Taking an unhedged, or partially hedged, approach on international shares should be banned for the default investment options of super funds.

If a super fund chooses to fully hedge the international share investment, then they are removing the effects of such currency movements and investing solely on the basis of whether the investment in the overseas location is a good investment. Now, most super fund members would be expecting to this to be the usual approach, and would be fairly shocked to discover that the fund managers and super fund trustees are playing Russian roulette with their super savings by taking an unhedged approach.

Around 80% of fund members have their retirement savings in investment options where the investment approach taken on international shares is not explained, and even worse, not disclosed. This lack of disclosure applies to most super funds, even when the super fund hedges the international share investments.

Hedged international share investments outperformed unhedged international shares over 1, 5 and 10 years.

Why would super funds continue to take this approach if it continues to lose money for fund members?

Quoted on the website of industry magazine Super Review in August 2011, NAB’s global head of financial institutions, funds and insurance, Donald Hellyer, said: “By doing nothing more than hedging foreign equity positions, managers would have made a 4.5 per cent positive return, even if equities didn’t move at all, while unhedged managers would have lost 12.7 per cent due to currency moves.”

Super Review also reported Hellyer stating that the volatility in the market had forced many super funds to re-evaluate the hedging used within super funds.

In my view, reviewing the hedging used within super funds is not enough. The flawed investment approach taken by the majority of Australian super funds when investing the money held in default investment options needs to change immediately.

For more information on unhedged international share investments, and my detailed views on the topic, see SuperGuide article: THE SOAPBOX: Is your super fund gambling with your retirement savings?

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1. THE SOAPBOX: Is your super fund gambling with your retirement savings?
2. Asset classes: Naming the investment winners for 2011
3. Super funds deliver 9.2% for 12 months (2010/2011 year)

Failing to fully hedge against the Australian dollar on international share investments held by large super funds is what I would consider to be a major investment boo-boo.

Hedging is commonly used to fully or partially eliminate the impact of foreign currency movements on the value of investments. For the record, the Australian dollar is one of the most frequently traded currencies, and consequently one of the most volatile foreign currencies. (I will explain what hedging is in more detail, and the difference between unhedged and hedged investments later in the article, but for the moment I want to talk about investment returns.)

Hedged outperforms unhedged over 1, 5 and 10 years

Super funds that hedged the international share allocation of an investment option delivered a gross return (before fees and taxes) of 22.3%, on average, on that portion of the super fund’s investments for the 2010/2011 year. Super funds that failed to hedge international shares delivered a gross return of 2.7% on that portion of the investment portfolio, according to rating company Chant West. A gross return is an investment return before fees and taxes.

Nearly 20% is a massive difference in investment performance for one year for an asset class. Yes, but that’s only one year, you may say. Let’s look at investment returns over the longer term, shall we? Perhaps, we can examine returns over 5 years or even better, over 10 years.

Over 5 years, international shares (unhedged) lost 5.1% each year, on average, according to Chant West and this is before taking into account fees and any taxes. In comparison, international shares (hedged) delivered a gross return (before fees and taxes) of half a per cent each year. A return of 0.5% is still dismal but a lot better than negative 5.1%.

Over 10 years it surely must get better for the unhedged international share option because why would super funds continue to take this approach if it continues to lose money for fund members? A very good question if I do say so myself. Let’s examine this further.

Over 10 years, international shares (unhedged) lost 3.7% a year, on average, according to Chant West and again, this is before taking into account fees and any taxes. In comparison, international shares (hedged) delivered a gross return of 1.6l%. A return of 1.6% is depressing but not as depressing as negative 3.3%, which means that the hedged option outperformed the unhedged option by more than 5% a year for the past 10 years, on average.

How this flawed (unhedged) approach affects you

I’ve heard all the reasons and excuses for remaining unhedged, or partially unhedged, and I’ll get to those in a moment, but I want to highlight what this flawed investment strategy means for anyone in a super fund where the trustees choose not to hedge international shares.

If you’re a member of a large super fund, such as a company super fund, industry fund or retail super fund, and you haven’t actively chosen your super account’s investment option, then your super savings will be invested via your super fund’s default investment option. Typically, your money will be invested via your super fund’s balanced or growth investment option. If you’re in such an investment option then there is a strong chance that at least 20% of your super money is invested in international shares, and another reasonable chunk of money invested in international listed property (global real estate investment trusts – REITs) and international fixed interest investments.

