Hedging international investments
Currency Movement
Since April 2001, the Australian dollar has moved from its lows of 0.4801 against the US dollar to the current level of 0.6685 (June 13, 2003). This represents an appreciation of nearly 40 per cent in just over two years.
What does this mean for investors in international shares?
• The Australian dollar appreciation against the other currencies in an international share portfolio has detracted from returns.
• Even small reductions in returns from adverse currency movements are important where the outlook for international equity returns is low.
• Investors should be aware of this and use funds where the currency risk is managed through hedging.
• Hedging becomes more important where an investor has over 20 per cent of their portfolio in international shares. The currency effect of large allocations to international equities increases the riskiness of returns.
Does hedging add value?
Hedging can add value when the Australian dollar is trending upwards (appreciating) against other currencies.
When the Australian dollar is appreciating, as has been the recent experience, and the manager can hedge between zero and 100 per cent of the currency exposure, then it is possible for a manager to outperform an unhedged benchmark. International fund providers vary in their approach to currency hedging. Some will hedge actively — that is they will aim to hedge when the Australian dollar is appreciating; some will hedge strategically — that is a constant hedge of between zero and 100 per cent; and some managers do not hedge at all.
To show the potential to add value, Table 1 below compares two funds in the market that are offered as both fully hedged and fully unhedged, the Vanguard International Shares Index Fund and the Merrill Lynch Global Small Cap Fund.
Both the hedged and unhedged versions of the funds contain the same underlying assets. Since the appreciation of the Australian dollar, the fully hedged funds have clearly outperformed their unhedged counterparts. This outperformance has come solely from the currency hedge.
Case Study
This is a simple example of how a movement in currency affects returns from a US dollar denominated equity investment.
An investor buys US dollar denominated shares with an initial investment of $50,000. The initial exchange rate is 0.5600. That is, the investor buys US$28,000 worth of shares. We assume that the shares return 12 per cent over the investment period. If the exchange rate is the same at the end of the investment period, then the investor will have earned 12 per cent in Australian dollar terms.
However, if the Australian dollar appreciated against the US dollar by 10 per cent, the following example shows the net return to the investor:
USD investment return: USD 28,000 x 1.12 = USD 31,360
Exchange rate at year end: 0.5600 x 1.10 = 0.6160
Convert back to AUD: USD 31,360 / 0.6160 = AUD 50,909
Return on investment: ($50,909 - $50,000) / $50,000 = 1.81%
The return to the investor is 1.18 per cent.
Alternatively, a depreciation of 10 per cent would increase the returns:
USD investment return: USD 28,000 x 1.12 = USD 31,360
Exchange rate at year end: 0.5600 — (0.5600 x 0.1) = 0.5040
Convert back to AUD: USD 31,360 / 0.5040 = AUD 62,222
Return on investment: ($62,222 - $50,000) / $50,000= 24.44%
The return to the investor is 24.44 per cent.
The US dollar investment returns have varied between 1.18 per cent and 24.44 per cent due to currency movements of plus or minus 10 per cent. The volatility or risk of the investment has been increased because of the currency movement.
Margaret Callinan is research manager, Tandem.
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