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(March-2003) To hedge, or not to hedge…
Much soul searching is underway among super fund managers as they battle to explain their exposure to the newly popularised “double whammy effect” of falling global equity markets being amplified by a strengthening Australian dollar (see box).
Super fund managers have certainly become more aware of the impact currency can have on total returns and more appreciative of the need to develop a forward looking active currency policy to protect their international allocation.
The consequences of the “double whammy” have been horrendous for investors.
According to Mercer Investment Consulting, all Australia’s biggest super fund managers suffered a negative return in 2002, losing a median 7.3 per cent for the year, the worst performance since 1974. This has cancelled out most of the previous two years’ gains — largely on the back of a falling Aussie dollar — and has dragged down longer term returns.
InTech senior consultant Andrew Korbel reckons that the appreciation of the A$ wiped an additional average of 3 percentage points off unhedged world investments over 2002.
This is in sharp contrast to the previous two years. With the plunging A$, unhedged positions added 12 percentage points to world investment returns in 2000 and 4.5 points in 2001. Many poor investments were masked by currency gains. With the A$ and global markets going in the right direction, it was hard to lose. At the same time, over the last three years, Australia has outperformed all the major global equity markets. The MSCI equity index for Australia has appreciated by 8.2 per cent compared to declines of 31 per cent in the US, 25 per cent in the UK and 47 per cent in Japan.
With around 25 per cent in international assets and buying an average $10 billion in international equities each quarter, Australian super funds have high average levels of international exposures by international standards.
Those with the highest international allocation are suffering the hardest falls.
Pareto Partners vice president of research Jim Coleman notes that over the past few years the international allocation has been the key factor in determining whether a fund is at the top or bottom of the performance league table. Until a year ago the weakening Australian dollar gave a windfall currency boost to the poor international equity returns.
“As the A$ fell it meant that any currency hedging reduced the windfall foreign currency gain. Viewed in isolation, currency hedging was costing return. So currency hedging has been cut. A recent survey by the Reserve Bank shows that only 20 per cent of international equity investments are currently hedged. This leaves funds in a difficult position if the currency continues to strengthen.”
At the end of last year, van Eyk surveyed international equity managers on their exposure levels to various currencies and found these managers had a wide spread of hedging positions — anything from 0 to 75 per cent. On average, the managers tended to hedge well below 50 per cent of their currency exposure.
The argument for not hedging is that it reduces overall risk by increasing portfolio diversification. By hedging back into Australian dollars, all eggs are effectively in one basket.
An unhedged policy means that the returns from international investments will depend on the movements of the value of the Australian dollar relative to the currency in which the overseas investment is being held, as well as the performance of the investment.
A partial hedging policy — such as 50/50 or 70/30 — means the investor won’t ever experience the major highs of an unhedged portfolio, but won’t be subject to the lowest returns either.
Coleman argues: “Currency is an unrewarded risk. There is no reason to believe that hedged currency returns will outperform unhedged returns, or vice versa. As currency risk is unstable, it should be actively managed.”
It is in this sense that many super fund managers are revisiting their hedging strategies.
Macquarie Funds Management division director Jill Pleban recalls that up until 1996, only around 16 per cent of balanced fund portfolios were invested in global equities, so the issue of currency hedging was not as important as it is now. The depreciation of the A$ from 1996 pushed the issue into the background.
“However, with levels of international exposure now at 25 per cent, and expected nominal returns for equities expected to be relatively muted, the issue of currency hedging is likely to be a board level issue.”
The decline in the A$ reduced the popularity of hedging.
“Now we see a renewed interest in hedging strategies. This is a function of the most recent experiences,” says Pleban.
No one seriously argues against international diversification or reducing global exposure. The trend over the past seven years, notes Korbel, has been for super funds to increase their international exposure by one percentage point a year. Now one quarter of their assets is invested abroad. “We expect this to continue in the present environment. It is still too little,” he says.
There are many reasons why super funds will continue to boost their offshore investments. It allows them to share in the profits of some of the world’s most successful global companies — only 2 per cent of the world’s equity capital or investment opportunities are in Australia — and it opens the door to industries that are not represented, or are under-represented, in Australia. And over the past 30 years, international shares have provided a higher annualised return, at considerably lower risk, than Australian shares.
But with this diversification comes a problem not found in all domestic portfolios — currency risk. The difference now, notes Pleban, is that investors are more likely to hedge and keep their international portfolios in place.
AUTHOR
Simon Segal
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