, a significant drawdown in their local currencies. However, as the US market fell you can see the AUD fell with it. The weaker AUD (-33% v USD) means that one US dollar of return buys 33% more Aussie dollars. Consequently, the US market in AUD terms has only fallen -13%, offering significant benefit to an Australian investor.
In a period of significant stress for many investors the currency has saved a huge 30% of your super. Part of the diversification benefits of investing overseas are actually generated by diversifying your assets away from the $A which historically has the tendency to weaken in times of financial market stress.
So, should you use currency hedging?
Currencies can be volatile and there is a natural tendency for new investors in global markets to feel the need to hedge away currency risk. As I have outlined, however, an unhedged allocation to global equities can work to reduce investor risk against falling markets and imported inflation. Investing in a broad unhedged global allocation provides diversification and can reduce overall portfolio risk. This can outweigh the benefits of hedging
At Plato we don’t hedge such that our clients can get the diversification benefits of exposure to other currencies, given the strong tendency for the Australian Dollar to weaken in times of weak equity markets. Of course, investing in global shares presents a range of possible risks for a new investor and every investor’s circumstances are different, so one should always seek professional advice.
When the Aussie Dollar weakens it can make paying for an overseas holiday that bit more painful, but if you have unhedged exposure to global assets you’ll rest easier around the pool knowing that the fall has increased the value of those unhedged assets in your long-term super investment!
Plato Investment Management is an Australian owned boutique equities fund manager specialising in maximising retirement income for pension phase investors and SMSFs. To stay up to date with our latest insights click the follow button below.