Hedging out of favour in Morningstar global review

Morningstar has taken a cautious view of fully hedged international share funds in its International Equities Sector Wrap-up, with only two of the 49 strategies given the top "highly recommended" status.

MFS Global Equity and Platinum International were the strategies to retain the highest ranking, while funds from Capital International and GMO slipped off the top rung due to management changes and research quality respectively.

Morningstar described the past 10 years as a "lost decade" for Australian investors in unhedged global share funds due to the rise of the Australian dollar, but said fully hedged international share funds had been much riskier over that period even though they had delivered a positive performance. This was partly due to the increasingly pro-cyclical behaviour of the Australian dollar, particularly since 2008, which had increased the volatility of hedged global funds.

Morningstar did not favour hedging international share fund portfolios, stating they did not offer superior risk/return attributes and that currency movements would be likely to wash out in the longer term.

Morningstar fund research analyst John Valtwies said the Australian dollar is a play on global growth, which has been amplified in recent years.

That means the Australian dollar is a "risk on" trade - when people expect growth the Australian dollar rises; when things look bad for growth the Australian dollar gets sold rapidly, he said.

So the hedged versions of global investments become riskier because of potential rapid downward movement in the Australian dollar, he said.

In the short-term, there could be a case for hedged, but in the long run Morningstar feels from risk/return perspective unhedged is a better option - and Morningstar's model portfolios reflect that, he said.

Morningstar also found that emerging markets are playing a significant and increasing role in international share fund portfolios, with the proportion of portfolio holdings fund managers purchase directly from emerging country stock exchanges on the rise.

Investors also tend to underestimate their exposure to emerging markets due to a combination of large-cap international share fund owning companies listed on emerging market exchanges, as well as having indirect exposure with a dedicated emerging markets fund. This is more significant for Australian investors, given the high correlation between Australian shares and emerging markets companies, Morningstar stated.