Is it time to hedge global equity investments?
The slide in the Australian dollar (A$) over recent months begs the question of whether it’s time to consider hedging global equity portfolios in anticipation of a potential rebound in the currency.
The A$’s drop from more than US70 cents in early 2023 meant a 100% hedged investment in the MSCI World ex Australia index fell 2.87% in the September quarter as global shares retreated, versus a more modest loss of 0.43% from an unhedged investment.
Some experts are forecasting the dollar will soon recover from its recent lows, which would potentially reverse those returns in favour of hedged investments.
Russell Investments in its fourth quarter Global Markets Outlook argues the A$ has some upside, “given it is slightly cheap and could benefit from a compression in interest-rate differentials against the United States”.
On October 11, NAB was forecasting the AUD/USD spot exchange rate will rise steadily from US64 cents in September to US73 cents by year-end and continue its upward trend into 2024. Westpac had a more conservative view on October 6 than its banking rival, predicting the $A will reach US66 cents by December and not hit US70 cents until the end of 2024.
History though shows currency forecasting is inevitably fraught due to the wide range of variables that can alter the direction of an exchange rate, including geopolitical events, monetary policy decisions and an inflation outlook.
Take your pick
As a result of this unpredictability, many fund managers offer both unhedged and hedged versions of the same global equity funds forcing advisers and retail clients to choose a currency strategy that best suits their own outlook.
This dichotomy is evident in the Australian Exchange Traded Fund (ETF) market, where there is both an unhedged iShares S&P500 ETF (ASX: IVV) and a hedged version of the same fund (ASS: IHVV).
Likewise, there is both an unhedged version of Vanguard’s MSCI Index International Share ETF (ASX:VGS) and a hedged version (ASX:VGAD). Betashares also offer an unhedged option for its NASDAQ 100 ETF (NDQ), as well as a hedged option (ASX:HNDQ).
The returns of iShares two S&P500 ETFs show just how much volatility in the $A can impact returns. The unhedged version gained 13.82% in the three years to September 30, versus a 7.78% gain in the hedged product.
But Betashares’ investment strategist Tom Wickenden recently provided a useful illustration of how the reverse situation could easily apply if the Australian dollar does move higher from its recent levels.
“Historically, we have observed US65 cents being a key level for investors considering whether to start investing into currency hedged ETFs. The Australian dollar recently fell below this mark for just the fifth time in the past 20 years,” Wickenden wrote in late September.
“The long-term average exchange rate has been around US81 cents. If the Australian dollar mean reverted to this level from US65 cents, investors in unhedged US dollar exposures would suffer approximately 20% in losses due to currency returns,” he said.
Over the long term though, the difference between hedged and unhedged portfolios may be less stark. Various research studies invariably suggest the difference between the two forms of investment is neutral over long periods.
Some pundits argue this makes currency hedging a more appropriate consideration for people with relatively short investment horizons, such as those close to retirement, while for others it’s a zero-sum game.
“Long term, currency has no intrinsic return; there is no yield, no coupon, no earnings growth. Therefore, long term, currency exposure affects only return volatility,” Vanguard analysts wrote in 2021.
“Those with a long investment horizon who are comfortable with equity’s high potential return and volatility, may be disposed to accept short-term currency volatility. Those with shorter horizons or an explicit objective to minimise volatility, may prefer to hedge the currency risk,” they said.
There is no right or wrong answer to the question of whether to hedge global equity portfolios; in fact, this is perhaps more so for this asset class than any other. It may all come down to individual circumstances and objectives just like all asset allocation decisions.