Pathfinder Monthly Commentary: Don’t hedge currency exposures – part 2
Don’t hedge ever? Hedge always? May be sometimes? In a country with an incredibly volatile currency, returns from hedging (or not hedging) can swamp returns from the underlying offshore assets. This is part 2 of Pathfinder’s commentary looking at the merits or otherwise of not hedging.
Monday, April 1st 2013, 8:30AM
by Pathfinder Asset Management
Given the investment impact, hedging should be a topic at the forefront of discussions on markets and portfolio construction. Last month we served up 5 of the most common reasons for not hedging. This month we look at 5 more. By way of reminder, last months’ arguments were don’t hedge because….
1. there’s extensive research telling us not to hedge
2. hedging is a “zero sum game”
3. hedging currency is expensive
4. in the long run the NZ dollar is depreciating
5. ignoring currency lets me avoid the hedging debate
Below are reasons 6 to 10:
Reason 6 - don’t hedge because…. there are no hedging tools available
It is frustrating for investors and advisers that currency hedging tools are not widely available in New Zealand. Even large wealth management groups struggle to access the right tools. Hedging transactions used by fund managers (currency forwards) are not widely available as these often require security over a portfolio and larger transaction sizes.
The simplest (and virtually only) available hedging tool for financial advisers is to select funds investing in offshore assets that offer hedged and unhedged pairs. This means there are 2 international equity funds with the same underlying exposures but one is hedged and one is unhedged. Hedged/unhedged fund pairs allow setting bespoke hedging ratios for each investor.
The absence of a range of hedging tools is very inconvenient. But is not in itself a reason to ignore the currency hedging debate. The “right” hedging ratio for a client portfolio is a “first level” portfolio construction decision. This is independent of a “second order” implementation decision regarding the availability and cost of hedging tools.
Reason 7 - don’t hedge because…. you need to protect against “catastrophe risk”; and
Reason 8 – don’t hedge because…. hedging increases the “home country bias”
These are in essence the same argument – and on the face of it they look compelling. Our agricultural/farming economy is vulnerable. If a catastrophe occurs the NZ$ could fall very far and very fast – meaning lower purchasing power in international terms.
These arguments are typically used to justify a fully unhedged (not partially hedged) currency exposure. Is that right? They make sense to justify a bias away from being fully hedged – but it seems a stretch to use these arguments to justify an unhedged position at all times for all investors. Here are some thoughts:
1. Assume an adviser wants to diversify a client away from their NZ “home country bias” and deems their offshore assets should be 40% of their investment portfolio. Does that automatically mean that the “right” proportion of that client’s exposure to non-NZD currencies should also be 40%? Why? Offshore exposure (hedged or unhedged) introduces diversification away from NZ markets. Should the diversification for equity or bond exposures also exactly match the diversification (as a % of the portfolio) required for currency? It seems far too simplistic to say the market and currency diversifications should exactly match – they should be looked at independently. Currency should be treated as a separate asset class.
2. A fully unhedged position has an opportunity cost for investors (see Reason 3 in last month’s commentary). Make no mistake, the 1.5% p.a. “interest rate differential” is the effective cost of not hedging an investor’s US dollar assets. Look at this another way – are investors happy effectively paying an annual 1.5% insurance premium to protect against a catastrophic but low probability event that may or may not happen in their lifetime? Are they even aware of the protection cost?
3. In recent times NZ has been hit by terrible human and economic catastrophes (Christchurch earthquakes, kiwifruit PSA and severe drought). Each is exactly the “home bias” or “catastrophe event” that advisers remain unhedged for – and yet ironically the NZ dollar has not been hit.
Reason 9 - don’t hedge because…. being unhedging protects when global markets fall
The GFC market collapse in 2008 provided a great illustration of this. The S&P500 had an extraordinarily bad year falling 36% and the NZD/USD exchange rate moved from 0.7686 to 0.5569 (a 27% fall). On a net basis the 36% S&P500 move was only a 12% fall for an unhedged NZ investor. The unhedged position softened the equity market fall.
While this is entirely true over selected short periods, this argument does not hold true over longer periods. Let’s compare the currency impact on the S&P500 over a shorter (1 year) and a longer (5 year) period:
Comparisons are of course time dependent – the start and end points can be critical. However, this could be repeated for other global market free-falls. The result is the same – there is a short term improvement (lower drawdown in NZD terms) but this often reverses over longer periods. This may point to using an unhedged position as a short term tactical (but not long term strategic) move – as long as you can successfully market time the move between being hedged and unhedged.
Reason 10 - don’t hedge because…. commodities driving inflation are priced in US$
This reason to not hedge requires the most brainpower to analyse. Here’s the argument - by living in NZ you are effectively “short” US$ because in the future you will earn in NZ dollars but the costs of consumption (driven by commodities) are priced in US$. If commodity price inflation (in US$) is higher than inflation in NZ then the earning power of your NZ dollar is eroded. Being unhedged on offshore investments deals with this by giving a matching US$ exposure. Make sense?
As manager of a Commodity Fund we are happy to accept the assumption that future commodity price inflation will be high! However in our mind this does not justify a 0% hedge for all investors in all circumstances for all their international investments - some level of hedging is still likely appropriate.
This argument attempts to hedge future personal expenditure with current investment holdings. This sounds a lot like trying to use an investor’s personal balance sheet to hedge their personal profit and loss statement. This is not a simple calculation to run – i.e. somehow calculate a present value of future expenditure that is sensitive to commodity prices (and the US$) and then match that with the current value of offshore investments. This means that the “right” hedging ratio will be different for each investor – it will be dependent on their individual circumstances - age, income, expenditure levels, NZ vs offshore net assets, stomach for volatility etc. Do advisers relying on this argument for not hedging really go to this level of calculation - or is it more convenient to have everyone go unhedged? We struggle with arguments used to justify “a one size fits all” fully unhedged position for everyone.
Conclusions on currency hedging
Some final thoughts on currency and currency hedging:
1. Don’t apply a “one size fits all” (no hedge) to all investors. If you are concerned about an investor’s “home bias”, “catastrophe risk” or future expenditure exposed to US$ commodity prices then the portfolio response for each investor should be different. It is overly simplistic to use these arguments to justify a 0% hedge for all holdings of every investor in all circumstances.
2. Don’t assume the % of a portfolio held offshore should exactly equal the % of foreign currency exposure. Some level of hedging could be entirely appropriate – treat currency as a separate asset class.
3. Recognise the benefit lost by not hedging. A benefit lost is an economic cost (i.e. an opportunity cost). The 1.5% “forward points” foregone by not hedging is the effective annual cost of protecting against “catastrophe risk” or “home country bias”. Do investors willingly (and knowingly) pay this annual insurance premium?
4. The reality is that we are short of currency hedging tools in NZ. But not having a range of tools to implement currency hedging has no bearing on the question of whether you should currency hedge.
5. Don’t day trade the currency. We see little benefit in frequently trading the NZ dollar – there is real danger in trading daily, weekly and even monthly. Sophisticated and well-resourced hedge funds can get it wrong. Avoid the temptation to impulsively react to short term market moves. You are likely to have more success taking a medium to long term view to hedging.
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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