Currency hedging’s extra benefit
Currency hedging can help protect investors against movements in interest rates, paying a return when exchange rates move adversely. But Australian investors might not be aware of an extra benefit available from this strategy, thanks to the central bank.
Due to sluggish growth in recent years in the Eurozone, Japan and the United States, official interest rates in these major economies have tended to hover at or around zero. In contrast, Australia’s 24-year winning streak of uninterrupted economic expansion as of mid-2015 has seen official interest rates remain in positive territory, currently at a record low 2 per cent.
Economists and market traders are reportedly expecting another interest rate cut from the Reserve Bank of Australia within the next 12 months, while the U.S. Federal Reserve has long discussed returning to a “normal” monetary policy. But with global economic growth remaining weak, there are strong prospects for an extended period of higher Australian interest rates relative to the world’s largest developed economies.
What does this mean for Australian investors?
According to State Street Global Advisors, manager of more than US$400 billion (as of end March 2015) of exchange-traded fund (ETF) assets worldwide, this interest rate differential can offer advantages for international investors, known as the “carry” part of the return, which makes hedging even more attractive for Australians.
As explained by State Street Global Advisors in its publication, “Seven Essential Tips for Managing Currency Risk”: “When an investor takes out a currency hedge, they earn interest at their local (‘base’) rate, while paying interest at the foreign rate. Since Australia has had higher interest rates than most other developed nations for many years, the carry earned by Australian investors has historically been positive.”
In January 2015, State Street Global Advisors estimated the carry at around 2 per cent a year, giving Australian investors another reason for investing internationally to reap potentially higher returns.
There is no certainty the carry will remain positive indefinitely, and investors should also consider the fees and costs associated with hedging investments. But with the Fed still weighing an end to its long period of zero interest rates, the Eurozone seeking to spark growth following the “Grexit” crisis and the Bank of Japan waging war against deflation, a major rise in overseas interest rates appears unlikely anytime soon.
Since floating in 1983, the Australian dollar has been one of the most actively traded and volatile currencies around the world, with currency fluctuations having the potential to turn a loss into a profit, or vice versa. For international investors, the key challenge is achieving the right balance between risk and return, with currency hedging an important consideration in this strategy.
By diversifying offshore with a State Street Global Advisors SPDR ETF, Australian investors can gain access to a family of ETFs which provide the flexibility to select investments aligned to the chosen investment strategy, including hedged and unhedged investments.
When investing offshore, Australians should not forget about the extra benefit of the nation’s relatively high interest rates, which appear here to stay for some time yet.
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