Advisers need an appreciation about the circumstances in which currency hedging may or may not be appropriate for clients’ portfolios.
In today’s interconnected world, global companies play a significant role in our daily lives. However, when Australian investors allocate their capital to global markets, they are exposed not only to the performance of the underlying assets, but also to fluctuations in currency exchange rates. Whether or not to hedge this currency exposure is a key strategic decision that can impact returns, volatility and overall investment outcomes.
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.
Most 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 erode or add value to a global investment. However, like equity markets, the direction of currency can be mercurial and hard to predict.
A decrease in the AUD increases the value of foreign assets when converted into local currency. For instance, if the AUD declines by 15 percent, the value of clients’ global investments would increase by 15 percent when measured in AUD.
A stronger Australian dollar reduces returns when assets are converted to AUD. As a ‘pro-cyclical’ currency, the AUD typically appreciates with rising global equity markets and declines during selloffs.
The value of the AUD is influenced by both short- and long-term factors. In the short term, risk sentiment and speculation play key roles. Long-term drivers include interest rates, inflation, purchasing power parity, capital flows and commodity prices.
Currency hedging in practice
Currency hedging helps manage the impact of exchange rate changes on a global fund’s returns. While some managers don’t actively manage currency exposure, those who do usually follow two key steps.
Step one: Identify currency risk
When a manager buys global equities for a fund – whether an unlisted managed fund or exchange traded product – they are buying a dual exposure. This exposure is to the performance of the portfolio companies and to the currency in which each investment is denominated.
For example, if an Australian-based manager buys leader of the ‘mag seven’ Nvidia with AUD from investors, the USD/AUD exchange rate impacts investment value. A stronger USD boosts returns in AUD, while a stronger AUD lowers them.
Most managers that do engage hedging strategies don’t do so 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.
Step two: 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 let you buy or sell a set amount of currency at a future date for an agreed exchange rate, giving managers certainty about conversion rates at that time.
For example, an Australian fund manager holds 40 percent of a global equity portfolio in European companies denominated in Euros. Concerned that the Euro may depreciate relative to the Australian dollar, the manager decides to hedge this exposure by entering into a forward contract to sell Euros at the current exchange rate. The contract locks in the rate at which the Euros will be converted back into AUD at a set date in the future. If the Euro weakens as anticipated, the forward contract protects the value of the underlying European equity holdings when translated back into AUD, effectively offsetting the currency loss and preserving the portfolio’s return.
- Options allow the holder to buy or sell a set amount of currency at a fixed rate, offering flexibility and hedging against adverse currency moves.
For example, the same Australian fund manager with the 40 percent of a global equity portfolio in European companies denominated in Euros decides to hedge this exposure by purchasing a Euro put option. This option gives the manager the right, but not the obligation, to sell Euros at a predetermined exchange rate on or before a specified date. If the Euro does weaken as anticipated, the option increases in value, helping to offset the currency-related losses in the equity holdings when converted back to AUD. If the Euro instead strengthens, the manager can let the option expire and still benefit from the favourable exchange rate, albeit having paid a premium for the protection.
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.
The case for hedging equity investments
While the case for hedging fixed income investments is generally clear-cut due to their low expected returns and sensitivity to currency losses, the decision is more nuanced when it comes to equity investments. However, there are still several compelling reasons why Australian investors may choose to hedge currency exposure on international equities.
1. Reducing volatility and improving return consistency
Global equities can be volatile and adding foreign currency exposure can introduce another layer of uncertainty. Take for example, an investment in the ‘mag seven’. Should the AUD strengthen against the USD, any gains from share price growth can be diminished or even reversed when converted back to AUD. This currency effect may have nothing to do with the company’s fundamentals.
Hedging removes this variable. It allows investors to isolate the performance of the underlying stocks and may result in a smoother return path, particularly over shorter time frames. This can be important for investors who are risk-averse, approaching retirement or drawing income from their investments.
2. Avoiding currency-driven distortion of sector or regional exposure
Currency movements can sometimes mask or distort investment performance. For instance, if the AUD weakens, unhedged international equities may show strong gains and appear to perform well, even if underlying markets were flat or negative. Conversely, a rising AUD can lead to disappointing returns despite positive market performance.
