International International Shares - Hedged vs Unhedged?

Hi gang,

Too much time on my hands which is a dangerous thing so I decided to think about this topic especially from a “behavioural” perspective especially when one is nearing or in the earlier stages of retirement.

I’ll use AUD / USD as an example in the following. So assume an investor who decides to invest a significant part of their portfolio in unhedged US S&P 500 (@oracle ).

Personally I’ve favoured Unhedged International Shares mostly as a risk management strategy against a major long duration negative shock which is confined to Australia. That is, Home country risk. I suppose a Japan type scenario which is the favourite often used when discussing this subject. Not that I’m suggesting this would happen but managing risk is in part about looking at possible outcomes and the cost of insurance. Also fortunately our International holdings are surplus to our needs so hedging isn’t as much of a concern. Most may not be so fortunate though so I thought this might be an interesting topic for investors in general especially seeing holding unhedged international equities seems to be the favoured approach by forum members.

Hedging over the long term is generally considered a wash and tax efficient. It’s also noticeably less correlated compared to Hedged and given AUD is often considered a risk on currency this can be valuable is lessening the pain when the market tanks.

BUT now to BEHAVIORAL considerations if an investor is unlucky enough to RETIRE around 2001 and had significant UNHEDGED exposure to US Equities (becoming more popular nowadays with easy and cheap access to global equities):

AUD / USD Chart:


Ok now try to pretend this was you in the same scenario. How would you feel during the first 10 years of retirement and even now when the AUD is still well above where it was 17 years ago? Would you have stayed the course? Some will say the ASX did well during part of this time but it’s potentially likely that every time you look at your portfolio you won’t notice your Australian shares, attention will be firmly focused on your US holding will possible deep regret!

It’s often mentioned that 50 / 50 (Hedged / unhedged) exposure to International Shares is the position of least regret. From memory I recall some research suggesteding that 50 / 50 provides 80% of the benefit of a fully hedged portfolio but obviously with the advantage of the unhedged component. Would the retiree in the above example be wishing they’d chosen the path of least regret?

I’d love to hear others views and hopefully @dunno and @The Falcon being the deep thinkers will be kind enough to respond also.

 

Oops just noticed a typo:

I meant to say “unhedged” is more tax efficient ... .

 

I don't see how this is a behavioural problem. If you retired in 2000 with an all world unhedged portfolio, by the end of those 10 years, your money has effectively halved, actually more due to drawdowns, and you are continuing to drawdown at a high percent (think 8% vs 4%) so it is also being eaten up at a very high rate. This is worse than the GFC in terms of SOR risk. That's not a behavioural problem, that's a "I'm going to end up destitute" problem.

 

So Vanguard has data on its unhedged fund (est 1997) and hedged fund (est 2000). I dont have access at the moment to run them both from 2000, but as expected the total return is similar, 6.32% vs 5.83% pa.

 

LOL, you’ve got a way with words.

I haven’t done the analysis but one would need to look at the performance of the overall portfolio including the excellent performance of the ASX in part due to the mining boom and cash / term deposit / bond interest rates at the time. Diversification matters especially for those taking a Total Return approach.

But regardless investors have a tendency to focus on the bad area of the portfolio.

The aim of my post was to get others thinking about this and although currency might be a wash in the long term the wait can be a long one, sometimes very long. And for some retirees such lengths of time are not tolerable.

I suppose as mentioned elsewhere there’s a lot to be said about the “path of least regret” when formulating ones investment plan!

I find this area interesting and was hoping a few others might also. But I’m certainly no expert on currency matters hence why I’m looking forward to hearing other’s views.

 

Please explain?

Yours sincerely
Nodrog Hanson

 

Did this person convert all of their AUD to USD at 0.50 or had they been doing so for a long period of time perhaps? Step back a few years and this person has enjoyed the weakening AUD by remaining unhedged. Long term performance (per Vanguard numbers) there isnt much in it. The other thing I think is that "International" contains stuff with earnings in a bunch of currencies, not only USD.

 

Thanks mate, great points.

I suppose many retirees just look at what they’re worth when they retire regardless of how they got there. They may have had a good run leading up to retirement when the AUD hit 50 cents. But were they prepared for the 10 years that followed? There’s reversion to the mean but gee it can be painful getting there.

Looking at the similar comparative long term performance of hedged vs unhedged doesn’t take into account the journey along the way and what the investor is experiencing. Back to the good old behavioural aspect of investing being one of the most critical factors with success.

In fact I remember that period well. My wife accepted a role in Prague with the contract having her paid in US dollars around that time. We had significant property debt back in Australia. The severe hit to her income in AUD value as the currency nose dived and our liabilities in AUD played a major role in returning to Australia much sooner than planned. We knew bugger all about currency at the time and never expected the dollar to reach as low as 50 cents. Oh if only we had hedged.

But for the majority of retirees it would appear that when it comes to risk it’s not so much about hedged vs unhedged equities etc but the split between risk vs risk free (or as close as possible) assets that is likely to save ones ar*e. Very easy to forget though in an aging bull market!

 

https://personal.vanguard.com/pdf/ISGPCH.pdf

Not sure how useful this is though. They seem to be discussing 3 year rolling periods, which I am not sure helps with this situation:

 

Yes I read that recently but embarrassingly had forgotten about it already. Senility setting in. So thanks for posting.

Most reports / studies I’ve seen recommend unhedged International “equity” exposure for Australia and Canada. However some recommend partial hedging if there is large exposure.

But as usual there’s sometimes qualifiers as to whether the investor is in accumulation / decumulation and behavioural issues etc. For example this concluding comment after the Australian section of Vanguard’s report:

Hence why I focused on the behavioural aspect when starting this thread. All the studies under the sun won’t make any difference if worrying about the currency impacts your sleep at night factor!

