With the Australian dollar potentially having peaked over the short term, some fund managers have reduced hedging levels on international investments, with local economic activity expected to slow against an improving outlook for the United States economy.
Melbourne-based K2 Asset Management is prepared for a short-term decline in the Australian dollar and six months ago dropped hedging levels on its international equity fund to 65 per cent from 100 per cent, while hedging levels on its Asian equity fund dropped to 80 per cent from 100 per cent.
K2 chief investment officer Mark Newman said the fund was concerned about a slowing in domestic demand, against an improving outlook for the US.
"We're still positive on the currency, but less so than six months ago," Newman said.
"With the level of activity in Australia slowing, particularly outside the resources sector, we felt that there's a need for lower interest rates."
Against that, the US economy is showing signs of strength, which will eventually attract asset flows back to the US, taking pressure off the Australian dollar.
A moderate slowing in China was also taking pressure off commodity prices, Newman said.
"US growth has continued to surprise on the upside, while Chinese growth has encouragingly begun to stabilise in the face of some more proactive policy action from the central authorities," he said.
But the fund is still holding Australian dollars, given a robust longer-term outlook.
"Long term we're still positive on the Australian dollar as we believe there will be a period of long-term growth for commodity prices over the next 10 to 15 years, and that's a support for the Australian dollar," Newman said.
AMP Capital multi-asset group head of portfolio management Deborah Alliston said throughout 2011, many fund managers had reduced hedging levels because of the view the Australian dollar was looking fully valued.
"There's a view that the Australian dollar may be trading towards the top of its range at these levels. So investors are comfortable to increase their foreign exchange as it provides more protection in a downward market," Alliston said.
Indeed, within investment portfolios, holding foreign exchange or unhedged international investments plays an important diversification role.
"When riskier asset markets fall, such as equities, the Australian dollar tends to fall also, so it can provide an offset to negative international asset returns once you convert those assets back to Australian dollars," Alliston said.
"But there's some benefit from hedging also because you pick up the interest rate differential between the country that you're buying into and Australia.
"So at the moment, for example, if you invest in the US, where interest rates are very close to zero compared to Australia where they are around 4 per cent, you pick up around 4 per cent return per annum from hedging.
"So there's a real trade-off between hedging and benefiting from interest rate differentials at the moment and the diversification you get from holding foreign exchange."
She said her diversified funds, which are part of the multi-asset group, had a neutral target of about 20 per cent exposure to foreign currency, with the 80 per cent remaining assets held in Australia or the value of assets hedged back to Australian dollars.
