To Hedge or not to Hedge – is that the question?
With the recent ups and downs in the market, people have been asking should we hedge against currency shifts etc…?
I have been replying with a conversation along the following lines:
Given the goal of investing is to save now for future spending, it makes sense to match some of those potential future liabilities. Currency (hedging) helps achieve that.
In a simple explanation: as the Aussie dollar falls, imported goods or overseas trips are more expensive, but assets held overseas in other currencies (ignoring the change in asset value) are also worth more. This helps balance things out. Even for those who think they will never travel overseas on holidays, it is hard not to have currency exposure in your future liabilities.
What is correct depends upon the person and the potential disappointment they are prepared to tolerate. There are no right or wrong answers but generally there are 4 basic strategies to consider (assuming we are starting from a fully unhedged position). MLC Investment analyst Charles Brooks verbalised them in a recent article as follows:
- Total Exposure – remain fully unhedged
- Make the Switch - get fully hedged
- Its all in the timing - try to time when to be hedged and when to be unhedged and win both ways
- A bet each way - adopt a strategic ratio including both hedged and unhedged global allocations.
Staying unhedged has its bonuses. If the dollar has a big fall your returns will be boosted. However if the little Aussie battler soldiers on and gets stronger, the reverse occurs. Going fully hedged provided the same opportunities but in reverse. Both strategies have the inherent legacy that they will be wrong at some point in time. This is something few investors are comfortable for any length of time.
The common thesis is that currency hedging is a sum neutral game and while markets fluctuate through time the currency will even itself out in the end. This thesis heavily depends upon your starting point and the period invested, but overall it could be good, bad or ugly. The risk is how investors react. Inherent in either of these strategies is the need to be disciplined and have a suitable investment timeframe. The longer it is the more likely it is that investors will experience the rough and the smooth, resulting in a more equitable experience.
Its all in the timing - is interesting and frequently brings with it the suggestion that with all the bright minds, it should be a reality to predict where the currency is going. While this is an appealing strategy (after all who doesn’t want to have their cake and eat it), it also frequently destroys wealth. There are some shining examples of success in this area but there are many, many more examples of failure, and this lack of consistency is the root of the problem. Overall, this is a risky strategy with highly uncertain outcomes, which assumes a high tolerance for risk and pain on the part of the investor.
My preferred strategy is to Have a bet Each Way. It involves adopting a strategic allocation to both hedged and unhedged investments. This bet each way strategy is often termed ‘minimising regret’. As such investors are never right or wrong, thus helping to avoid reactionary behaviour. There is some potential regret, causing investors to say ‘we should have hedged it all’ or ‘we should not have introduced hedging at this point’. But for the longer term, through a series of ups and downs, investors are more likely to be comfortable with the overall experience. While discipline is needed to avoid the temptation of ‘adjusting it for a little while’, it is always more comfortable in the long run not to be totally wrong.
There is no right or wrong strategy. What is important is that you understand the risks and implications inherent within the context of your own investment. If you are uncertain of your position or would like some general advice, please contact your current adviser or Plan 2 Prosper.
In doing so, the answer to the question: ‘are you getting what you thought you paid for?‘ might be more like ‘Yes, I’m getting that and more‘ rather than ‘No, it would seem not”.
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Dan Smith is a self employed Financial Planner based in Rockhampton. He has clients in various locations throughout Australia but predominately in Central Queensland and specifically the geographic area encompassed by the Rockhampton Regional Council.