To hedge, or not to hedge? Editor's note
Currency movements add a whole new spin to global investing
Halloween is approaching but it’s not too late to pick up a scary, investing-themed costume. Liz Truss carrying a head of lettuce? Too expensive to use lettuce as a prop. Rate hiking central banker? Too likely to get punched by an angry homeowner. Vladimir Putin? Too many leftover COVID kilos to ride a horse bare chested in public. If you want to scare them—really scare them, then dress up as a hedged global ETF.
It has been the year of the bear for investors around the world. Yet, many Australians remain relatively unscathed. The ASX is currently down around 10% for the year and at the low in June, losses just topped 15%. Painful yes, but also well short of a bear market which requires a 20% loss from a market high. Australians investing abroad have been insulated from more substantial falls by weakness in the Aussie dollar. Well, those customers that aren’t hedging their currency exposure.
Judging by the questions I get in webinars, many investors are confused about how currency movements impact the returns they get from global investments. Australian investors benefit from the Australian dollar falling against global currencies. Other benefits from a falling Australian dollar include giving me the opportunity to spend $35 AUD for a cocktail in Chicago last month. I didn’t let those outrageous prices stop me from drinking in Chicago and investors shouldn’t let currency fluctuations stop them from investing globally.
This year is a perfect case study for the impact of currency movements on global investing. We all know what has happened to global markets. Yet the interest rate increases, inflation and economic turmoil that has sunk markets has also impacted currencies. On January 1st, $1 AUD could be exchanged for $.7265 USD. After a strong rally in the last week $1 AUD can now be exchanged for $ .65 USD. That has implications far beyond my bar tab. For Australian investors, it has turned a global bear market into a mere correction.
We can use two ETFs to illustrate this point. The iShares S&P 500 ETF (ASX:IVV) tracks the 500 largest companies in the US. The iShares S&P 500 AUD Hedged ETF (ASX:IHVV) tracks the 500 largest companies in the US and removes the impact of currency movements on returns. The currency movement is removed using forward foreign exchange contracts. The impact of choosing the hedged or un-hedged product this year has been stark. Through the end of September, the un-hedged product (IVV) had a return of -13.90%. The hedged product (IHVV) had a return of -24.72%. The weak Australian dollar has insulated investors from the true extent of the drop in US shares.
And this year has not been an anomaly. In times of crisis the Aussie dollar tends to fall against the US dollar. In June of 2008, $1 AUD bought $ .96 USD. By December of 2008, the Aussie dollar had fallen to $ .65 USD. And in-between? Fannie Mae and Freddie Mac were bailed out by the US government. Lehman Brothers went bankrupt. Ireland backstopped their banks and Iceland’s three largest banks collapsed. And finally, the US and UK bailed out their entire banking system to prevent a collapse. The S&P 500 responded just how you would expect and fell by around 34%. For Australians investing without a currency hedge, the drastic fall in the market was offset by the drastic fall in the Aussie dollar. Total local currency losses were only around 3%.
The million-dollar question is where we go from here. For those that have really embraced this article theme, you can also consider this the US$650,000 question. The market rallied in the past week in response to optimism that perhaps the Federal Reserve was going to slow interest rate increases. The Aussie dollar also rallied which partially offset those gains. The GFC bear market hit a low in March of 2009 and staged a strong rally. The Aussie dollar was worth $ .71 USD in March but quickly climbed. By December 2010 it had reached parity with the US dollar before topping out at $1.09 USD in April 2011. You missed out on almost half of the rally in local currency terms.
The introduction of a hedged version of almost every major global ETF is indicative of the challenge that confronts investors. We are spoiled by choice. That is a good thing because we have more options, yet the abundance of choice also has the downside of adding another dimension to investing decisions. Another reason for investors to just give up because it all seems too complicated. Another reason to trade into and out of different investment vehicles.
Many individual investors I speak to seem to think that the choice is obvious. They argue that now is the time to be in a hedged product as signs of the economic situation stabilising and an easing of rate hikes will cause the market to rally and the Aussie dollar to rally. They argue that the Aussie dollar has traded in a range with the USD over the last 20 years and we have reached the bottom of the range. Maybe they are right—their argument does have some sound points. But this is adding another dimension to timing the market.
I’m a big advocate for looking at your own situation instead of trying to time the market. Do you frequently travel overseas or aspire to frequently travel overseas in the future? Maybe it is best to hedge your own spending by using the un-hedged products. That $35 AUD cocktail in Chicago is a little easier to stomach if you’ve avoided a lot of the market pain this year.
I want to hear your ideas on how to dress up as a hedged ETF for Halloween. If you manage to send a picture of you wearing the costume, I will publish it in the Editor’s note next week. Email me at [email protected]
If you are in Brisbane on Saturday November 5th swing by the ASX conference. I will be presenting and you can swing by the Morningstar booth and talk to Shani and I.