Hedged $ funds or Unhedged $ funds ?

Hi everybody,

I am considerind the benefits of buying a managed fund that is hedged to the Australian dollar. Through Comparefunds; it appears that with exactly the same fund, apart from hedging, the return difference is staggering!

Questions.
What are the costs of Aus$ hegding?

How does it work?

What limitations are there?

Is it suitable for 10+ investing?

When would an unhedged Aus$ be in advantage?




Johny.

Johny these are some good questions,

The cost
This depends greatly on several factors however is usually a reflection of the costs incurred by the Fund in hedging their currency positions, and can range from 0% to in excess of 1% pa. Note that different currencies will often require different strategies and costs to hedge.

How does it work?
'Hedging' removes currency risk from the equation, and maintains the relative purchasing power of your dollar.

To illustrate this, lets say that you invest $1,000 into a US domiciled investment Fund. The exchange rate at your date of investment is $US0.80 for every Australian dollar....therefore your investment buys you $US800 worth of the Fund. Up to this point, the $US800 is exactly the same value as $AU1,000.

Over the next 12 months the Fund returns 10% on your initial investment of $US800 - or $US80.

Now currency comes back into the equation. If the Aussie dollar has strengthened to $US0.95 the conversion of $US80 will provide you with approx $84.21 in the hand ($US80 / $US0.90 = $84.21). If the Aussie dollar has fallen to $US0.60 then you will walk away with $133.33 ($US80 / $US0.60 = $133.33). Your return on investment in these scenarios is between 8.42% ($84.21 / $1,000 ) and 13.33% ($133.33 / $1,000).

If on the other hand you 'hedged' your position the currency risk would be removed, and your $US80 would be converted to $100 Aussie dollars worth (10% return on investment).

This is a pretty basis example & does not take into account each investment manager's approach to currency and interest rate management.

Limitations
There are some limitations on the availability of hedging strategies in developing/emerging markets were there are concerns of illiquidity or too much government involvement in their currency markets.

Suitability of 10+ year timeframe
Johny, unless you have any strong feelings on which way the Aussie dollar is going, hedging your international portfolio is certainly an idea worth thinking about (being careful not to provide advice here...). Have a think about where you think Australia as a country and economy is going....how do you think we are perceived by the US, China, Eurozone etc?? This has a direct bearing on our foreign exchange rates

When is an Unhedged Aussie Dollar an Advantage?
As illustrated in the example above, and unhedged Aussie dollar is going to be beneficial for your investment portfolio if the Aussie dollar falls as your offshore investment earnings, when converted to a weak Aussie dollar, will be appear inflated. From a macro and trade perspective, this also benefits exporters (as a $US1m export shipment @ $US0.50 will yield $2m) and disadvantages importers (they now have to pay $2m for $US1m of goods).

As a final note, it may be worth your while considering alternatives to purchasing directly through Comparefunds (or similar sites). Dependent on your circumstances there may be more appropriate options that provide greater flexibility and diversification and enable you to better track your portfolios.

Your financial adviser should be able to provide some guidance on this matter.

I hope this has been of some assistance

Regards,

Global1

I now have an idea how currency hedging works. The Australian dollar is currently equal to .92US$.

I have been reading, that Morningstar says "Over the long term, value from currency hedging is minimal, if not nil"

While Zenith recommends 50% hedging and 50% unhedged.

Which tactic would suit an international index fund over a long term. Hedged, unhedged or 50/50?


Thanks, Johny.

A lot of people misunderstand the role of hedging. All a hedge does is to lock in the status quo.
Some pro tend to regard them as a waste of time claiming that traders are much better served by playing a good defence than attempt to hold a certain line in the market.
More ‘confusion’ is here... http://www.invested.com.au/7/us-fund-distribution-1065/

The short answer is that it depends upon what happens to the Australian dollar over the period that you hold the investment. As none of us (including fund managers/research agencies) know for certain what is going to happen with our currency the best we can do is to make an educated guesss.

I would not agree with Moningstar's view as this discounts the (non-financial) benefit of knowing what rate your portfolio's earnings will be distributed back to you at. You may miss some opportunity, but for it you have peace of mind.

Zenith is sitting on the fence. They are certainly not alone - most research agencies (and several of the larger 'retail' Fund managers) have the same view on currency management at the moment.

As a licensed adviser myself I am (legally) unable to provide any specific advice. However, consider the following:
*The Aussie Dollar is sitting at around $US0.93 at the moment
*if it goes up, how much would you expect it to go up? (over your period of investment)
*if it goes down, how much do you think it will go down? (over your period of investment)

In short, if your feeling was (like many) that the Aussie will strengthen in the lead up to, and shortly after, Melbourne Cup's rate rises (lets say we see $US1.05). There is $0.12 benefit per dollar (lets say approx 13%). Looking towards the next 3 - 7 years, lets say that the US economy picks up again and we level out to an average of $US0.75. An unhedged portfolio would be hit with a currency depreciation of $0.18 (approx -19.5%).

My tip would be to decide upfront whether you want to play the currency game, and if you do then study up! Good luck!

Currency is very hard to pick. In the very long run I agree with morningstar that it probably doesn't make a huge difference but most investors want to redeem their investment at some point and if the currency is against them at that point then the losses stemming from the currency movement can be substantial.

Generally with diversified index portfolios the cost of hedging is negligable. This very small cost does however remove one of the significant risks of investing in overseas markets. As a result, if you are an investor and not a speculator and you are not of the strong view that the Aussie dollar will appreciate why not remove the risk?

The downside of wanting to hedge currency risk out is that it will limited the number of available investment opportunities as many funds/ETFs do not have hedged options available.