You’ve probably come across the term ‘hedging’ when choosing your investments either personally or within your super. This could be something like “International Share Fund – Hedged” or “Global Property Fund – Hedged” or “Hedged Global Bond Fund”.
The first thing to understand that hedging is something that primarily applies to assets held outside of Australia. So, when investing you will find hedging on investment funds named global, international or for a specific country like the U.S. You generally won’t find it on funds that invest in Australian assets. There are limited circumstances where Australian assets also need to be hedged, but it is rare.
The impact of currencies when investing
When you choose to invest in assets held outside of Australia, you (or the fund manager you employ) obviously can’t buy these assets using Australian dollars. So, you essentially need to change your AUD into the currency of whatever country you wish to invest in.
So, let’s say you had $100AUD to invest, and you wanted to buy some shares worth $5USD each on the U.S stock market. Clearly you can’t buy 20 of these shares. Assuming a 0.65 exchange rate, you could instead buy 13 of these shares with your $100AUD.
A year goes by, and you’ve made good money on your shares, that $5 share price has now grown to $6 which makes your total portfolio worth $78 USD. So, you decide to sell up your shares and take your profit.
You instruct the fund manager to make these sales for you, which they do, then convert your money back to AUD and deposit it in your bank account. To your surprise, the money that makes it back to your account is only $97.50. Lower than your original $100. Your shares increased by 20%, how could it possibly be that the money you get back is less than what you invested?
The answer is currency fluctuations. Whilst your money was invested the exchange rate between AUD & USD changed from 0.65 to 0.80. In essence, the AUD appreciated against the weaker USD.
In plain terms, whilst your money was invested in USD, the value of the currency went down against the AUD, making your investment (in AUD terms) worth less even when accounting for the growth in the share price. Conversely, if the AUD had depreciated against the USD, you could receive more AUD for your investment, enhancing your returns.
This somewhat exaggerated scenario shows that currency exchange rates can significantly impact the final value of international investments. It’s not just the performance of the investment itself that matters, but also how the currency values change relative to the AUD.
How hedging solves this
Hedging is the financial strategy that seeks to remove currency fluctuations when investing in international assets. Essentially hedging aims to lock in the exchange rate on the day you make your investment, so you are immune to any such fluctuations.
The fund manager will use certain financial instruments such as options, forward contracts or currency swaps to achieve this goal. These instruments and the management of them come with an additional cost. That’s why you generally see hedged investments costing slightly more in management fees than the unhedged alternative.
To understand hedging in practice, consider the earlier example where you invested $100 AUD in U.S. shares worth $5 USD each at an exchange rate of 0.65. If the fund was hedged, the fund manager would have used a forward contract to lock in the 0.65 exchange rate for converting the expected returns back to AUD.
Assume the shares appreciate to $6 each, making your total investment worth $78 USD. At the time of converting back to AUD, if the exchange rate had moved unfavourably to 0.80, the hedged position would protect your returns. The forward contract ensures that the conversion happens at the 0.65 rate, yielding $120 AUD (78 / 0.65), rather than $97.50 AUD, thereby preserving your 20% profit.
While hedging protects against adverse currency movements, it also means you won’t benefit from favourable ones. For instance, if the USD appreciated against the AUD (e.g., if the exchange rate moved to 0.50), the unhedged position could result in higher returns, but the hedged position would not capture this gain due to the locked-in rate.
Is it necessary?
It’s impossible to determine whether hedging will result in greater or lesser returns if it is used or not. Research indicates that exchange rate movements are largely random and subject to a myriad of unpredictable factors. Consequently, from a purely forward-looking currency perspective, the decision to hedge may seem irrelevant, as it’s impossible to consistently forecast currency trends to your advantage.
The study also confirms that currency movements are generally less volatile than that of the stock market itself. This makes hedging ineffective as a volatility reduction tool at least in share heavy portfolios. For fixed interest heavy portfolios however, hedging is an effective way to reduce overall volatility, which is usually the primary goal for such portfolios.
If we assume that hedging makes no real difference to long-term returns (less a very small additional fee) the decision whether to use it or not is largely irrelevant. The more relevant point is picking your strategy and sticking with it. That is, not chopping and changing your hedging strategy to suit your own personal opinions on the state of exchange rates. This only opens you up to the possibility for currency-based underperformance. The only other consideration is if you invest primarily in fixed interest, with a goal of volatility reduction, hedging may be a useful strategy to assist in this goal.