Investing in international assets makes sense from a diversification point of view because the Australian share market and Australian REITs market is a small market compared to the massive investment markets scattered around the world. Note that most super funds fully hedge all other international investments (bonds, REITs and listed infrastructure) but often not international shares.

By investing in assets located in other countries, your investment is subject to the usual investment risks and potentially country risk, political risk and even regional risk. An additional risk that your international investments face is currency risk. What this means is that when your super fund buys overseas assets it purchases those assets in the currency of the relevant country. In these circumstances, a rising Australian dollar would mean that the value of the overseas investment falls in terms of Australian money, even when the value of the asset in the overseas location has not changed. Conversely, a falling Australian dollar against the value of the relevant country’s currency can increase the value of the investment in terms of Australian money, even when the value of the investment doesn’t change in the overseas location.

If a super fund chooses to fully hedge the international share investment, then they are removing the effects of such currency movements and investing solely on the basis of whether the investment in the overseas location is a good investment. Now, most super fund members would be expecting to this to be the usual approach, and would be fairly shocked to discover that the fund managers and super fund trustees are playing Russian roulette with their super savings by taking an unhedged approach.

Around 80% of fund members have their retirement savings in investment options where the investment approach taken on international shares is not explained, and even worse, not disclosed. This lack of disclosure applies to most super funds, even when the super fund hedges the international share investments.

When did our super fund trustees become foreign exchange traders, and when did the millions of fund members consent to the fund trustees using their money for what is essentially a gamble on the most volatile foreign currency in the world – the Australian dollar.

Are you confused yet? This entire debate always gives me a headache because most fund managers and super fund trustees blur the actual investment, namely international shares, with the hope of gaining some mysterious extra return by gambling on the movements of the Australian dollar. I do acknowledge that hedging a portfolio does cost some money (generally involving the use of derivatives of some kind) which may also slightly affect the investment return of a portfolio but not to the same extent as a massive swing in the value of the Australian dollar.

Taking an unhedged, or partially hedged, approach on international shares should be banned for the default investment options of super funds.

Why do super funds fail to hedge?

Trotting out old investment practices must be embarrassing when the Australian dollar continues to climb. This currency effect (appreciation of the Australian dollar) has cost super fund members 3% in overall returns for the 2010/2011 year alone, according to Chant West.

The Aussie dollar has been going great guns for the past two years, and bullish economic pundits are predicting that the Australian dollar may even reach US$1.50, but investment managers are still claiming that exposing international share investments to currency fluctuations offers the portfolio extra diversification. For example, an international share portfolio could be exposed to more 20 different currencies. Yes, that’s true but these 20 currencies all have to be translated back to the Australian dollar at some stage.

Oops, even I am now confusing the investment with the currency effect.

Hedging an investment does cost money but all investments have costs and these costs should be taken into account when deciding whether an asset is a good or bad investment. Many super funds take a partial hedging approach across the entire portfolio, or portfolios, rather than specifically hedging the international share component of the portfolio. In my view, even this approach is blurring the task that they have been assigned by fund members.

If your super fund invests in international shares, then the investment has to be able to stand on its own. The value of the Australian dollar should not be a basis for an overseas investment unless your super fund takes this approach in a higher-risk investment option (rather than the default investment option) and the super fund fully discloses this practice and outlines the risks involved.

Your comments: I invite our readers to comment on this article, especially those who may not share my view about the need to hedge international share portfolios. I encourage readers, including those working in the super industry, to provide an alternative argument explaining why the unhedged approach should not be banned in default investment options.

Related posts:

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2. Asset classes: Naming the investment winners for 2011
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The table below sets out the performance figures for 13 asset classes (or sub-categories) for investment periods of 3 months, 1 year, 3 years, 5 years, and, if applicable, 7 and 10 years.

Background: Briefly, when a super fund hedges your international investments against movements in the Australian dollar or foreign currency, your investment return is solely based on the merits of the investment rather than the strength or otherwise of the Australian dollar. If your super fund chooses not to hedge your international investments, then the return you may receive on this part of your portfolio may have very little to do with the merits of your investment. I explain the significance of hedging in more detail in my July 2011 THE SOAPBOX.

Your super fund invests in a mix of asset classes to generate an investment return on your super account, which means that some of your super money is likely to be invested overseas, a fair chunk invested in Australian assets, and a portion squirreled away in cash. The super money of most Australians is invested via a balanced or growth investment option, typically 61-80% of assets are in growth-style assets such as shares, property and alternative investments, and 20-40% are in income-style assets such as cash and fixed interest (bonds). If you choose your own investment option, or you run your own super fund, then you decide on the mix of asset classes for your super savings, including whether you have exposure to international assets, and whether you have exposure to foreign currency movements (that is, unhedged).

