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Currency hedging: how does it work and do you need to do it?

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By Dave Gow, Strong Money Australia

2024-10-119 min read

In this article, Dave Gow from Strong Money covers how currency hedging works and why it may be worth thinking about.

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International shares are often a core part of an Aussie investor’s portfolio.

Having access to global companies can provide us with more diversification and growth opportunities than we get often here at home.

But owning assets overseas also comes with currency risk. An investment in Global shares is affected by currency movements – in particular, how the Aussie Dollar (AUD) moves relative to other currencies around the world.

One way to overcome this is by investing in funds which are “hedged”.

In this article, we’ll look at whether hedging is a good idea, and why it matters. I’ll share my thoughts on hedging in different scenarios and give you a framework to help you decide whether it makes sense for you.

I’m no expert on this topic, so take the information here as a basic understanding and a springboard to research the topic further if it interests you. And as always, reach out to a financial adviser to help you with your own personal goals when considering new investment strategies.

What is currency hedging?

Currency hedging is a strategy used to reduce the impact of exchange rate fluctuations on international investments.

When a fund is "hedged" it means that currency movements between the Australian Dollar (AUD) and foreign currencies are neutralised. Basically, the fund's performance is driven solely by that of the underlying companies.

On the other hand, an "unhedged" investment is exposed to currency changes. This means your returns will be affected by both the performance of the companies as well as fluctuations in the value of the AUD relative to other currencies.

How does currency hedging work?

Let’s take a simple ETF which invests in overseas shares, such as the Vanguard MSCI Index International Shares ETF (ticker: VGS).

There is also a hedged version of this fund – Vanguard MSCI Index International Shares (Hedged) ETF (ticker: VGAD)

By investing in VGAD, you get access to the same 1400 or so companies as VGS, but with some differences.

  • The fund’s value is not impacted by currency variations between the AUD and the rest of the world. Only the performance of the underlying companies.
  • Vanguard charges a slightly higher management fee, 0.21% for VGAD compared to 0.18% for VGS.
  • Distributions will be sporadic and unpredictable as a result of the currency contracts being used. Sometimes hedged index funds will have zero distributions, and other years, there will be massive spikes. Note: You aren’t “losing” the dividends from the underlying companies, as the value remains in the unit price. It’s just a quirk of hedging. The gains from these currency contracts can result in very large spikes in taxable income in a given year, which means more is lost to tax, frustrating some investors.

“Doesn’t hedging help protect my portfolio?”

At this point, one assumption is that hedging is a no-brainer because it means less variables can affect your portfolio. But leaving your portfolio “exposed” to currency movements isn’t necessarily a bad thing.

For example, if the Aussie Dollar (AUD) loses value relative to global currencies over the long term (which is possible), having unhedged global shares will shield you from some of that.

Also, during market sell-offs, the AUD tends to fall. This means your global shares are worth more than they otherwise would be. In practice, this often means they fall in value less during a downturn than a fund which is hedged.

Therefore, a portfolio combining Aussie shares and unhedged global shares is typically less volatile compared to when hedging is included. But let’s zoom out for a moment.

Over the long run, it’s widely accepted that currency movements tend to even out and have a relatively neutral impact. Although currency exposure does impact your portfolio, those movements don’t compound year after year like profits, dividends and market returns. How the underlying companies perform is historically far more important, and over time, this performance dwarfs the impact of currency.

A currency move of 20%, over a multi-decade timeframe, amounts to less than 1% per annum. This means, for long-term investors, hedging is less important than it might first seem. But don’t get me wrong – there are definitely cases when it makes sense.

When does currency hedging make sense?

Take an investor who owns mostly Australian assets. This investor may benefit from having unhedged global shares in their portfolio.

On the other hand, an investor who allocates most of their money outside Australia has almost exclusive exposure to global currencies. This means the currency markets have a greater impact not only on their returns, but on the investor’s local purchasing power.

To my mind, this creates an additional unnecessary risk.

