(03) 9020 2905PORTFOLIO POINT: Were you too scared to take off the hedging safety harness last year? There was a big bang reward for those who were unhedged.
Unlike most other investment opportunities, currency is very close to being a long-term, zero-sum, game. For every winner, there is, broadly, an equivalent loser.
Share and property markets tend to go up. But all else being equal, currencies will bounce around a long-term average. If they stray too far from that average, it seems almost inevitable that they will return to it eventually.
Sharp movements in the Australian dollar create winners and losers in the economy itself. Our exporters are the losers when the Australian dollar is rising (against the US dollar), as the prices of our goods become relatively higher and we have to accept lower prices and/or volumes.
Conversely, importers benefit as our Australian dollar can get more bang for its buck. Prices for imported goods, such as electrical goods and fuel, are cheaper. This is the benefit Australian consumers can see. It’s the reverse when our dollar is low – exporters do well at the expense of importers.
From an investment point of view, the focus tends to be on which individual listed resource companies are hedging and which ones are not and whether they got it right.
But what about retail investors? Can SMSF trustees and self-directed investors take advantage of currencies? Absolutely. Most easily through “hedged” and “unhedged” versions of international managed funds. And while many fund managers offer both versions of some of their funds, I’ll use index fund manager Vanguard.
Hedging can be a divisive issue. Many say that if you’re already making bets in offshore markets, on which you know considerably less about than your own market, you’d only be compounding your risk by adding in a currency play.
As a result, most funds that flow from Australians into international managed funds are “hedged”. The potential impact of currency fluctuations is taken out of the equation for a small “hedging cost”, so the concentration of risk is solely on the performance of the international market/s being invested in.
However, investors with patience could be missing out.
The theory at its simplest is this: When the Australian dollar is high, buy offshore assets. When the Australian dollar falls, convert those assets back to Australian currency. It doesn’t guarantee a win, but, in theory, it will mean that you “beat” the same investments where currency was taken out of play with hedging.
Over the last 18 months, we’ve witnessed an extraordinary opportunity in this area, as the Australian dollar rose above US97c, before crashing down to around US60c and its subsequent rebound to US80c.
We won’t play extremes here. For the purposes of this example, we’ll assume that when the Australian dollar reached US90c, our investor believed that it was overvalued and it was a good time to be buying offshore assets. For the portion of the portfolio that we have exposed internationally (which for some might be as much as 40% of their entire portfolio), we decided to shift from the Vanguard hedged funds to the unhedged versions of the same funds.
Over the next six months, the Australian dollar continued to rise, peaking at just above US97c, which would have made us a little nervous, as we clearly hadn’t timed the market perfectly and the “experts” were talking about the Australian dollar hitting parity with the US dollar.
However, from there, the Australian dollar fell considerably. In three months, it fell US37c to US60c. It continued a wild ride before settling around US65c between February and March this year.
At that time, our investor decides to exit, having “made” US25c on the falling Australian dollar. The following graph shows what would have happened to the performance of our managed funds. (We’ve assumed that we simply bought on the last trading day of each month to remove absolute timing issues. Further, we have allowed for trading costs by using Vanguard’s quoted buy and sell spreads.)
Table 1: Hedged versus Unhedged – playing the currency game
| Vanguard fund | Feb 08
(Purchase price) |
Feb 09 (Withdrawal price) | Performance % | Outperformance % | |
| International shares (unhedged) | 1.3097 | 0.9949 | -24.04 | +26.88 | |
| International shares (hedged) | 0.7534 | 0.3698 | -50.92 | ||
| International small companies (unhedged) | 0.8452 | 0.6243 | -26.14 | +23.02 | |
| International small companies (hedged) | 0.8463 | 0.4303 | -49.16 | ||
| International global infrastructure (unhedged) | 0.8809 | 0.9115 | +3.47 | +30.29 | |
| International global infrastructure (hedged) | 0.9219 | 0.6746 | -26.82 | ||
| International property securities (unhedged) | 0.8624 | 0.4926 | -42.88 | +22.68 | |
| International property securities (hedged) | 0.9548 | 0.3288 | -65.56 | ||
The non-weighted average of these four unhedged funds is an outperformance of 25.7%. Yes, the investor has still lost money in three of the four, but everyone who has lost 25.7% less money will be smiling.
If we took the top of the market (US97c) to the bottom of the market (US60c), the situation might look even better. However, we’re just trying to show that it was reasonable to make the judgement that at US90c, the Australian dollar was high and that at US65c, the dollar was back within the band of its long-term average.
How much of your portfolio should be invested in international markets comes down to your personal risk tolerance.
A “balanced” investor should classically have about 20-25% of their money invested in international shares. A high-growth investor should have up to about 40% of their money invested in international shares.
Let’s assume SMSF trustee members with a super fund of $800,000. The couple are balanced investors and had determined to have 25% of their money in international shares, so $200,000 is invested into international shares and property. During the times mentioned above, the investors made the unhedged bets for their entire international exposure.
The investment would have meant their investment portfolio was more than $51,000 ($200,000 and 25.7%) better off. That is, instead of the investment falling from $200,000 to $103,770, it would have been worth $155,205. (It still would have been better to be in cash, obviously. But worse in Australian shares.)
Further, had you switched back from unhedged to hedged in February this year, you’d have also been winning on the recovery. The same style of comparison as above for hedged versus unhedged shows hedged has outperformed unhedged by an average of about 21%. This is for the period of the end of February to the end of May.
Our investor from above whose $200,000 had turned into $155,205 would now be at approximately $187,800 and within striking distance of breaking even, despite the constantly hedged investment being down 39.5 per cent over the same period. That has lifted the outperformance to 33.4%, or one-third.
Had we all followed advice hinted at by Alan Kohler in April 2008 (Time to adopt a US accent), this hedging play still would have been worthwhile.
A play of this type is unlikely to make much sense when the Australian dollar is at or near its average, as it could ride either way from there, a 50-50 bet. From a risk minimisation perspective, the odds would seem to have naturally shortened if the Australian dollar was sufficiently above its long-term average as to make it more likely than not that it would fall.
Other things to keep in mind? There are many. The following is not exhaustive.
- It significantly increases the risks. It is akin to adding leverage to your portfolio.
- The funds on which you can get both a hedged and unhedged version are quite small.
- Fundamental shifts in the value of some currencies can occur, which can catch investors out.
- Currency movements can occur every bit as quickly as share price movements, so you need to be alert.
The dollar is hovering around US80c. And there are more people saying our dollar is overvalued than undervalued. Is it sufficiently above its long-term average to consider a currency play of this description? Probably not. But the potential to add significant value to your SMSF portfolio means you should be keeping an eye on Australia’s dollar and unhedged international funds.
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None of the recommendations in this article should be taken as personal investment or financial advice. In any investment program, your personal situation and needs should be taken into account. Please see your adviser/s before implementing any major changes to your investment program.
Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.