Is it time to re-think currency hedging strategies?
CIO MONTHLY | OCTOBER 2020
This month we look at hedging strategies for offshore portfolio exposures. The Australian dollar’s trend decline since 2011 has delivered positive return to unhedged global investments. We ask whether this trend will continue and consider if there is an optimal hedging strategy that investors can adopt.
- For Australian investors willing to take unhedged offshore equity positions over the past decade, the Australian dollar’s trend has been very favourable for portfolio returns, having fallen from around USD 1.10 during the 2011-2012 European sovereign bond crisis to around USD 0.70 currently.
- In the coming decade, however, there is increasing uncertainty over whether this trend will continue. Improving short-term and longer-term fundamentals argue a relatively positive outlook for the currency. In addition, the correlation between the Australian dollar and offshore equities has been declining. These factors raise the question whether fully unhedged positions will be as beneficial in the coming decade. While hedging away some currency exposure can lower risk-adjusted returns, it can benefit by reducing exposure to currency volatility and aiding diversification.
- In cases where currency hedging is required, it is difficult to have a one-size-fits-all approach. An investor’s hedging decision should depend on their objectives, risk appetite and investment timeframe. The decision should also be part of the strategic investment policy statement, to minimise the potential for reactionary sub-optimal decisions during times of extreme market volatility.
- 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. Based on history, our analysis shows this to be around the 20-30% hedging mark.
- From a tactical perspective, and for those who have not previously considered hedging growth assets, now 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. 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.