Looking out over the next three to five years, one needs to consider whether that tailwind will continue to be in play? Of course, forecasting currencies is unusually difficult.
With the Australian dollar likely to retain much of its risk-on/risk-off qualities, it remains vulnerable to a near-term pullback. However, both the short-term (multi-year global recovery and low US interest rates) and longer-term fundamentals (improving trade and relative debt positions) argue a relatively positive outlook for the currency. It’s no surprise some analysts are forecasting its rise over the coming years.
It is important for investors to consider that hedging away currency exposure can increase portfolio total risk. The correlation between domestic equities and unhedged international equities has typically been positive. However, the positive correlation between the Australian dollar and offshore equities (on a rolling five- year basis) has been declining (from around 0.75 per cent a decade ago to 0.45 per cent now), questioning whether the extent of “protection” from a fully unhedged global equity portfolio is as significant as it has been in the past.
For investors, it is near impossible to predict the direction of the Australian dollar for any sustained period. But given its decline through the past decade, it’s now below-average level, and the more positive fundamental drivers supporting its valuation, the argument can be made that the prior strong positive return benefits from fully unhedged offshore equity positions may be less significant over the coming cycle than they have been in recent years.
Is there an optimal hedging strategy?
While some investors are comfortable with currency dominating portfolio returns (and thus remain completely unhedged), others find it an undesirable driver of performance (and choose to be completely hedged). Determining an ideal hedge ratio is never straightforward and historically many have adopted a least-regret hedge ratio of 50:50 or 60:40.
Ironically, with the benefit of hindsight, the best currency hedge ratio for Australian investors from the perspective of maximising returns will always be either completely hedged or completely unhedged. This is because the currency tends to go through defined risk-off and risk-on periods. But, in practice of course, the future is uncertain and currencies unpredictable.
Therefore, a preferred approach for hedging international equities within a portfolio domiciled in Australia is to calculate a fixed static hedging rate that delivers the maximum reduction in volatility for the minimum reduction in risk-adjusted returns (rather than simply defaulting to a 50:50 style ratio of “least regret”). Our analysis, based on history, shows this to be around the 20-30 per cent hedging mark. This level achieves the lowest annualised portfolio volatility by reducing foreign exchange exposure without sacrificing much of the diversification benefits.
Now may be the time to consider a level of hedging
Currency remains one of the few diversifiers or risk controls left in portfolios, given historic low bond yields and fewer shock absorbers in economies and equity markets. In that context, hedging away currency exposure in growth assets can increase portfolio total risk, particularly given hedging should be thought of as a mechanism to reduce overall volatility, and not viewed as a driver of long-term returns.
For Australian investors, that portfolio diversification has been particularly driven by the Australian dollar’s negative correlation to domestic equity returns. And while not evident in all periods through history, the currency’s downtrend over the past decade has actually contributed to portfolio return.
However, there is increasing uncertainty over whether that will continue to be the case, particularly given improving longer-term fundamentals for the Australian dollar (notably against the US dollar). Some forecasters see the currency approaching US$0.80 by end-2022. There is also some evidence to suggest the negative correlation with offshore equities has diminished.
For most investors, running sophisticated dynamic currency overlays will not be an option. But we note that the cost of using many hedged versus unhedged managed funds is often below 4 basis points (bps) per annum and can be as low as 2 bps for exchange-traded funds. With this in mind, we believe that, for some investors, the reduction in volatility from a static hedge of 20-30 per cent may be attractive given only a modest negative impact on long-term returns (at a little over 0.3 per cent per annum).
Of course, issues around minimising tax events, incurring switching costs or the cost impost from partial hedging, may warrant a progressive move over time to the desired target level.
From a tactical perspective, and for those who have not previously considered hedging growth assets, this may be an optimal time to consider a level of hedging for offshore developed market growth assets, given the currency is below its long-run average.
In cases where currency hedging is required, it is difficult to have a one-size-fits-all approach. The hedging decision should depend on the objectives, risk appetite and investment time frame of an investor’s portfolio.
Stan Shamu, senior portfolio strategist, Crestone Wealth Management
