Brent Sheather: Unhedged portfolios make good sense

So why would local fund managers embrace hedging so vigorously? Photo / 123RF

Most local fund managers have historically hedged the overseas currency exposure of all of their global bond funds and part of the currency risk of their global share funds.

This column has argued in the past that a hedging strategy is inappropriate for most retail investors on the basis, firstly, that if diversification works for shares and bonds the rationale should apply equally to currencies as well and, secondly, as a risk reduction strategy unhedged portfolios make good sense.

The reason for this is while most local investment assets — think houses, National Super etc — are denominated in New Zealand dollars a good proportion of our expenses are priced in US dollars — think milk, meat, petrol etc.

Holdings in overseas shares and bonds thus effectively hedge the fact that New Zealanders are exposed to exchange rate movements in respect of goods which are charged out at export equivalent prices.

To understand this think of the farmer who has a sheep for sale — he can sell it in Auckland or in London and if the kiwi falls against the British pound he can shift the product to London and maximise the price. Many goods are priced in this way.

On this basis, perversely, it is New Zealanders who don't invest overseas who actually take on foreign exchange risk. Overseas assets also provide insurance against an extreme local inflationary event — an example of this occurred in Germany's hyperinflation where the local currency became worthless and Germans with overseas assets were better able to maintain their standard of living.

Investing in overseas shares naturally means investing in overseas currencies so it is something of an insurance policy for NZ dollar-based investors against local natural disasters like foot and mouth disease, a huge earthquake or Sir Robert Muldoon.

So why, when common sense tells us that an unhedged strategy is the way to go, would local fund managers embrace hedging so vigorously? Most fund managers say they hedge because it reduces risk but the facts don't support that argument.

The real reason local fund managers hedge is that, in the past, it has increased performance and performance is critical to fund managers because it assists in maximising assets under management.

High relative performance means more funds under management. In the past hedging has increased returns because, without going into the technicalities of the trade, as US short-term interest rates have been zero and NZ short-term rates have been 4 per cent or higher a hedging strategy can add 3 to 4 per cent a year to returns.

Such a strategy has worked well for the past 10 years but like all strategies it only works until it doesn't and today, with US interest rates rising and NZ interest rates falling, the interest rate differential is close to zero which means there is virtually no gain from hedging.

Local financial advisors seem to have swallowed the line that hedging lowers portfolio risk; however, this argument does not stand up to a lot of scrutiny as research by GMO illustrates.

They cite the case of US investors in Swiss equities after the recent rapid appreciation of the Swiss franc. At this time the Swiss franc rose dramatically in value and Swiss equities dropped like a stone. US investors in Swiss equities that hedged the currency were confronted with the loss on Swiss equities but unhedged investors saw their Swiss investment virtually unchanged in value as the loss on the shares was offset by a gain on the currency.

The same thing often happens for NZ investors with international shares. On risk-off days we frequently see the NZ dollar fall in value at the same time that global shares decline thereby delivering NZ dollar investors reduced losses. We can see if this translates to actual reduced risk if we calculate the standard deviation of the world stock market on a hedged versus unhedged basis.

We estimate that, using standard deviation, an unhedged portfolio of global equities is actually marginally less risky than a hedged portfolio.

The caveat to this analysis is that risk is a dynamic variable and historic measures of risk may not be relevant for the future but the key takeaway is that hedging doesn't seem to have offered much in the way of risk reduction in the last three years in respect of international equities.

Hedging has been a profitable strategy over the past 20 years because the NZ dollar has risen in value but with the benefit of the Global Investment Returns Yearbook database we can see that the recent trend hasn't always been so.

One NZ dollar was worth US$2.28 in 1900, adjusting for the fact that we were in pounds back then, so the NZ dollar has been on a very slippery slope over the long term.

Perhaps the strength in the NZ dollar in the past 20 years has been due to the fact that NZ interest rates were much higher than US rates.

The kiwi doesn't have that support today and with hedging gains consigned to history it will be interesting to see if fund managers gradually change their tune and start marketing unhedged portfolios.

• Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request.