The truth about hedging

Children playing with paper money, rendered virtually worthless by post-war hyperinflation in Germany, circa 1923. When the currency became worthless, those Germans with overseas assets were better able to maintain their standard of living. (Photo by FPG/Getty Images)

Why, when common sense tells us that an unhedged strategy is the way to go would local fund managers embrace hedging so vigorously? Brent Sheather explains.

The milk price is going down and taking with it interest rates and the NZ dollar. Short term bank deposit rates are currently around 3.0 per cent and the experts are talking 2.0 per cent within six months. Against this backdrop it is hard to see the Kiwi dollar, down against the US$ by 22.3 per cent in the last 12 months, recovering any time soon. Given that the average balanced Kiwisaver fund typically has around 20 per cent invested in overseas bonds and 30 per cent invested in international shares one could reasonably expect to benefit from any depreciation in the NZ$.

Unfortunately many KiwiSavers will not gain from the lower kiwi dollar to the extent that their pie charts suggest because the local fund management practice is to hedge 100 per cent of international bond portfolios and around 50 per cent of overseas share portfolios.

This column has argued in the past that a hedging strategy is wrong for most 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 rationale for this is whilst most major investment assets - think houses, National Super etc - are denominated in NZ$ a good proportion of our expenses are priced in US$ - think milk, meat, petrol etc. Overseas assets 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 NZ$ falls against the GBP 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 a 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.

So why, when common sense tells us that an unhedged strategy is the way to go would local fund managers embrace hedging so vigorously? The answer is it assists short term performance and performance is critical to fund managers because it assists in maximising assets under management.

So why, when common sense tells us that an unhedged strategy is the way to go would local fund managers embrace hedging so vigorously?

High relative performance means more funds under management. A hedged strategy can assist returns because, without going into the technicalities of the trade, as US short term interest rates are zero and NZ short term rates are 3per cent or 4 per cent a hedged strategy can add 2 per cent to 4 per cent pa to returns.

Such a strategy has worked well for the last ten years but like all strategies it only works well until it doesn't and in the last twelve months it has spectacularly underperformed. With the NZ dollar having fallen by 22.3 per cent in the last 12 months against the US dollar advocates of a non-hedged policy will thus be emboldened and retail investors need to understand the hedging policies of their fund managers. For further perspective on this remember that the NZ$ has fallen by an average of 1 per cent pa against the US$ since 1900.

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. Hedged investors 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 observe if this translates to actual reduced risk if we measure the standard deviation of the world stock market on a hedged versus unhedged basis - remember standard deviation is the academic worlds preferred measure of risk.

If we calculate the standard deviation of the world stock market on a hedged versus unhedged basis we see that on a hedged basis the standard deviation of global equities is actually marginally higher than that of an unhedged 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.

An academic from Cambridge University writing to the London Financial Times the other day made the point that as share prices are the discounted present value of best guess future earnings and, with a qualification, that present values are more likely to drop than to rise with currency appreciation swings in local currency equities are more likely than not to be naturally offset by currency movements.

He added however that in the case of bonds a depreciation in the currency would generally push interest rates up and prices down ahead of the expected currency movement and therefore that hedging on the whole should pay off for bond portfolios.

Standard deviation is the scientific method however to get an extreme and totally unscientific view of whether or not to hedge one's overseas investments. I put that very question to a randomly selected group of 15 retired Argentinian dentists coincidentally holidaying in Whakatane this week.

Unsurprisingly given the roughly 70 per cent depreciation of the Argentinian "peso" over the last ten years against the US$ all were of the view that hedging was not a good idea.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have a financial interest in the companies mentioned in this article.