This technique can give you the edge in investing overseas – if you stick with it, writes Simon Hoyle.
Currency hedging and dieting have more in common than you may think. Both require that you decide what you’re going to do and stick with it.
It’s particularly difficult to predict how currencies will move in the short term. One blink from US Federal Reserve chairman Alan Greenspan, and the US dollar rebounds to three-month highs against the euro. When we woke up on Friday, the Australian dollar had jumped above US78c.
Predicting currency movements is a mug’s game. But if you plan to send money overseas, the currency is an unavoidable part of the equation. When you invest money overseas, you expose yourself to currency risk – that is, there’s a risk you could lose money, or suffer a lower return, because of adverse movements in foreign exchange rates.
There are a couple of things you can do to eliminate this risk. You can take a very long-term view and trust in the theory that currency movements more or less wash out over time, or you can hedge your currency exposure, so it doesn’t matter what happens to exchange rates while your money is offshore.
This is when it becomes a similar exercise to dieting.
Grant Harris, manager of applied portfolio solutions at Macquarie, points to some recent US medical research. “Michael Dansinger, a doctor at the Tufts-New England Medical Centre in Boston, reported in the Journal of the American Medical Association that 25 per cent of 160 overweight or obese adults, aged 22 to 76 years, lost more than 5 per cent of their initial body weight during a 12-month clinical trial, regardless of the type of diet the individuals followed during that period,” Harris says.
“The report concluded that for an individual whose goal it is to lose weight, sticking to any chosen diet is more important than the type of diet chosen.”
Likewise, if you’re a long-term investor in overseas assets, it makes little difference whether you decide to hedge your currency exposure or not, as long as you make a decision and stick with it, Harris says.
Since December 2001, investors in overseas equities have lost about 9 percentage points from their returns as a result of the Australian dollar rising in value against the US dollar.
Since October 2001, the Australian dollar has appreciated about 60 per cent against the US currency.
Harris says investors may conclude that it’s better to be hedged, but over longer periods the evidence is less conclusive. Over the 10 years to the end of 2004 the difference between a hedged and an unhedged investment in international shares was 0.05 per cent.
In other words, hedging can be seen as the equivalent of a fad diet. Investors may seize on it as a panacea when it’s going well, but if it’s a fad it will be just as quickly abandoned when it does not appear to be working.
“Like the dieters who stuck to their plan, investors who chose a hedging strategy and stuck to it over that 10-year period achieved a similar rate of return on their international shares portfolios,” Harris says. “The actual strategy didn’t matter anywhere near as much as adherence to the strategy once implemented.”
It’s not always obvious how currency movements affect offshore investments, but if you’ve travelled overseas you’ll probably have an inkling.
When you go overseas, you may take travellers’ cheques with you. They’re easy enough to obtain: you go to a travel agent, bank or currency exchange outlet, and you buy cheques denominated in a particular foreign currency, such as the US dollar. Then you take the cheques with you and use them to buy goods and services in the countries you visit.
If you’re lucky you’ll have some cheques left when you return to Australia. To get your money back, you can go to the travel agent, bank or currency exchange outlet again, and they’ll convert your $US cheques back into Australian dollars.
If this has happened to you, you may have noticed that when you convert your $US travellers’ cheques back into Aussie dollars, you normally don’t get the same amount as when you bought them. You may get more, you may get less. What determines this is not only the commission that is charged on the transaction, but how the exchange rate between the US and Australian currencies has moved while you’ve been away.
When you invest overseas a similar process occurs. You can think of investing as sending your money on a working holiday: it goes overseas, but you expect it to do something for you while it’s there.
You have to convert your Australian dollars into the currency of the country where you’re going to invest. So if you plan to invest in the US, for example, you have to first buy US dollars so you can use them to buy US shares.
When your investment strategy has run its course, or when you decide to realise some profits, you sell the US shares. You get the proceeds in US dollars, and you have to convert them back to Australian dollars. Just like the overseas traveller, you may get more Australian currency for each US dollar, or you may get less, depending on currency movements.
The idea of your money losing value while it’s off on holiday may not appeal. Hedging will remove short-term volatility due to currency movements, but it’s less likely to lift long-term returns.
So if you’re planning to invest overseas, a key decision is whether you want to hedge your foreign currency exposure. There are arguments for and against, but the experts agree that two of the factors that will eventually influence your decision are the sort of assets you plan to invest in, and how long you plan to leave your money overseas.