Top performing asset classes for 2010/2011 year

The top-performing asset class for the 12 months to 30 June 2011 was Global Listed Property (hedged) with a majestic 12-month return of 32.5% before deducting fees and taxes, according to rating company Chant West. The second top-performing asset class for the 2010/2011 year was International Shares (hedged) with a 12-month return of 22.3% before fees and taxes, but a mediocre 2.7% on an unhedged basis (the worst performer), due to the strength of the Australian dollar. Global Listed Infrastructure (hedged) came in third with a return of 17.1%, while Australian shares came in

According to Chant West global Real Estate Investment Trusts (REITs), that is the official term for listed property investments, was the top performer for the second year in a row. Australian REITs returned a ho-hum 5.9% for the year, while Australian bonds returned 5.5% and international bonds (hedged) returned 6.9%.

Top performing asset classes for 10-year and 5-year periods to 30 June 2011

The top performers among the 13 asset classes (or sub-categories) are different when you look over a longer timeframe. For example, over a 10-year period, Australian unlisted property has outperformed all asset classes with an average annual return of 9.5%, followed by international bonds (hedged) with an annual return of 7.9%, and then Australian shares with an annual return of 7.2%.

Note: Figures over the 10-year and 7-year period to 30 June 2011 don’t include performance statistics for private equity, global listed property (hedged), global listed infrastructure (hedged) and unlisted infrastructure, due to the relatively recent development of these asset sub-categories.

The devastating effects of the Global Financial Crisis (GFC) can be seen in the 5-year performance figures for the higher risk asset classes, such as shares, listed property and private equity. The top performers over the 5-year period are international bonds (hedged) with an average annual return of 8.4%, followed by unlisted infrastructure (7.2%), Australian bonds (6.5%), Australian unlisted property (6.5%) and then cash (5.6%) and hedge funds (5.5%). Australian shares have delivered a dismal 2.4% a year over the same 5-year period, and international shares (hedged) a pathetic 0.5% a year. Even worse, international shares (unhedged) delivered negative 5.1% every year for the past 5 years, on average, while Australian listed property, that is A-REITs delivered a depressing negative 10.3% every year for the past 5 years. What this means for investors in A-REITs, is that their A-REIT investment has more than halved in value in the space of five years.

Source: Chant West

Table notes: The table contains gross investment returns, that is, investment returns before fees and taxes have been deducted. The asset classes and categories listed are the main asset sectors that super funds invest in. Chant West has used market indices for performance figures for all sectors other than private equity and unlisted infrastructure. For those two categories, Chant West has used the returns of a major super fund in the Chant West survey that is representative of those sectors.

Related posts:

1. Asset classes: Naming the investment winners for the 2011 calendar year
2. Ban unhedged international shares in default investment options
3. Super funds deliver 5.8% for 12 months to April 2011

Trish’s response: Before I answer your question about options, I need to clarify your comments about contracts for difference (CFD). In certain circumstances, the Australian Tax Office has indicated that CFDs are allowable investments for self-managed super funds (SMSFs), provided that cash is used as collateral for any margin payments on the contract, rather than using fund assets as collateral. Now, in my view, cash is a fund asset, and I’m surprised that the ATO has taken this view on CFDs but there you have it, although I would be closely following the ATO’s views if any SMSF trustee is considering using CFDs within his or her fund. (If you want to read more about the ATO’s view on SMSFs and CFDs, check out the ATO website).

In response to your question on options: Derivatives, such as options, are allowable investments for a SMSF, subject to certain conditions, including:

• ensuring that the fund’s investment strategy (and trust deed) permits the SMSF to purchase options and
• the fund has a derivative risk statement, that is a statement that explains the SMSF’s risk management policies when using derivatives.

For the most part, options are used as a hedging tool to minimise the volatility in an investment portfolio, although some investors use options as a pure trading tool for profit. Any SMSF trustee considering using options within a SMSF portfolio needs to confirm the use of such instruments with the ATO and/or with the fund’s adviser.

Note: Anyone considering derivatives within a super fund should also read Regulation 13.15A of the Superannuation Industry (Supervision) Regulations 1994, for some background on the use of collateral and derivatives.

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