Let’s say an investor allocates 25% to Aussie shares and 75% to global shares. They may have great diversification as far as countries go. But now their portfolio is a bit lopsided as far as currency is concerned.

So, to ensure the portfolio’s purchasing power is more reliable, some hedging can be useful. Why does local purchasing power matter? Because as investors, our goal is to have this portfolio pay all our AUD expenses someday.

To me, having a balance of both seems like a good idea. For a portfolio that is somewhere around 50/50 Aussie and international assets, hedging seems less appealing because there’s already a balance.

Now, whether a portfolio is 60/40 or 35/65, I don’t think it matters all that much. The split is still somewhere in the region of balance. But it's always helpful to reach out to a financial professional to understand your own balancing needs.

In my opinion, whether it’s about currency or anything else, trying to fine-tune a portfolio to a high degree is often more for intellectual satisfaction than any meaningful real-life benefit.

Portfolio examples and currency hedging

To flesh out what I mean, here’s a simplified scale of how I think about the currency discussion:

100% Aussie shares. Low company/industry/country/currency diversification. Could possibly benefit from unhedged global shares.

75% Aussie, 25% Global shares. Possibly no hedging needed as it holds mostly AUD assets. But could benefit from greater company/industry/country/currency diversification.

50% Aussie, 50% Global shares. Decent diversification and balance of currency. Possibly no hedging needed.

25% Aussie, 75% Global shares. Good diversification, but relatively high global currency exposure. Could possibly benefit from hedging.

0% Aussie, 100% Global shares. Good diversification, though missing local industries and tax benefits. Low certainty over local purchasing power. Could possibly benefit from AUD assets such as Aussie shares or unhedged global shares.

For those who have an all-in-one fund such as VDHG or DHHF, you don’t even need to worry about this topic. It’s all been decided for you!

VDHG has about 40% Australian shares and bonds, 60% international. Some hedging is used, giving an overall currency exposure of 55-60% AUD.

DHHF, on the other hand, has 40% Australian shares, and 60% global shares (no bonds). After a recent change, currency exposure is now basically the same as VDHG.

How to hedge your portfolio

To hedge some of their portfolio, an investor could consider split their international shares between VGS and VGAD.

So for the 25/75 Aussie/Global, an investor would have, say 25% VAS, 25% VGAD and 50% VGS.

This maintains their desired 25/75 Global/Aussie shares exposure, but moves currency exposure to 50/50.

Obviously, you’ll also want to consider what other assets and income streams you’ll have in your portfolio.

For example, if you expect to have 1-2 paid off rental properties, or even a government pension, then currency hedging is probably less of a concern.

For those that decide hedging does suit their circumstances, they often wonder about the following.

Should I change my allocation based on currency movements?

As the question suggests, this is basically a different version of timing the market. Which, broadly speaking, is pretty damn difficult to do.

The problem is, we simply don’t know what’s coming next. The only time things are clearer than normal is when markets are at some type of extreme level based on history. Most of the time, however, things are just fluctuating between different levels of normal.

For example, during the last 30 years, the AUD has fluctuated between $0.47 USD and $1.10 USD. That’s a pretty big range. But for most of that time, it has hovered between $0.60 and $0.80.

What does this mean in reality?

If the AUD was at 50 cents, for example, our money doesn’t go as far when purchasing global shares. This is at the lowest end of the long term range.

In this case, a “hedged” global share fund may be more appealing. When the AUD eventually recovers to a more normal range, an unhedged fund (VGS) would be negatively impacted, whereas VGAD wouldn’t.

The same works in reverse too. If the AUD reaches the incredible highs it did in 2011 at the peak of the mining boom (over $1 USD), purchasing VGS may be more attractive, since our Aussie purchasing power is so strong.

If/when the currency moves back towards a more normal level, you get an extra return-boost since the weaker AUD means your unhedged global shares are now more valuable. Buying VGAD would mean missing out on that extra boost.

