Currency hedging for SMSFs

How does hedging work?

Currency hedging is like a type of insurance to reduce the risk of adverse currency fluctuations on your international investment returns.

If you are investing via a managed fund or exchange-traded fund (ETF), the fund may have hedged and unhedged versions of the same underlying investment portfolio. The difference in the hedged version is that the fund manager has hedged currency risk by entering into forward foreign exchange contracts (or similar instruments) with a third party, enabling the buyer to set an exchange rate at a certain price for a certain period. The cost of these hedging instruments means hedged funds tend to have slightly higher fees than the unhedged equivalent.

What impact do currency movements have on returns?

A simple example can help illustrate the impact of currency on investment returns. Say you purchase shares in US-listed Company B for a total of US$100 when the exchange rate is US75c for one Australian dollar. In Aussie dollars, the purchase will cost you A$133.

As you can see from Scenario 1 in the table below, an appreciating Australian dollar – for example, when the amount one Aussie dollar buys increases from US75c to US80c – will have an adverse impact on a US dollar investment when it is converted to Australian dollars. In this case, your original $133 investment is now valued at $125.

If the currency depreciates, it will have the reverse effect. In Scenario 2, the exchange rate falls from US80c in the dollar to US70c, and your investment increases in value to $143.

Scenarios 3, 4 and 5 show the different outcomes of exchange rate fluctuations on the value of a US-based company when its shares increase in value by $10. In Australian dollar terms, there is a difference of nearly $20 depending on which direction the currency moves.

The asset sector performance table from Chant West (below) highlights the differences in outcomes for a portfolio of international shares depending on whether they were hedged.

“Hedging is about managing foreign currency conversion (back to Australian dollars) risk and its importance/benefit won’t be obvious from simply looking at the table below,” Chant West senior investment research manager Mano Mohankumar says.

“As an example, during periods where the Australian dollar appreciates, the return for international shares hedged would be higher than that of international shares unhedged.”

As the Australian dollar has been depreciating of late, returns for unhedged shares are greater than for hedged shares.

International shares performance (results to August 2023)

Source: Chant West

“It is also worth noting that [large] super funds generally look at foreign currency exposure at the overall investment option level (that is, it is part of the asset allocation decision)” Mohankumar said.

Gaining exposure to international assets

The vast range of international exchange traded funds (ETFs) now available to Australian investors, and listed on local exchanges, makes it much easier and cheaper to gain exposure to global equities than it was in the past.

SMSF trustees no longer need to rely on expensive managed funds on a platform for international exposure and can choose from hundreds of ETFs that offer access to a variety of global sectors, countries and themes. Below is a table of eight broad global ETFs available on the Australian Securities Exchange (ASX), two of which have hedged options.

You will notice that where there is a hedged and unhedged version of the same underlying investments, the hedged version has a slightly higher fee.

To hedge or not to hedge?

Choosing whether to hedge an international exposure means you need to take a view on the currency as well as on the investments in your portfolio. This adds an extra layer of complexity to any investment decision.

Generally, currencies are linked to interest rate movements. If a country’s central bank raises rates, its currency is likely to appreciate, as global investors follow the higher yield. If it lowers its rates, the reverse occurs.

But there are many other factors driving currency movements around the world, including general economic sentiment.

If we look to the professional investors as a guide, Australia’s large super funds, on average, do not hedge their international equity exposure.

According to the June 2023 Australian Prudential Regulation Authority (APRA) quarterly statistical data (for super funds of more than four members), of the $631.99 billion invested in international equities, just $164.677 billion, or 26% was hedged. That percentage of hedging has remained relatively constant over the past three years but it’s difficult to say whether that reflects the long-term nature of super, the outlook for the Australian dollar, or a combination of both.

As an SMSF trustee, you need to include any decisions you make about currency in your fund’s investment strategy. You should also consider including an explanation of why, or why not, you decided to hedge any international exposure.

The bottom line

When it comes to global investments, it’s important to consider the impact currency fluctuations may have on your returns. If you would prefer to eliminate currency risk and sleep a little easier, then a hedged investment product might be appropriate.

Some investors take a bet each way, by splitting their international allocations between hedged and unhedged versions of investment options. This helps protect a portfolio from the potential detrimental effect of an adverse movement in foreign exchange rates, while also enabling their SMSF to benefit if the currency moves in a favourable direction.