Long-term readers of this SuperGuide website may recall my strong support for hedging international investments within default investment options. Alternatively, you can see my position as strong opposition to super funds punting on currency movements when their authority is to invest in international share assets. A default investment option is how super money is invested for fund members who don’t make an active investment choice.
Complacency is a dangerous state of mind when you’re investing billions of dollars on behalf of millions of Australians, especially in the wake of the global financial crisis (GFC). Apparently the trustee boards of many of our large super funds believe that unhedged international shares are a perfectly acceptable investment strategy for super fund members who do not make an active investment choice to have their international investments subject to foreign currency movements.
This issue affects all types of super funds, and an important question you need to ask about your super fund: is the trustee board running your super fund gambling with your retirement savings?
Unhedged international shares are a much riskier option than hedged international shares, but very few super funds disclose their hedging strategy, if any. Trustee boards who fail to hedge international shares in default investment options are taking on so much extra risk on behalf of fund members who have not made a choice, compared with hedged international shares.
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 more volatile currencies, which has been proven to be the case before the GFC (global financial crisis), during the GFC and confirmed with the more recent slide by the Australian dollar. You also have to factor in the volatility of other currencies when assets are purchased overseas, as part of investment portfolios.
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. (I explain how hedging works in more detail later in the article.)
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 trading item in the world – foreign currency, including the Australian dollar.
Default investment options are designed for the majority of fund members who fail to actively choose an investment option. The default investment option, now known as the MySuper option, is a growth or balanced investment option. Around 80% of fund members have their retirement savings in this type of investment option 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.
I believe that taking an unhedged, or partially hedged, approach on international shares should be banned for default investment options (now known as MySuper option) of super funds.
For fund members who actively choose an investment option, whether international share investments are hedged or unhedged should be fully disclosed and the implications properly explained.
Unhedged outperformed hedged over 1 year, 3 years, 5 years and 7 years
Some readers may find my view surprising considering that for the 2014/2015 year, unhedged international shares delivered a spectacular 25.2%, while hedged international shares delivered a more humble, but still strong, 8.5% for the year, according to figures released by Chant West. The massive difference in the two returns reflects the fall in the Australian dollar, rather than superior investing.
According to Chant West, the currency movement on unhedged international shares added 3% to the median annual return for growth investment options of 9.8%, for 2014/2015 financial year.
Hedged outperforms unhedged over 15 years
Of course currency movement works the other way as well. The story is not so happy when looking longer term. Over 15 years, hedged international shares delivered nearly double the average annual return (3.0%) that unhedged international shares delivered (1.7%), although the performance of both categories is mediocre over the 15-year timeframe.
Over the past 3 years to June 2015, unhedged international shares delivered spectacular returns, averaging an annual return of 26.1% for each of the 3 years. Although hedged international shares also delivered impressive results with 17.1% for each of the 3 years.
Over 10 years to 30 June 2015, the average annual return on hedged international shares (6.4%) was on par with unhedged (6.3%), but unhedged international shares carries a much higher risk because the final return is also dependent on the vagaries of currency movement.
Hedging is about managing the risk
Comparing investment returns is always very interesting, but the main point of my argument is that unhedged international shares carry a much higher risk for investors, and this risk is not properly disclosed, and this risk is not suitable for fund members who don’t make an investment choice.
Failing to fully hedge against the Australian dollar on international share investments held within default investment options, by large super funds, is what I would consider to be a major investment boo-boo. I believe that passively punting on the movements of the Australian dollar against foreign currency is reckless when investing on behalf of fund members who have not made an active choice for investments to be this risky.
I also believe the lack of disclosure about the high risk of currency movements is unacceptable. Of course, I fully support offering hedged or unhedged international share options as investment choices for fund members, provided that fund members understand the difference and the implications of choosing one over the other.
My position on hedging is not necessarily a popular one within the funds management industry or within the super fund industry. Some people even suggest I am reckless to suggest unhedged investments are a bad thing for super fund members who have not made an active choice for investments to be subject to currency movements.
At the very least, each super fund should have a hedging strategy where the decision is made, year by year, or over a timeframe, whether to hedge or not, but this should not be a discretionary decision for the MySuper investment option. I believe the MySuper option, the default investment option, should always hedge international shares.
How the unhedged approach affects your investment
I’ve heard all the reasons and excuses for remaining unhedged, or partially unhedged for default investment options, 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 (REITs, listed infrastructure and bonds) 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.
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.
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.
I repeat my position: Taking an unhedged, or partially hedged, approach on international shares should be banned for the default investment (MySuper) options of super funds.