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Hedging your bets

HOW often have you heard investors and fund managers talking about hedging their currency exposure and wondered what in God’s name they were talking about?

For those of us who choose to invest money in international shares we expose ourselves to returns on two fronts — the performance of the share in its local currency, and the movement of the foreign currency against the Australian dollar.

The second part of the return has been more significant in the last 12 months with the volatility being displayed by the Australian currency as it plumbed new depths.

In the Australian context, currency hedging refers to transactions in the foreign exchange market that brings the offshore currency exposure of your investments back into Australian dollars. This is usually done through financial instruments such as forward foreign exchange contracts or currency options.

The main purpose of entering into these instruments is to try and reduce the volatility of your returns. Hedging can be quite significant in reducing the impact of currency moves.

Once the currency factor is removed then the returns that flow through will be those related purely to the performance of the company itself.

During a period of Australian dollar appreciation a hedged portfolio will protect the returns generated. When the Australian dollar is undergoing a sustained period of depreciation as we have experienced over the last few months, then hedging will cost you additional returns.

Obviously, hedging is not something that every investor or fund would need to have. The decision as to whether to hedge will reflect a fund manager’s outlook for the Australian dollar against the currency of the country in which the money is invested. It can be said that in general, hedging is suitable for the more risk-averse long-term investor who wishes to reduce the volatility of their returns.

If you were looking at a potential rise in the Australian dollar, you would want to be invested in a hedged portfolio.

At the present time most fund managers are anticipating a rise in the Australian dollar. Hence a hedged portfolio would be what you would look for.

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