How does currency impact global equity investments and under what circumstances is currency hedging appropriate for investor portfolios?
There are lots of great reasons to invest in global equities. However, many investors don’t realise they may be investing in two asset classes – equities and currency. This article from GSFM examines the investment case to hedge or not to hedge.
We live in an increasingly globalised world. Global companies have become an everyday part of our lives. Although Australian investors tend to have a ‘home bias’ in their equities exposure, there are several good reasons to diversify into global companies. These include:
- the small size of the Australian sharemarket, which comprises less than 2% of global markets
- access to a range of markets, sectors and geographies
- access to a broader range of innovations and industries, many of which are not represented on the local bourse
- the ability to benefit from demographic trends across the globe – ageing populations in developed economies, the rising middle class in emerging markets, decarbonisation worldwide.
As well as getting exposure to global opportunities, in many cases, investors are also exposed to foreign currency. While not often considered a separate asset class for retail investors, it is treated as such by many institutional investors.
Currency hedging is a strategy employed by investment managers to mitigate the risk associated with fluctuations in foreign exchange rates. In the context of global equity funds, currency hedging aims to minimise the impact of exchange rate movements on the fund’s performance.
Global equity funds in Australia may be fully or partly hedged or unhedged. A hedged fund is one where currency risk is deliberately reduced or eliminated using financial instruments to offset the impact of variations in exchange rates.
The majority of global equity funds available to Australian investors are unhedged; in other words, the investment manager does not attempt to reduce or eliminate currency risk. The underlying performance is, therefore, subject to both company performance and currency movements.
How does currency affect global investing?
The decision to hedge your clients’ currency exposure is important because movements in the Australian dollar (AUD) can either erode or add value to a global investment.
A decline in the AUD generally helps investors as it magnifies gains when assets are converted into local dollars. For example, if the AUD falls by 15 percent, the value of clients’ global investments would rise by 15 percent.
Conversely, a rise in the Australian dollar diminishes returns when assets are sold and converted into AUD. The AUD is considered ‘pro-cyclical’ – it typically rises when global equity markets rise and fall when global equity markets sell-off.
What affects the value of the AUD?
There are short and long term drivers that impact the value of the AUD. Short term drivers include changes in risk sentiment and speculation. Over the longer term, the value of the AUD is impacted by a number of factors, including interest rates, inflation and purchasing power parity, capital flows and commodity prices.
How does currency hedging work?
Currency hedging is used to manage and mitigate the impact of currency fluctuations on a global fund’s returns. Not all managers choose to actively manage their currency exposure. However, for those that do, there are several steps an investment manager generally takes to manage currency.
1. Identifying currency risk
When a manager buys global equities for a fund (whether an unlisted managed fund or exchange traded product), they are buying exposure to not only the performance of the underlying companies but also to the fluctuation of exchange rates between AUD and the currency of the country in which the stock is listed.
For example, if an Australian-based manager buys current market favourite Nvidia with AUD from investors, changes in the USD/AUD exchange rate will affect the value of the investment. If the US dollar strengthens against the AUD, it could increase the returns from that investment when converted back to AUD. Conversely, if the AUD strengthens against the USD, the return to Australian investors is reduced.
Most managers don’t hedge on a company by company basis; rather they look at the overall exposure to different currencies in the fund and make hedging decisions from there.
2. The hedging mechanism
To manage currency risk, an investment manager may employ a hedging mechanism, utilising financial instruments such as forward contracts or options.
- Forward contracts are agreements to buy or sell a specific amount of a currency at a future date, at a predetermined exchange rate. This provides the manager with certainty about the conversion rate a specific point in time.
- Options give the holder the right, but not the obligation, to buy or sell a specific amount of currency at a predetermined exchange rate. This provides the investment manager with flexibility and can be used to protect against unfavourable currency movements.
Locking in exchange rates using financial instruments can provide the investment manager with a known and stable conversion rate for the future. The goal is that even if exchange rates move against the fund’s base currency, the investment returns are shielded from potential losses due to unfavourable currency movements.
