International Exposure

What is a Foreign Exchange? 

If you are investing in a currency other than Australian dollars (AUD), you are (or someone is on your behalf is) participating in the foreign exchange (FX) market.  For example, by purchasing a foreign asset, you are selling AUD and simultaneously buying another currency (such as US dollars (USD)) to purchase that asset.

One of the risks of foreign investment is that during the term of the investment the AUD could appreciate relative to the foreign currency, effectively meaning that you lose money when you convert your money back into AUD.

Ways to deal with FX: Hedged, Unhedged or Managed

When investing in overseas markets, investors must decide whether to hedge (mitigate the effect of FX), remain unhedged (accept the FX movement whether positive or negative), or invest with a fund manager that has the mandate to be either hedged or unhedged depending on their view of the market.

The most common way for retail investors to hedge is to purchase hedged managed funds. 

Please note that hedging does come at a cost and it is practically impossible for a fund to be perfectly hedged at all times.

What should Investors do? 

We believe the key to this decision is an understanding of the AUD and the currency that it is being exchanged.  It is generally accepted that the AUD is a commodity currency (i.e. its strength is generally positively correlated with commodity prices). Furthermore, it is commonly accepted that commodity prices are positively correlated with the global economy. Therefore we would expect the AUD to weaken if the global economy weakened.

Example – To hedge or not to hedge?

An investor wants to invest directly in China through managed funds. It should be noted that the Chinese currency is fixed to the USD.  So, investment in Chinese stocks is effectively a conversion of AUD to USD. 

Our Comments:

• If the Chinese and the Global economy continued to grow one would expect the Chinese share market to appreciate.  So, as long as the investment appreciated at a greater rate than the AUD relative to the USD, an unhedged investor would make money.
• A hedged investment however would appreciate or depreciate at the same rate of the Chinese share market.
• The AUD/USD is currently trading above 93 cents, which based on historic rates is high.
• If the Chinese and the Global economy went through a downturn, you would expect the Chinese share market and AUD (relative to the USD) to depreciate.  In effect, the depreciation of the AUD against the USD in this example would help protect an unhedged investor from the fall in the underlying investment.  There would be no such protection for a hedged investor.
• There is talk of the Chinese appreciating their currency against the USD. If this occurred it would be beneficial for an unhedged investment.

Other Considerations:

• Investment timeframes.
• Cost of hedging.
• For managed funds that are FX managed, the track record of the fund manager.
• The strength of the AUD at the time of the investment.
• Capital Gains Tax issues if converting exposure from hedged to unhedged, or vice versa.