Hedging is one of those pieces of financial jargon tossed around indiscriminately and commonly misunderstood. Hedging is most easily described as a form of insurance, and vice versa, insurance can be called risk hedging. If you decide to hedge, you are insuring (at a cost) for or against an event impact. Like insurance, it comes at a cost, because rather than reducing the risk, you are transferring the risk, and the insurance policy often costs more than the long-term benefit.
Currency hedging simplistically, is about locking in the exchange rate. If you are buying shares in Amazon you need US dollars (USD). If the value of the NZ dollar (NZD) rises (maybe from a stronger NZ economy, foreign investment or higher NZ interest rate), the value of your shares fall, even if the share price doesn’t change, because when you convert your investment back from USD, you receive less NZD. Take the example below:
|
NZD Value |
Exchange rate |
USD Value |
|
|
1. Convert NZD to USD |
$10,000 |
0.60 |
$6,000 |
|
2. Buy 3 shares @ USD 2,000 each |
$10,000 |
0.60 |
$6,000 |
|
3. Shares increase to USD 2,200 each |
$11,000 |
0.60 |
$6,600 |
|
4. Exchange rate changes, NZD value of investment changes |
$ 9,429 |
0.70 |
$6,600 |
While the value of shares increased in USD from $2,000 to $2,200 (+10%), the strengthening of the NZD from 60c to 70c (16%) means that your investment value falls 5.7%. Alternately, if the NZD weakens to 50c, the double positive effect would increase the valuation to $13,200 or +32% return.
Hedging, therefore, removes the currency fluctuations, meaning that your investment returns are comprised solely of the return on the physical investment you have made, and not impacted by any movement in the currency.
How is hedging implemented?
An investor or fund manager might pay for a currency forward (a financial contract between two parties) to lock in the current exchange rate with a bank to negate any future movements. For a global fund, this would need to be done and updated with each currency held both for new money invested and as each forward contract (normally 3 months) matures. It’s important to note that every hedge has a cost, so before using hedging, you must ask yourself if the benefits received from it justify the expense.
As an investor, if you looked at two identical international funds, except one was hedged, then you would likely see a higher management fee on the fund that is hedged. Remember, the goal of hedging isn't to make money but to remove the risk of currency fluctuations. Particularly to avoid a negative currency movement at the time you need to convert your international investments back into NZD. Conversely, should the exchange rate move in your favour, you don’t get any of the benefit.
So why don’t we hedge?
There are two main reasons why we chose not to hedge our first international funds: the diminishing carry trade and the natural macroeconomic hedges.
Historically, economists and actuaries have noted that because interest rates are higher in New Zealand compared to similar credit-worthy developed countries, there is a forward contract discount leading to a potential hedging profit under normal market conditions. In short, when hedging is put in place there can be a positive gain made by the investment being hedged to NZD, while still removing the currency risks. Conversely in times of market stress, investors may flee higher interest rate currencies = higher risk currencies.
During the initial stage of COVID-19 in February-March 2020, we saw a short-lived flee to safety of the 6 major currencies (USD, GBP, EUR, JPY, CHF and CAD), which has normalised by June. However, it is questionable whether with low interest rates in New Zealand and the Official Cash Rate (OCR) being comparable to other developed countries, at close to 0%, whether there is still a positive carry benefit available for hedging.
Recognising natural hedges. Most of the companies we hold within the global funds are large and multinational, listed in the 6 major currencies and will be protecting their own profits through their own treasury management. Therefore, hedging the listing currency, cancels out the activities of the company’s.
Meanwhile, there is a macro portfolio diversification effect, in that should the NZ economy have a political or economic shock independent of the global economy, that our investments in New Zealand will be worth less, but the currency will generally weaken leading to foreign currencies and investments being more valuable. The opposite is also true.
So we would suggest considering it part of the overall asset allocation, the home and away decision. So long as you have a reasonable proportion of wealth in New Zealand, an individual should not get caught at the stage in the economic cycle where there is a currency mismatch, i.e. you are forced to convert your international investments to NZD at a time when the currency conversion rate isn’t favourable.
In summary, we believe that having an unhedged global equity investment as part of a diversified portfolio is a sensible decision for those investors who are contributing regularly to their portfolio, have a large portion of their wealth in NZD (house, job, KiwiSaver) and have flexible investment horizons.
Does this mean hedging is of no value? Of course not, and for some investors it can be a very valuable tool depending on their lifecycle and investment objectives, something we will be expanding on in the future.