Your currency exposure - 'to hedge or not to hedge?'
Hedging is investing without the impacts of currency movements moving against the Australian Dollar. Hedging is an investment decision in itself, and often a difficult one at that. Nowadays we often have the choice between a hedged and unhedged investment, and we’ll explain how to approach this decision below.
What you’ll learn:
- What hedging is
- When not to hedge
- When to hedge
- How to trade the hedge
What is Hedging:
Hedging is when you remove a risk through another investment.
Currency hedging is when you remove the risk of a currency moving up or down. Currency hedging is achieved by making a trade in the foreign exchange markets.
Most investments these days provide a hedged and un-hedged version. Rather than going to the FX Markets, investors can now choose to hedge or not, as easily as choosing full cream or lite milk.
You want to travel to the United States next year. You’ve seen the travel agent and know that your savings will cover all your expenses including spending money. What you don’t want is the Australian Dollar (AUD) to fall against the USD and suddenly everything doubles in price because the AUD fell!
You could hedge this risk by paying for all of the US flights and accommodation in advance and converting your spending money to USD now, not waiting until you leave to change the money over to USD. Paying for everything now in USD is ‘hedging your risk’.
We can now easily buy many international investments on the ASX, such as baskets of International shares. We can often buy the same basket of shares with or without the currency being hedged. The difference is which ETF or ‘share’ on the ASX we buy.
When Not to Hedge:
Hedging for a holiday is very different to hedging when investing.
Investment hedging should be done when you believe that your domestic currency (AUD) is cheap against the rest of the world. For many Australians this is when they see the AUD in the USD rang of $0.50 - $0.59 – or when they think it’s just too expensive to travel the USA.
The reason is that if the investment stays at exactly the same price in USD, but the AUD goes back up the investment has decreased in value.
You buy an ETF on the ASX; it’s a basket of US shares. When you buy the ETF, the AUD is trading at USD $0.50. This means that every USD $1 dollar costs $2 AUD (like accommodation in New York being twice as much in AUD as it’s advertised in USD).
If the AUD goes back up to be equal to one USD, (the price of that room in New York is now the same in AUD as advertised in USD), but the investment has not moved, then you have now lost 50% of your investment - because you paid for the ETF when it cost $2 AUD for every USD, but now it is only worth $1 AUD for every USD.
In other words, it’s like the room in New York cost you $500 a night in AUD, but if you need to get a refund you’ll only get $250 AUD back. Meaning you’ve lost 50% just because the currencies moved.
The point is that when the AUD is lower than where you think it will be, hedging does not help the investment.
When to Hedge
After the GFC the AUD was higher than the USD.
There was a time in 2010 that $1 AUD bought $1.10 USD. This is when many investors say not to hedge because as the AUD falls against the USD your investment is growing in value (in AUD terms anyway).
You book your room in New York for $250 USD a night when $1AUD buy $1USD.
Your trip gets cancelled and you get a full refund for your room, except the AUD has fallen. Now $1USD buys $2 AUD and you are refunded $500 a night for your room. You have just doubled your money for not going on holidays.
Often investors call the currency, or FX, moves, a ‘shock absorber’ for your investments. When the AUD is falling, normally the economy is doing poorly on a relative scale to the world. If you have not hedged your investments, then the value of your international shares increases for no reason other than that the AUD is falling. This acts as a shock absorber to negative moves in the Australian economy.
In summary, the idea is not to hedge investments when the AUD is higher than where you think it will be later during that investment.
How to Trade the Hedge:
With all the new investment options on the ASX, you can now trade the hedge within your portfolio. Sometimes easily.
For example, you might own an ETF that holds the US S&P500 shares unhedged. You want to hold these shares for 10 years or more, so you don’t want to sell them yet.
When you bought the shares in 2018 the AUD was buying $0.80 USD. After COVID-19 saw countries announce lock-downs and global cases started to rise dramatically the AUD fell to only $0.55 USD in early 2020.
You decided that you still wanted to own the same shares, or ‘underlying investments’, but wanted to now hedge the currencies.
You sell your original (unhedged) ETF and buy a hedged ETF for the same exposure in US S&P 500 ETF.
Moving from the one ETF to the other has seen you realise a 31.25% increase in your investment from the currency alone (coincidently the US S&P 500 is almost at the identical level after COVID-19 shocks to the market).
Looking at the chart below, the blue line is the US S&P500, which saw a strong rise up until COVID-19 in early 2020. The green line is the AUD in USD which steadily fell from 2018 into a dramatic fall around early 2020. Despite the wild movements in the S&P500, if you bought unhedged shares in the S&P in 2018, you’d have effectively bet that the AUD would fall (which it did) and you could now ‘cash that bet in’ by moving to a hedged investment on the S&P 500. You’d keep the same basket of shares, just without the changes in currency moves. At a later date, you might move back from a hedged ETF to a non-hedged ETF again.