Opinion
While our dollar has fallen against the US dollar, it has strengthened against the euro, yen and pound. So check your currency exposure.
Amid the turbulence of global financial markets this year, one of the most notable things has been the inexorable strength of the US dollar against every other global currency. The corollary has been a relatively weak Australian dollar.
One of the great lessons of the COVID-19 crash in 2020 for anyone investing overseas was the more than 40 per cent difference that putting money in a hedged asset made to returns over the following year.
Research argues the long-term effects of currency fluctuations are negligible because the dollar tends to gyrate around the average. Louie Douvis
Hedging is like a form of insurance where a manager neutralises the so-called currency effect of the Australian dollar rising, or becoming more expensive, relative to other currencies so that the investment’s return only reflects the change in its underlying value.
For example, buying $US20,000 worth of US shares when the Australian dollar is buying US65¢ will cost $30,769 (20,000/0.65).
If the share price rises by 10 per cent over the next year and the currency remains unchanged, the investment will be worth $33,846 (22,000/0.65).
However, if instead the Australian dollar appreciates by 20 per cent, to 78¢, the investment would be worth only $28,205 (22,000/0.78). The currency effect has more than wiped out the benefits of the higher share price.
Buying a hedged version of the investment in the first place takes the currency effect out of the equation, so the return would equal the change in the underlying investment, in this case 10 per cent, regardless of what the Australian dollar does.
Given this example, it might sound sensible to simply buy a hedged version of any overseas investment and not worry about what happens to the local dollar. But there are times when the heightened volatility can work to your advantage, and being unhedged can help returns.
For example, buying $US20,000 worth of hedged US shares when the Australian dollar is trading at US75¢ would cost you $26,667 (20,000/0.75). If the shares fell in value by 10 per cent, the investment would be worth $24,000 (18,000/0.75).
However, if the exchange rate had fallen to US65¢ over the same period, the value of the investment will have gone up to $27,692 (18,000/0.65). Given the Australian dollar is seen as more risky than the US dollar, and in a downturn investors often rush to safe haven assets like the greenback this scenario is not unrealistic.
Is the Australian dollar cheap enough to hedge now? Unfortunately, there is no scientific formula to work out whether it is cheap versus other currencies. Last year, research by the Vienna University of Economics and Business that examined more than 50,000 currency forecasts from 136 different institutions over a 15-year period concluded that the forecasts were worse than random predictions, in other words guessing.
Dan Miles, chief investment officer at Innova Asset Management, which uses quantitative analysis to determine asset allocation and portfolio construction, says: “Historically, because the Aussie dollar has been seen as a risky currency compared to the US dollar, it’s done a pretty good job of helping to insulate investors against share market volatility. So our policy has been to remain unhedged unless the exchange rate gets to extremes.”
So, what is extreme? Miles admits there is no effective mathematical rule to apply but observes that the local currency has averaged US76¢ over the past 30 years, and got to as low as US61¢ in the global financial crisis and US57¢ in the COVID-19 crisis. At levels of around US64¢, he believes it is defendable to be 50 per cent hedged.
Smart investors already holding overseas shares that are entirely unhedged, even at a loss, could consider switching to a hedged version for a portion of the investment if there is one available.
However, something else to bear in mind is that while our dollar has fallen against the US dollar this year, it has strengthened against the euro, yen and pound. Before deciding to hedge an investment, it might pay to check what its currency exposures are.
Alternatively, another option is to buy a currency ETF as a kind of insurance overlay. For example, the BetaShares Strong Australian Dollar Fund is designed to increase by more than 2 per cent if the Australian dollar rises against the US dollar by 1 per cent. Its Strong US Dollar Fund does the opposite.
Finally, for long-term investors the third option is to do nothing. There is research that argues the long-term effects of currency fluctuations are negligible because it tends to gyrate around the average. So, those times the Australian dollar appears cheap simply offset those when it appears expensive.
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