SMSF guide to hedging

Generally speaking, says Evans, over a longer period of time currency fluctuations don’t have a big bearing on returns. “But if you pick a particular point in time, it can either have a very good effect or a very bad effect.”

For example, an investor who allocated funds to the iShares S&P 500 ETF 12 months ago would have benefitted both from the performance of the US economy, given this fund is exposed to the top 500 US stocks, and from the decline in the value of the Australian dollar over the same time, delivering a currency gain as well.

As the first table below shows, an investor who had hedged the currency over the 12 months to 31^st December 2018 would have suffered a loss, while over the long term, the difference in the performance of hedged or unhedged assets is much more narrow.

International Shares Performance (Results to 31 December 2018)

	1 Yr (%)	3 Yrs (% pa)	5 Yrs (% pa)	7 Yrs (% pa)	10 Yrs (% pa)	15 Yrs (%pa)
International Shares (Hedged)	-7.5	6.1	6.1	10.4	10.1	6.3
International Shares (Unhedged)	1.5	7.5	9.8	15.2	9.6	6.6

Source: Chant West

Furthermore, when looking over financial years, unhedged international shares significantly outperformed hedged international shares for most time periods, but over 15 years hedged just edged in front.

International Shares Performance (Results to 30 June 2018)

	1 Yr (%)	3 Yrs (% pa)	5 Yrs (% pa)	7 Yrs (% pa)	10 Yrs (% pa)	15 Yrs (%pa)
International Shares (Hedged)	10.8	8.6	11.1	10.5	7.3	7.9
International Shares (Unhedged)	15.4	10.0	14.9	15.0	9.2	7.4

Source: Chant West

Gaining exposure to international assets

With the rise of exchange-traded funds (ETFs), it’s now much easier for SMSF investors to get exposure to Asian, European or the US assets. Many of these funds have either a hedged or unhedged option, allowing investors to express their opinion about the direction in which the overseas currency to which the asset relates will move. Go to ASX’s web site, where there is a list of ETFs and their hedged and unhedged alternatives. 

For example, if investors want exposure to the S&P 500, they may buy the iShares S&P 500 ETF. This also gives them exposure the US dollar’s currency fluctuations. If they wish to remove this risk they would choose the unhedged option.

While local ETFs are available directly through ASX, international versions can be bought through investment platforms. Many managed funds – listed and unlisted – also have hedged and unhedged versions.

“It’s not difficult to invest in international assets. SMSF investors should also remember the Australian economy is just 1.7 per cent of the world economy. Keep this in mind when doing the asset allocation,” he adds.

A popular option is the iShares S&P Global 100, which Evans says is often used as the core international component of an SMSF’s asset allocation, augmented by smaller tilts towards different areas.

“So, when Europe was emerging from its slump, people were getting on board with the iShares Europe ETF. Now we’re seeing a bit of rotation into the iShares Asia 50 ETF,” Evans says.

It’s also possible to directly invest in international shares through investment platforms. Some investors who do this may wish to take positions in derivatives such as options and futures to mitigate currency risk, but this requires considerable skill.

“It’s a bit of a dark art, to tell you the truth,” says Evans. “The foreign exchange market is many times larger than the equity markets. There are companies whose job it is to do this on a daily basis and they get it wrong all the time. So, when it comes to taking out financial instruments as a way to negate the currency risk, you’re normally better off investing in something that is purpose-built to remove this risk, rather than the onus being back on you.”

To hedge or not to hedge?

Whether to hedge depends on the investor’s long term view of the Australian dollar against world currencies, if they are investing in international markets generally, or against the particular currency of the country they are investing in, says Justin McMillan, a financial adviser with Smart Wealth.

“Most investors understand it is difficult enough to forecast the movement of stocks and the performance of companies, let alone also trying to forecast currency movements, especially over the longer term. So exposure to both hedged and unhedged investments is often prudent,” he says.

Evans also cautions investors when it comes to hedging. “We look at portfolio theory, which says you shouldn’t hedge. They’ll be good times and bad times that work both in and out of your favour. Currency hedging is not a money-making exercise. It’s better to have a balanced exposure across multiple currencies and economic jurisdictions.”

How the big super funds approach currency hedging

Experts say the big portfolio managers often don’t hedge away their currency exposures.

“We want that exposure,” says Evans. “We like to express a view on how different currencies may move so we can benefit from the upside and downside. Very rarely do we see large swings in currencies in a short timeframe. Two come to mind. The 2015 Brexit vote didn’t go the way everyone thought it would and the pound devalued 15 per cent. So, that’s a huge swing.”

Another big shift came when the Swiss Central Bank removed the currency peg it had with the euro subsequent to the financial crisis.

“People need to be mindful of those events. But sometimes you want that exposure if you’re taking a long-term view. Short-term investments across five and ten years period may not want to be exposed to the uncertainty of the currency. But if you’re looking longer term than that, then you may want it. In our high-grade portfolios, we have upwards of 40 per cent international equity exposure because we think there’s further downside risk on the Australian dollar and the US economy is going well. So, that’s how we weighed our portfolios.”

The message to SMSF investors is to understand the potential for currency fluctuations to impact the value of their portfolios, take a view on how currencies to which they are exposed may move in the short-term and implement a strategy that protects against downside risk and takes advantage of currency gains.