Charles Brooks, an investment analyst for MLC, says deciding how much of a portfolio to hedge is just like any other asset allocation decision. The manager thinks of hedged overseas exposures and unhedged exposures as two different asset classes, he says.
“Our general philosophy is that we allocate a strategic hedging ratio and it’s considered in the same question as when we’re creating our asset allocation,” Brooks says.
“We don’t see that there’s much reward for the risk taken in terms of making the decision ‘should I be hedged or unhedged’ at any one time.
“We say that there’s an additional risk associated with holding overseas currencies for Australian investors, but there’s also additional diversification benefits for holding overseas currencies. Unhedged and hedged [exposure] will give you different returns.”
Brooks says the level of hedging MLC uses depends on how much of its funds’ money is invested offshore, and how much is invested in equities. The level of hedging is higher for higher equity exposures. But once the strategic ratio is set, it’s fixed.
“If you look at long periods of rolling returns, there’s very little in terms of gains or losses from your currency exposure,” he says.
“In the short term there’s considerable volatility, so we take out some of that short-term volatility by hedging, at a minimal cost. It just helps to control your risk and to minimise the short-term regret that investors have from being on the wrong side of [currency movements].”
MLC’s diversified funds range from having no equity exposure at all (the Horizon 1 fund) to 100 per cent equity exposure (Horizon 6).
“As the proportion of equity increases, so does the proportion of global equity in the portfolio,” Brooks says.
“We increase the amount of hedged global shares in Horizon 6 compared to Horizon 2. In Horizon 2 they have only got 30 per cent of their assets invested in equities, full stop.
“Of that, they may have, say, 6 per cent in global equities, in total. We hedge only, say, 20 per cent of that, so it’s only 20 per cent of the 6 per cent.
“In Horizon 6, 40 per cent [of the portfolio] is in global equities, and hedging is a bit over 50 per cent of the global equity exposure.”
Currency plays: benefits and costs of protection
When we invest money offshore and hedge our currency exposure, there are several steps from the beginning to the end of the transaction.
If we plan to invest in, say, the US sharemarket, we must use US dollars to buy the shares.
“To buy the US shares we need to sell Australian dollars and raise the equivalent US dollars, based on the prevailing exchange rate,” says Chris Loong, manager of foreign exchange for AMP Capital Investors.
If we want to hedge our currency exposure, we have to be sure that when we come to sell our US shares and use the US dollar proceeds to buy Australian dollars again, we transact at the same exchange rate.
Loong says investors can use a forward exchange rate contract to buy “forward” the Australian dollars. This is a contract with another party – usually a bank – to buy a particular currency at the current price at a particular time.
We might buy a forward exchange rate contract for a year from now – although we can realise some of our US dollar investments at any time before a year is up, if we wish, and we also can extend the hedge beyond a year.
“Effectively, we are locking in the same exchange rate in [the future],” Loong says.
The $US/$A exchange rate is likely to change while we’re invested in the US.
It may move up or it may move down. But we’re hedged, so we don’t have any great concerns. Exchange rate movements won’t affect our overseas investment.
However, before we put our hedging strategy in place, we have to understand two things.
First, of course, if the exchange rate moves against us, we’ll be insulated.
Second, if the exchange rate moves in a way that would have been favourable to us if we weren’t hedged, we won’t get any benefit.
When our US investment play has run its course, we sell our US shares. We unwind our forward exchange contract at the same time. It makes no difference what the exchange rate has done during the year, because if we incur a loss on our US investment due to exchange rate movements, we make it up with our forward currency contract. If we make a profit on our US investments because of the exchange rate, we hand it back to cover the loss we’ve incurred on our forward exchange rate contract. We should, in theory, come out square.
In practice, Loong says, the forward exchange rate contract won’t necessarily be for exactly the same rate as today’s. The forward rate may be higher or lower than today’s, to reflect interest rate differentials (and therefore the returns investors could have earned on the cash) in the two countries whose currencies are being bought and sold.
Loong says that in practice the nature of the instruments used means it’s generally easier for institutional investors to hedge their currency exposures – and to monitor and manage hedging strategies – than it is for individuals, but the concept is still simple and relevant.
Source: Sydney Morning Herald
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