14 May 2020
This piece was first published in April 2019. Content and data has been updated as at 20 April 2020.
For any investor with international equity exposure, the decision regarding currency hedging is a key component of the portfolio construction process. The below insight explores the implications for Australian investors of hedging or bearing currency risk within global equity portfolios, with potential benefits and drawbacks for each. The Macquarie Professional Series' suite of active global equity Funds are offered in both hedged and unhedged options, assisting investors to consider currency exposure within a global equity allocation.
Interactive article: click on the blue headings in the table below
||Aims to reduce the risk of currency movements from investment returns
||Exposed to swings in currencies
||Tends to outperform when AUD rises
||Tends to outperform when AUD falls
||Historically higher returns, aided by AUD currency “carry” pickup
||Historically lower returns, however, often buffers against global equity market sell-offs
||Historically higher volatility of returns, despite removal of currency risk
||Historically lower volatility of returns
||Lower diversification benefits to traditional Australian assets
||Greater diversification benefits to traditional Australian assets
The Australian market: state of play
When it comes to investing, Australians have a home-country bias, with portfolios heavily weighted towards the “lucky-country”.
Global equities present local investors with a range of opportunities, including the ability to diversify their portfolios away from the Australian share market, currency and economy.
With rising investor awareness as to the benefits of adding global exposures, it is no surprise that international investments are now a core allocation within portfolios, with the average Australian superannuation fund comprising a 25%1 allocation to international equities. Interestingly, of this international equity exposure, over two thirds is currency unhedged.1
Hedging 101: How can you manage your currency exposure?
Global investments are naturally exposed to swings in the value of the Australian dollar (AUD) and the currencies in which the underlying securities are denominated. This is where currency "hedging" comes in, which aims to reduce the risk of currency movements by providing certainty over exchange rates. A hedge, in its simplest form, can be thought of as a means of defense, aiming to protect a portfolio from adverse currency movements. Generally speaking, there are two types of currency hedges: a passive hedge, aiming to provide protection against currency movements, and an active hedge, also aiming to provide protection while actively seeking to add value from currency movements.
While hedging can assist in protecting portfolios from unfavourable currency fluctuations, it’s important to remember that it can also remove or reduce gains from favourable currency movements.
An illustration — Australian dollar movements
As a general rule, a depreciation in the AUD relative to a basket of international currencies will result in higher returns for investors who have not hedged the portfolio. This is because, as the AUD falls, the international currency denominated assets become more valuable in AUD terms. See Scenario 1 in the chart below, where the AUD depreciates against the USD by 5%.
Conversely, an appreciation in the AUD should generate higher returns for investors who hedged a portfolio, as international currency denominated assets become less valuable in AUD terms. See Scenario 2 in the chart below, where the AUD appreciates against the USD by 5%.
The below example, assumes 1) a $US100 return, 2) a AUD/USD exchange rate of 0.70 and 3) a depreciation / appreciation of 5%.
To hedge or not to hedge?
That is the question. While some believe that currency impacts “wash out” over the long term, historically this has not proved to be the case for Australian investors.
Below we explore the impact of currency movements on returns from an Australian investor’s perspective, both over the long term and during specific market events, as well as the volatility of these returns.
Over the period 31 March 20052 to 31 December 2019, exposure to hedged international equities has produced positive excess returns for passive Australian investors, with the MSCI World ex Australia Hedged Index returning 9.0% p.a. versus the unhedged counterpart return of 7.8% p.a. However, over the year to 31 December 2019, unhedged MSCI World ex Australia Index returns have proved more lucrative, returning 27.9% versus hedged returns of 26.7%.
Ultimately, outperformance can and does frequently oscillate between hedged and unhedged, determined by a myriad of underlying market forces.
|MSCI World ex Aus. Index
|MSCI World ex Aus. Index (Hedged)
Interest rate parity
A key contributing factor to the long-term outperformance of hedged returns is the notion of interest rate parity.