 

I am 100% equities: 50 / 50 (Aus / Global): 100% unhinged (sic) unhedged

 

Two things I see regularly in relation to hedging debate is 1) over the long term hedged vs unhedged is a wash and 2) being unhedged provides you home country risk insurance.

To me the two beleifs are contradictory.

If you are invested in another currency and that country does better economically over the long term than your home country, then you will get a long-term currency return and vice versa.

In our country the wash theory seems to come from comparing US to Australia over the long term. But both Australia and US have had similar GDP growth per capita on a purchasing power parity basis over the long run. That is the underlying reason why their currencies have been similar over the long run. If the economic performance varies over the long run so will the currency outcome.

 

Thanks @dunno even though you might not think so at times I do always look forward to your posts. Often you give us so much to chew on and challenge our thinking. And for a old fart like me set in his ways this can be hard to accept at times which sometimes elicits a silly and less than mature response. But as your message / analysis sinks in I get to appreciate how valuable it is. I do aim to improve but poor personality traits are hard to control at times. So thanks for putting up with me.

Back to topic.

Yes interesting thoughts. As mentioned earlier unhedged International equities is first and foremost about home country risk for us. As for being a wash I suppose it might also depend on one’s timeframe.

Looking at Super / Pension / Diversified Managed Funds and professional advisors etc it appears that the majority tend to favour some degree of hedging against international equities. Often they have a baseline of 50 / 50 and adjust up or down from there within set bands. Others just take a passive approach whether it be 50 / 50 or whatever. Typically there is generally some partial hedging in place.

It’s also common to favour unhedged global equities for those in accumulation but hedged (fully / partially) for retirees, especially those who rely on most / all their investments to fund retirement.

But for us who favour a high allocation to equities the insurance that unhedged provides is highly valued.

 

hedging should be based on the value/your outlook of the dollar against the currency you are hedging.

For me, you would only hedge when the dollar is below a certain level, and never ever around $1 etc. To me it is not something that is constantly done or a set and forget type scenario.

 

Hedging is a difficult subject because what’s best differs from circumstance to circumstance.

To me hedging is never a wash. It’s a diversification issue, along the lines of do you want to be in 1 stock or do you want to be in a basket of stocks. 1 stock will win or lose vs the basket – drawing is a low probability. The likely outcome of the basket is a lot more dependable than the outcome of the individual stock. Do you want to be exposed to 1 currency (typically your home country) or do you want to be exposed to a basket of currencies?

If you want 50/50 currency exposure, and you hold half of your assets offshore you do not need hedging to achieve the 50/50 currency exposure.

If you want 50/50 currency exposure and you hold 80% of assets offshore than it would make sense to use hedging to bring the 80% exposure back to 50% currency exposure.

Sequence of return risk also plays into hedging. You do not want your volatility dampers (bonds etc) exposed to short term currency volatility. If you are close to the line on capital adequacy to fund retirement, you probably also need to consider hedging equity to dampen short term currency – but in saying that unhedged is sometimes less volatile especially if the home currency is a commodity exposed currency like Australia.

 

If people start to default on mortgages against our expensive residential housing, the Australian dollar is overvalued. If India starts to industrialise then the Australian dollar is undervalued. If somebody in Aus makes a significant resource find we are undervalued, If our politicians have a brain fart we are overvalued, If technological disruption keeps getting imported from other countries we are overvalued. blah blah blah…

If you could just let me know the date and causes of all the important macro events in advance – I’ll arrange the dynamic hedging


- thanks

 

For my portfolio I find it a simple proposition. I am investing internationally to diversify my portfolio outside of Australia. Hedging reduces the benefit of that diversification.

All unhedged for me.

 

Max 50% offshore unhedged sounds like a good rule of thumb.

If someone was near or at retirement/drawdown, would you decrease it further from 50% offshore currency exposure? Maybe to somewhere around 30-40%

 

Uummm, if I was to hedge it would likely be more passive in nature. Dynamic hedging is considered by some as pure speculation rather than a hedging strategy.

To say that if the AUD is below a certain level then I’ll hedge removes some / all the invaluable insurance unhedged equities provide. Imagine if the AUD got back down to 50 cents in which case it would be tempting to fully hedge. BUT what if it keeps going down down down and stays down for a couple of decades? Japan might be considered an extreme example when their market crashed but had an investor there held a decent allocation of “unhedged” international equities the pain over the last two decades would likely to have been significantly less.

I’m very much a novice though when it comes to currency. However it was reading about the history of markets and risk management that really drove home the huge value unhedged international equities play in managing home country risk.

That said I can see why some, retirees in particular given specific circumstances, might want to “partially” hedge their International equity exposure. It’s easy to see why 50 / 50 as the position of least regret might appeal to some.

I think International Bonds have been mentioned. I’ve rarely seen it suggested that international bonds should be unhedged for an investor. Speculators will of course try their luck.

This excellent small booklet (costs peanuts, $5.25 for kindle edn) by Bill Bernstein is useful in understanding some of the risk management issues investors face and in part how an unhedged internationally diversified equities portfolio can provide valuable protection:

https://www.amazon.com.au/Deep-Risk...537232855&sr=1-1&keywords=Deep+risk+Bernstein

This article by Ben Carlson is also useful:

Deep Risk Under President Trump

 

Generally it’s suggested accumulators favour unhedged and retirees depending on their circumstances consider hedging (partially / fully).

Hence if one did feel the need for hedging it would likely increase in retirement rather than decrease.