13 December 2007
By Tim Hewson
These days we're often encouraged to think about diversifying our investments globally so we can access a significantly broader range of investment opportunities.
Especially with the growth possibilities that Asia, and in particular China, India and other rapidly emerging markets offer.
But have you considered the effect foreign currency volatility could be having on your offshore investment returns, particularly in light of the recent gains the Australian dollar has made?
Hedging your bets
For those that haven't come across the term before, hedging is a strategy adopted to reduce risk in one investment, while attempting to profit from another.
When it comes to hedging currency, there are a number of strategies and techniques fund managers can use in an attempt to negate or neutralise currency volatility on global investment portfolios.
For example fund managers might hedge their entire portfolio, particular investments or only partially hedge against specific currencies.
Then there are those managers that specifically trade currencies as part of their investment strategy, or those that outsource currency risk management completely to currency overlay specialists.
And finally, there are fund managers that don't hedge currency at all. These fund managers either actively seek currency exposure, or try to account for future currency movements within their strategies.
To hedge or not to hedge?
A volatile currency, rarely if ever, offers all investors a win-win outcome. And presently thanks to the strength of our ever-increasing dollar, the relative values of certain global assets are often weakened once converted back into our currency.
However, the opposite can also be said of a decreasing dollar as the implied value of your global investments increases once converted back into Australian dollars.
So at the moment whilst the capital value of your investment might continue to increase, its performance in terms of foreign currency might decrease if the investment is left unhedged.
But if we could all pick the right time to buy and sell in line with currency volatility, then I wouldn't be writing this article and we would all taking our Christmas holidays in the Caribbean.
The 'perfect hedge'
Let's get one thing clear. When it comes to investing overseas, there is no such thing as the 'perfect hedge'.
Capital values can be mostly hedged, but they are still subject to small variations as a result of fluctuating values.
Income generated from offshore investments will also be subject to currency hedging mismatching.
And either over-hedging as a result of not generating the expected level of income, or under-hedging as a result of earning more income than anticipated also often occurs.
So despite the multitude of currency trading strategies available, you'll probably never fully be able to negate all the effects of global currency exposure.
Currency considerations
Whilst the impact of currency volatility obviously adds another layer to your investment decision-making process, it is an important one.
Take for example the movement in the Australian dollar relative to the major currencies since the beginning of 2007. The AUD has risen close to 20% against the USD, more than 15% against the Japanese Yen, more than 12% against the Pound and just over 8% against the Euro.
That's obviously great news for anyone travelling overseas. But to provide you with an example of the magnitude that a currency movement can have upon an investment, in a recent NAB Capital Superannuation FX Survey of Australian Superannuation Funds, it was stated that a $0.01 increase in the AUD would result in a $1.5 billion foreign exchange loss across the industry.
Sceptics would argue that this is partly due to the size of the Australian superannuation industry, but it also demonstrates the impact that fluctuating currencies can have on the modestly sized international equities portfolio.
Especially when you consider that roughly 25% of all Australian super fund assets are invested into global equites.
So whilst you are putting your feet up over the Christmas break, it may be worthwhile considering the impact of a volatile Australian dollar nearing its 23 year high, and the impact it could have upon the performance of your global investments.
And match that thought with the uncertainty of an Australian equity market that refuses to play dead.
Not forgetting of course the anticipation of continued growth, further interest rate rises, global interest rate decoupling, a lingering US sub-prime crisis and a steadily increasing oil price edging its way to USD$100 per barrel.
And decide for yourself whether it's time to find out just exactly what hedging strategy your fund managers adopt.
Happy investing.