This economic theory says that arbitrage opportunities are cancelled out when forward exchange rates (the contracts utilised to implement currency hedges) account for the interest rate differential between the two countries. Theoretically, a country with higher interest rates will trade at a forward exchange rate discount, approximately equal to the interest rate differential. Therefore, when a portfolio is hedged it gains (or loses) additional returns approximately equivalent to the difference in the interest rates.
Australian investors have typically gained from this effect, referred to as carry, given Australia’s historically higher interest rates relative to the basket of currencies represented by global equities.
An approximation of the benefit of the “carry” trade is illustrated below. However, as shown, the size of this pickup has been declining and turned negative in 2019 driven by the higher US Federal Funds rate, with the USD typically being the largest currency exposure in an international equity portfolio.
*Estimation of historical currency carry pick up
Share market sell-offs
Generally, major share market sell-offs are accompanied by a depreciation of the AUD, as investors seek shelter in typical safe-haven assets, such as the US dollar, while avoiding perceived higher risk "commodity currencies" such as the AUD and Canadian dollar.
Unhedged exposures often benefit from a falling AUD, which can act as a "buffer" against global share market weakness.
This pseudo-downside protection was clearly demonstrated during the global financial crisis. From the period starting June 2008 to the end of January 2009 the AUD/USD fell more than 30c or approximately 33%, while the MSCI World ex Australia Index (ie unhedged) returned -16%, and the MSCI World ex Australia Hedged Index returned a more extreme -42%.
Similarly, the AUD exhibits a high correlation to global growth, underpinned by the Australian economy’s reliance on export-led growth. Therefore, when global growth expectations fall, usually accompanied by a sell-off in global equity markets, the pro-cyclical AUD is often prone to a depreciation. Again, acting as a buffer to drawdowns for unhedged investors.
Volatility of returns
As mentioned, the principal intention of currency hedging is to reduce currency risk from portfolio returns. Interestingly, the reduction of currency risk to Australian international equity investors has, inadvertently, over the long run resulted in higher overall volatility of returns.
The MSCI World ex Australia Hedged Index had a standard deviation of returns of 13.5% p.a. since inception (as at 31 December 2019)2, versus 11.3% p.a. for the MSCI World ex Australia Index, over the same period. The overall lower level of risk is likely attributable to the AUD "buffer" provided by unhedged returns during equity sell-offs, reducing drawdowns, as described above.
Correlation to Australian assets
It is also important to consider the implications of hedging international equity exposure on broader portfolio outcomes.
Behind international equities, Australian equities (22%) and Australian fixed income (12%) are the next largest exposures within the average superfund portfolio1. Interestingly, unhedged international equities have historically delivered a lower correlation to both Australian equities and fixed income than hedged equities, offering investors superior portfolio diversification potential.
|Correlation: 31 March 2005 to 31 Dec 20192
||MSCI World ex
|MSCI World ex
|Australian Equities (ASX/S&P 200 Index)
|Australian Fixed Income (Bloomberg AusBond Composite +0yr)
Correlations closer to 0 provide greater portfolio diversification.
What is the optimal level of currency hedging?
In short, there is no optimal level. The optimal level of currency hedging is one of the many portfolio construction choices an investor must make. It should be considered in light of broader portfolio exposures and an investor’s risk-return profile, outlook and time horizon.
While there are valid reasons for either hedging or leaving exposures unhedged, there may also be value in hedging a portion of the exposure or having the flexibility to quickly switch between hedged and unhedged when the outlook for currencies change.
How can we help?
Just as with any other financial market, currencies can be volatile and unpredictable, making it difficult for investors to actively manage their currency exposures. The Macquarie Professional Series offers a suite of active global equity funds, in both unhedged and hedged options, allowing investors the flexibility to achieve their desired level of hedging or to switch when outlooks change. These hedging overlays are passive and are implemented in house, for no extra management fee, by experienced currency specialists from the Macquarie Fixed Income team who have been managing currency portfolios for over 20 years.
Global Equities Funds available from Macquarie Professional Series:
1Source: APRA, Quarterly Superannuation Statistics, December 2019.
231 March 2005 represents the official start date of the MSCI World ex Australia Hedged index in AUD