To hedge or not to hedge

Australians, being the intrepid travellers they are, understand currency risk. It is something that is learnt the hard way, usually at a young age when trying to scrape by on modest savings in a foreign land.

That real-world experience can also serve us well when thinking about our investment portfolio and the question about whether to hedge or not hedge the currency exposure that comes along with investing overseas.

Sadly, unlike our overseas travel jaunts, the decision is complex and nuanced and the long-term impacts could be a lot more severe than simply cutting short a trip by a week or two.

One of the drivers for undertaking the research is that as investment markets have become more global, investors are increasingly investing overseas.

Home country bias is the term used to describe how much more investors have invested in their domestic market compared to the global market benchmarks.

From 2001 to 2012 Australian equity investors lowered their home country bias by 14 percentage points. Over the same time US, UK and Canadian equity investors lowered their home country bias level 11, 23 and 10 percentage points respectively so this is clearly not just an Australian phenomenon.

From a forward-looking perspective, we expect hedged and unhedged portfolios to produce the same gross return in an arbitrage-free world.

In contrast, from a backward-looking perspective currencies have played an enormous role in determining a portfolio's profitability.

In a sense the currency hedging question sits alongside the broader portfolio asset allocation question.

A key consideration for investors when pondering the currency hedge question is what is the fundamental goal you are trying to achieve? Is it to try to maximize returns or to reduce overall portfolio risk?

For this research work the objective was to evaluate currency hedging through the lens of reducing risk.

The results suggest that investors focus on two specific questions when determining what an appropriate level of currency exposure is.

They are:

1. What is the portfolio's asset allocation?
   Fixed interest-oriented portfolios will benefit more from hedging than equity portfolios because bonds typically have lower volatility than shares. Because of that many investors may consider fully hedging their fixed interest allocation.
2. What is the correlation between currency and equity?
   There is a potential diversification benefit, the researchers say, in owning foreign currency but there is no "one size fits all" hedging prescription.

But the research suggests that unless the currency-to-equity correlation is expected to be negative, consider currency hedging even in the equity portion of your portfolio.

All  of Direct Advisers' portfolios incorporate currency hedging, which is adjusted from time to time as economic conditions change.