The downside to picking and choosing when to invest in VGS or VGAD is that this complicates your investment strategy portfolio. Not only do you have an extra fund to own/manage, but you’ll constantly agonise over which one you should buy at a given time.

You’re also assuming that the future looks like the past. What if the normal range of the AUD changes over time? It certainly could.

In my opinion, it’s generally better to choose an allocation and stick with it. If that includes a hedged portion of global shares, great. If not, that’s fine too.

Choosing an allocation will make it much easier to decide what to invest in at a particular point in time. When you take this approach to your portfolio, you naturally end up buying, or “topping up”, the one which is offering the best value, since it will have recently underperformed.

I find this to be the simplest and most effective approach in managing a portfolio.

Currency hedging in retirement

Some people worry about hedging and currency movements when it comes time to live off the portfolio. This is when the risk becomes real.

The last thing you want is to have large currency exposure and it moves against you when you’re reliant on your portfolio to pay the bills. And the biggest periods of worry will be during market sell-offs.

As we’ve discussed, it depends on your portfolio as to whether hedging makes sense. But here’s a simplified summary of what happens during different scenarios…

The AUD falls during poor economic conditions. During these times, global unhedged shares generally perform better (or fall less), and can help reduce volatility.

The AUD rises during strong local conditions such as a mining boom. Here, hedged global shares help performance because they aren't negatively impacted by the rising AUD.

Much of the time, the AUD will float within a somewhat normal range, not really affecting your portfolio much at all. For those particularly concerned about currency risk, a mix of hedged and unhedged global shares can offer a balanced approach.

How do I decide whether to go hedged or unhedged?

When deciding whether to invest in hedged or unhedged international shares, there are a few things to think about.

Unhedged global shares are by far the most common used by investors. It means your global shares are influenced by global currency markets as well as share market performance.

As we’ve covered, this can provide additional diversification.

Unhedged options tend to suit investors who already have a large amount of investments and reliance on Australia: shares, property ownership, their job, possibly a business, and so on.

In this case, the additional diversification of owning assets denominated in other currencies is useful.

Hedged options tend to suit investors who are investing a significant percentage of their assets overseas (more than 50%, for example). Using a hedged option for part of their portfolio helps to reduce the risk of currency movements hurting their purchasing power in AUD.

The AUD/USD will rise and fall against each other based on many different factors. Over the long run, currencies fluctuate but usually stay within a long-term average range.

The unfortunate answer is: what you choose will depend on your portfolio choice, personal situation, and what risks you’re comfortable with. This “conundrum” could make you think it’s better to just go with a one fund solution such as DHHF or VDHG, since that’s one less decision to make and an ongoing factor to deal with. But like always, seek out personal financial advice to know what's best in your situation.

Final thoughts

As you can see, currency hedging is a complex topic.

I hope I’ve helped you think through the different options and what could make sense for your circumstances.

You might be wondering how I approach it.

Personally, I invest in unhedged global shares and I’m working towards a target of 50% of my portfolio (not there yet). I like the simplicity and balance of just having two funds – VAS and VGS.

I could only see myself adding VGAD to my portfolio in the event of a relatively extreme scenario – AUD under 50 cents for example.

For the most part, though, I much prefer to keep it simple and just have a single fund for the global shares part of my portfolio.

Thanks for reading, and happy long-term investing!


Dave’s best-selling book Strong Money Australia is available on
Amazon. Listen to the audiobook on Spotify or Audible.

WRITTEN BY
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Dave Gow, Strong Money Australia

About Dave Gow | strongmoneyaustralia.com Dave reached financial independence at the age of 28. Originally from country Victoria, Dave moved to Perth at 18 for job opportunities. But after a year or two at work, Dave became dismayed at the thought of full-time work for 40+ years, with very little freedom. To escape the rat race, Dave began saving and investing aggressively into property and later shares. After another 8 years of work, he and his partner had reached financial independence.

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