This may make it harder to assess portfolio performance and asset allocation decisions. Hedging helps ensure that investment outcomes more accurately reflect the performance of global equity markets, rather than currency fluctuations. This can be particularly helpful for advisers when making recommendations or assessing manager performance.
3. Strategic or tactical hedging in specific environments
There may be times when a stronger AUD is more likely; for example, during a commodities boom or during periods of rising Australian interest rates. In such scenarios, unhedged international equities may suffer due to currency losses.
Some investment managers may choose to implement tactical hedging to protect against these movements. Alternatively, a strategic hedge ratio – such as hedging 50 percent of foreign equity exposure – may help balance risk and return over the long term.
4. Currency moves can cancel out or exaggerate returns
Equities are typically purchased for growth, and in strong global bull markets, hedging can help ensure investors fully benefit from share price gains without having them diluted by a rising AUD. Conversely, in periods of global equity declines, a falling AUD can buffer losses, but this is a form of passive protection and may not always align with long-term investment goals. Relying on currency to boost returns introduces a speculative element, which may not be suitable for all clients.
In summary, the case for currency hedging focuses on minimising the impact of currency fluctuations. While equities can withstand more volatility than bonds, currency fluctuations can still have a material impact on returns. Investing in a fund with a hedged equity exposure allows clearer insight into asset performance and can reduce short-term volatility and align outcomes more closely with your clients’ financial objectives.
The case for unhedged equity investments
While hedging can reduce volatility and protect against adverse currency movements, there are also strong arguments against hedging currency exposure of global equity investments. Unhedged global equities unhedged can offer meaningful diversification benefits, reduce costs and improve long-term returns.
1. Currency as a natural portfolio diversifier
A key reasons not to hedge currency exposure is that it can act as a natural shock absorber during periods of market stress. Historically, AUD has functioned as a ‘risk-on’ currency – it tends to strengthen during global economic booms and weaken during downturns. When global equity markets fall, the AUD often declines as well. This dynamic means that currency gains from a weaker AUD can help cushion losses on global equities.
For example, during the Global Financial Crisis or the COVID-19 market downturn, the AUD fell sharply. This reduced the impact for Australian investors holding unhedged global equities. In this context, currency exposure provides a form of automatic downside protection, which can be valuable during market corrections or recessions.
2. Speculative risks and timing challenges
Hedging may introduce a level of speculation on currency movements. Unlike equities, which are expected to generate long-term growth, currency returns tend to mean-revert over time and are driven by short-term interest rate differentials, sentiment and macroeconomic shifts. Predicting currency moves is notoriously difficult, and getting the hedge “wrong” can result in opportunity cost.
For example, if the AUD falls and your client is fully hedged, they will miss out on the currency boost that would have added to their global equity returns. Over the long term, these currency tailwinds can materially contribute to performance.
3. Cost and complexity of hedging
Hedging is not free. It involves ongoing management and transaction costs, particularly when currency forwards or derivatives are used. These costs can add up and detract from total returns, especially during times of heightened currency volatility or when interest rate differentials between Australia and other countries are wide.
4. Long-term investors may not need to hedge
Currency volatility tends to average out over long time horizons. While exchange rates can swing wildly over months or even a few years, they generally revert toward long-term fair value over time. For investors with a long investment horizon, these fluctuations may be less relevant. In fact, over the long term, unhedged global equities have historically delivered strong returns for Australian investors, with currency impacts largely evening out[1].
So…to hedge or not to hedge?
The decision to recommend a client invest in a hedged or unhedged global equity strategy will likely be based on several 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, and currency hedging is no different.
Over the longer term, currency hedging in global equity portfolios may not consistently add value for several reasons.
- As stated previously, 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 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 is 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.
Currency hedging in global equity funds helps stabilise returns by reducing currency risk. While it can protect against losses from adverse movements, it may also cap gains if currencies shift favourably. Advisers must weigh these trade-offs when making financial product recommendations, and importantly, keep client objectives and risk tolerance in mind, as the best approach depends on individual circumstances.
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Notes:
[1] Past performance is not a guarantee of future returns.
The information included in this article is provided for informational purposes only and is general advice only. It does not take into account an investor’s own objectives. The information contained in this article reflects, as of the date of publication, the current opinion of GSFM and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. None of GSFM Pty Ltd, its related bodies or associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.
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