For example, a local manager has 35 percent of a global equity portfolio invested in companies denominated in Euros. If the fund manager anticipates that the Euro might weaken against the AUD, they could enter into a forward contract to buy Euros at the current exchange rate. This contract would specify the amount of Euros to be exchanged at a specified future date. If the Euro weakens as expected, the investment manager will be able to convert their investment back into AUD at the predetermined, more favourable exchange rate.
Hedged or unhedged funds?
The decision recommend a client invest in a hedged or unhedged option will likely be based on a number of variables, including the investor’s risk tolerance, investment timeframe and ability to deal with volatility in their investment returns.
A hedged exposure to global equities may be more appropriate where:
- The investment is in a country or region with high currency volatility; for example, some emerging markets where currency movements can be unpredictable.
- An investor has a lower risk tolerance; in such cases, a hedged exposure to global equities can often provide a more stable and predictable return profile, because it reduces the uncertainty associated with currency fluctuations.
- Depending on the client’s overall investment strategy, a hedged exposure to global shares may align with their broader financial goals or work with other strategies in their portfolio.
- During periods of heightened currency volatility or uncertainty in global financial markets, investors may prefer a hedged exposure to minimise potential losses associated with adverse currency movements.
As with any investment, there are always positives and negatives. Currency hedging is no different – there are downsides to this approach, in particular, the potential cost and complexity it introduces.
Implementing a hedging strategy typically involves transaction costs. The fund incurs expenses associated with acquiring and managing the financial instruments used for currency hedging. These costs can erode the fund’s overall returns.
Currency hedging can be imprecise and may not always provide the intended protection. Exchange rates can be influenced by a multitude of factors, including economic indicators, geopolitical events, and market sentiment. Each currency has its own drivers. Predicting the direction and magnitude of currency movements is inherently uncertain – even the most sophisticated hedging strategies may not entirely eliminate currency risk.
A hedged strategy can also risk over or under hedging. Over hedging happens when the fund manager hedges too much, potentially limiting potential gains if the foreign currency strengthens. On the other hand, under hedging leaves the fund exposed to significant currency risk. Striking the right balance requires a deep understanding of both equity markets and currency dynamics, making it a complex task.
Finally, currency hedging may not always align with the investor’s investment objectives. For investors seeking diversification and exposure to foreign currency movements as part of their investment strategy, hedging may not be in line with their goals.
Currency movements – and how they move with equities – are difficult to predict. Accordingly, most managers treat currency hedging as a way to manage risk, rather than a tool to add return. Investors should view currency hedging in the same way.
Over the longer term, currency hedging in global equity portfolios may not consistently add value for several reasons.
- As stated above, currency movements are difficult to predict. They are influenced by a complex interplay of economic, political and market specific factors. Attempting to consistently outperform currency markets through hedging strategies can be likened to trying to time the market – notoriously challenging and often results in suboptimal returns.
- As previously noted, currency hedging comes with costs. Implementing hedging strategies involves transaction costs, which can erode returns over time.
- Currency movements can sometimes act as a natural diversification tool. When a portfolio is unhedged, it can benefit from the diversification effects of different currencies.
- Hedging can limit potential upside gains. If the manager hedges against a weakening foreign currency and that currency strengthens instead, the investor would miss out on potential gains.
For many long-term investors, a well-diversified global equity portfolio without active currency hedging can provide exposure to a broader range of opportunities and potentially lead to more stable and consistent returns.
Factors for advisers to consider
Deciding whether to recommend a global equity strategy that hedged or unhedged is a client centric decision. Advisers should consider:
- the client’s risk tolerance
- the client’s tolerance for periods of underperformance
- the client’s investment horizon
- other investments in the client’s portfolio.
Other factors could also include:
- the currency profile of the fund
- the broad macro-economic and geopolitical environment.
Overall, currency hedging in a global equity fund aims to provide a level of stability and predictability to the returns of the fund, reducing the uncertainty introduced by currency fluctuations. However, it’s important to note that while hedging can protect against losses from adverse currency movements, it can also potentially limit gains if the currency moves in a favourable direction. Therefore, fund managers carefully consider the trade-offs when implementing currency hedging strategies. Likewise, it’s important to consider your clients’ specific investment objectives and risk tolerance. The best decision for the client will depend on their individual circumstances.
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