Diana Clement: Investors should be aware of hedging

Hedging. It's something the neighbour plants for privacy.

For our purposes, however, it's a technique used by fund managers and others to offset or reduce exposure to the risk of losses resulting from fluctuations in exchange rates.

Books have been written on the subject of hedging, points out Binu Paul, head of institutional markets at Tyndall. Yet many investors don't give the issue any consideration when investing - or even know about it.

As an investor you may want to invest in the BRIC (Brazil, Russia, India and China) or eastern European markets, but not their currencies, because of the added risk that entails. By buying into a fund that hedges currency, you can separate the exchange risk from that of the investments you are buying.

In the case of unhedged funds, a 20 per cent change in the New Zealand dollar against the foreign currency or currencies is not unheard of and it can have a huge impact on your returns over and above the movement in price of the underlying securities.

This can, of course, be good if the currency moves in your favour. But most private investors simply can't stomach that sort of volatility, says John Berry, executive director of Pathfinder Asset Management.

At the end of the day, says Paul, currencies eventually revert to the mean - which means they end up following a fairly straight path over time. Hedging gives investors a smoother ride along the way.

Long-term investors who are neutral to currency over time do not need hedging. "The challenge in the short term is the volatility and the question really is what the investor's risk tolerance is," says Paul.

Mark Brighouse, president of the CFA Society of New Zealand, says active hedging strategies might result in an overall gain.

That is what Pathfinder found when it modelled the impact of hedging and not hedging US dollar returns over the period from 1990 to 2009. Hedging not only smoothed out the volatility, but added 1 or 2 per cent on the upside each year.

Hedging is done with the purchase of forward contracts on currency giving more certainty that the gains or losses on the offshore investment will not be amplified by currency movements. That is if the fund is 100 per cent hedged back to the New Zealand dollar. If it's 50 per cent hedged, the manager can only be certain of half of the investment.

There are times, says Janine Starks, investment director at Liontamer, when an investor might want to buy unhedged funds - although her company provides capital-protected fully hedged funds. Those times are usually when the New Zealand dollar is especially high.

"[For] people who have a trading mentality, there are some good gains to be made when the kiwi is at 80c [to the US dollar]." An investor would then sell when the dollar dropped down to the mean, says Starks.

However, for mum and dad investors without that inclination, hedged funds are a more suitable option, she adds. Liontamer's funds are closed-ended with a five-year time frame and the hedging is necessary for the capital guarantee that comes with them. Reasons to be wary of hedging that private investors may not consider come from Diversified Investment Strategies.

Managing director Norm Stacey points out that investors who are hedged on offshore assets prosper when the currency rises and suffer when it falls. The reality "longer term", he says, is that the New Zealand dollar has fallen post float, and particularly relative to Asian currencies. "So mindless, passive hedging programmes to the New Zealand dollar have lost value more often than gained.

"There is also the catastrophic risk factor hedging to the New Zealand dollar, which is entirely diversifiable by holding a basket of currencies instead. What if New Zealand were struck by foot-and-mouth disease, a major quake, or economic disaster?" says Stacey.

The New Zealand dollar, he says, is "equity" in a small, remote, trade-dependent economy confined to geologically shaky isles. "Hedging to the New Zealand dollar adds risk and detracts from long-term return."

But not everyone agrees. For example, Berry says investors in his company's Pathfinder Commodity Plus Fund want exposure to international commodities markets. Without hedging, their returns could be affected by currency swings.

"If unhedged you could be gaining on commodities and losing it on the exchange rate, especially given the close relationship between the New Zealand dollar and commodities."

Typically bond fund investors are looking for income and this is an area that is usually 100 per cent hedged for that reason. Equity funds are a different story. The default position for many managers, such as Tyndall, is 50 per cent hedged, and for Pathfinder, 100 per cent. This can move tactically if they predict a long-term trend evolving.

Very active hedging by a manager, says Berry, can enhance returns - "capturing some of the volatility in the Kiwi dollar".

Hedging does come with transaction costs. However, they are relatively low, says Berry. They are especially low for fund managers because of competition between banks in wholesale foreign exchange transactions.

Regardless of whether you're an institution or a private investor, the decision whether to hedge or not is dependent on individual requirements, says Paul. "It comes down to the particular person's investment profile."

He says there are a number of questions to be asked by an adviser or investor:

What are you looking to get from the hedging - value or protection? And then:

What is your investment horizon and how much volatility can you take within that horizon?

What are your cash flow requirements during the term of the investment?

In theory it would not be necessary for super funds to hedge because it is a long-term investment. But, says Berry, if you're the investor who comes out at the very worst time in the cycle you may not agree.

Having said that, there are a few unhedged products available. For, example one of the investment pools in SuperLife that investors can choose from is overseas unhedged shares.

What's more, says Greg Ball, markets director at BNZ Capital, according to an annual Superannuation FX Survey run by his company, currency strategy is becoming increasingly important for super managers. That is especiallythe case after the volatility of theNew Zealand dollar late lastyear.

Hedging is not something to be ignored. You do need to know what your fund manager's approach to hedging is, says Berry because currency should be treated as if it was another asset class.

One problem for the DIY investor in New Zealand is that information about funds hedging isn't easy to come by. You need to read the investment statement in the prospectus of every fund you're interested in. Even then the statements about hedging can be vague.

The other difficulty for DIY investors who want to invest directly overseas is that there are not that many opportunities in New Zealand for private investors to hedge their own investments - although they can do their own currency and derivatives trades.

But that requires a very hands-on approach, which while possible for the full-time investor, may be difficult for time-poor individuals.