Pathfinder Monthly Commentary: don't hedge currency - ever!

Don't hedge currency - or maybe you should - part 1 of a commentary from Pathfinder looking at the merits of not hedging.

Wednesday, March 6th 2013, 8:30AM 1 Comment

by Pathfinder Asset Management

Fund managers, financial advisers and investors provide many reasons for not hedging currency. Below is the first part of a two part commentary looking at the merits of the “top 10” reasons to not hedge. We focus on the long term strategic hedging costs and benefits. These are quite distinct from short term tactical views on whether at current levels the NZ dollar is fairly valued (we will save the current valuation question for another day). Below we provide 5 commonly heard reasons for not hedging – and conclude by providing some practical hedging thoughts.

Reason 1 – don’t hedge because…. there is extensive research telling us not to hedge

True, there’s plenty of hedging research – the problem it’s typically not from a NZ investor’s perspective (mostly US or European perspectives). We are not aware of any credible research establishing in the long run NZ investors shouldn’t hedge. In fact to the contrary, what limited research there is establishes a compelling argument for NZ investors to maintain at least a partial hedge. (See for example MSCI Barra’s 2009 paper titled “Currency Hedging: a free lunch?” which looks at currency hedging for investors in 10 countries. They conclude “for NZD based investors, hedging made sense from a return/risk perspective regardless of market and horizon.")

Reason 2 – don’t hedge because…. hedging is a “zero sum game”

The “zero sum game” argument has become an urban myth. A research paper by Credit Suisse in 2012 established that if you take investors from all countries and add currency hedging gains by some and losses by the others, the end result will add up to zero. Hard to argue with that – it states the obvious that hedging is a zero sum game for the entire universe of global investors. But it doesn’t come close to proving hedging is a zero sum game for investors from a single country like NZ. Hedging creates winners and losers on a country by country basis. As we will see, NZ is typically a winner not a loser from hedging.

Reason 3 - don’t hedge because…. currency hedging is expensive

For an investor to engage an outside consultant to arrange and advise on hedging will cost. But pure transactional hedging at a wholesale level does not. Currency trading is a high volume commoditised product, meaning bank margins are virtually frictionless. Currency transaction costs (recognised through the bid/offer spread) are as low as 0.0002%. On a trade of $10m that is $2,000 – not zero but given the trade size it is far from outrageous.

To complicate matters there is also a financial benefit for NZ investors hedging exposures to other currencies with lower interest rate environments. Most of the developed world has a lower interest rate structure than NZ (US, Japan, Europe, UK and Canada, but not to Australia). Without going into the supporting algebra the “interest rate differential” currently delivers a return benefit of about 1.5% p.a. for NZ investors hedging US dollar exposures.

Assume we convert NZ$100 into US$83 (spot rate 0.83) and lock in a one year hedge. For that year we don’t care what the currency does - it can go down to US$0.75 or up to US$0.90. Under the hedging contract we receive back NZ$101.50, being our original NZ$100 plus the 1.5% pick up (we also get the gain or loss from where we invested the US$83). If this 1.5% p.a. applies for the next 5 years then a hedged investor is only be worse off if the kiwi is below US$0.769 in 2017 (a fall of 1.5% p.a. from the current $0.83). What side of that equation would you want to be on? This “interest rate differential” can be confusing but the 1.5% p.a. pick up is a very real benefit of hedging, not a cost. We urge you to read up on it (or ask your fund manager to explain it for you in more detail).
Note that the NZ Superannuation Fund believes it is better to hedge offshore exposures and collect the 1.5% p.a. “interest rate differential” than remain unhedged. They provide a compelling benchmark for any NZ investor with a long term horizon.

Reason 4 - don’t hedge because…. in the long run the NZ dollar is depreciating

In 1985 the NZ dollar floated its way into a new era, first trading at US$0.44. It has since almost doubled to US$0.83….. this is far from proof of depreciation.

We regard pre-float data as less relevant, but we don’t ignore it completely. In the “old” pre-float world of fixed exchange rates, politicians and not markets decided currency levels. Many opponents of hedging point to the 1967 NZ$/US$ exchange rate of $1.62 and the fact that the rate is now $0.83 (note: NZ adopted our decimal currency in 1967). On the face of it this is clear evidence of depreciation - but the maths is not that simple. Note our discussion about the “interest rate differential” (Reason 3 above) being the benefit of a high interest rate economy (NZ) hedging currency against a lower interest rate economy (the US). It currently generates a 1.5% p.a. benefit (this is in fact also the average since floating in 1985 – it has since been positive in 26 of 28 years).

If a 1.5% p.a. interest differential existed since 1967 then an investor would have been better off hedging at $1.62, accepting 1.5% p.a. and now converting back at $0.83. The 1.5% p.a. outweighs the apparent depreciation! (Note it is not possible to easily establish the interest rate differential pre-float and hedging tools did not then exist. The point here is the “depreciation” argument is more complex than merely quoting headline depreciation from 1967 to 2013. Please also note that for simplicity, tax impacts have been left out of calculations.)

Gareth Morgan had been a supporter of this argument that the NZ dollar depreciates in the long run (and therefore should not be hedged). Interesting to note his reversal on this view and adoption of currency hedging for his kiwisaver scheme in 2011.

Reason 5 – don’t hedge because…. ignoring currency lets me avoid the hedging debate
This is possibly the most dangerous approach of all. Ignoring a problem does not make it go away - currency volatility is very real for NZ investors. Make no mistake, choosing to ignore currency is making an active decision – it is choosing to be fully unhedged. Being unhedged may or may not be the right outcome, but relying on this argument is entirely the wrong way to arrive there.

Conclusions on currency hedging

So what does this mean in practice? Some final thoughts:

1. Think about currency hedging. The impact of currency on offshore investments cannot be ignored. If you choose to ignore it then you’ve just chosen a fully unhedged default position for your portfolio. So by deciding not to choose a hedging level you have in fact actively chosen 0% as the right level! We encourage all investors with offshore assets to think about how they articulate their hedging strategy - and what data based support they have for that position.

2. Be clear on your strategic vs tactical currency positions. The NZ dollar is volatile and is moved by both offshore and domestic events (currently offshore influences have a larger impact). Be sure to constantly challenge and review your position – but you need a compelling reason to adjust a hedge. Challenge often, change rarely. Clearly differentiate long term currency strategy (what is my long term default hedging position?) from short term tactical positions (is there any reason to currently deviate from my long term default hedging position?).

3. Understand the real costs and benefits. Hedging against the US dollar consistently provides an “interest rate differential” benefit of 1.5% p.a. That’s right – one of the few “free lunches” in markets. The cost of implementing that strategy (via the bid offer spread) is 0.0002% (not zero, but close). What part of that is expensive?

4. Don’t just accept urban myths: There are plenty of convenient arguments not to hedge. “Hedging is a zero sum game”. “There is plenty of research saying don’t ever hedge”. We urge you to explore currency research – even though NZ specific material is hard to find. Ask fund managers for their thinking. Conduct your own review – don’t let a convenient urban myth catch phrase stop you.

This commentary is intended to look at whether there is merit in commonly used arguments for not hedging. Our view is that an NZ investor should have a “default position” bias towards being at least partly hedged. In our next commentary we discuss a further 5 arguments for not hedging. After completing a review of the arguments, the next logical question is “what is the right long term hedging ratio?” (25%, 50%, 75% or 100%?). We will come to that question in another commentary shortly.

John Berry
Executive Director
Pathfinder Asset Management Limited

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

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