Welcome to the Manager Panel! Each month, InvestNow will ask a few of our fund managers some questions about a topic. Read below their thoughts on currency-hedged funds, in regards to the November article  — Currency hedging for Kiwi fund investors: The easy way to steer safe in the $2.4 quadrillion tide.

Q1: Why do you offer both hedged and unhedged versions of the same funds?

Historically the case for hedging assets back into NZD was strengthened due to the interest rate differential leading to a significant ‘pick-up’ or ‘carry’ from the FX forward positions used to hedge the portfolios. However, given the ‘carry’ from hedged foreign currency positions has now all but disappeared (though possibly re-emerging?), this benefit is not currently a major driver behind currency hedging.

There are also benefits from being unhedged (i.e., having exposure to foreign currency), in particular it acts as a protection against a significant fall (or even just a general downward trend) in the NZD. We all have ‘liabilities’ in foreign currency, whether it’s fuel we buy, imports, foreign holidays etc. and therefore having some foreign currency exposure makes sense in a diversified portfolio.

Hedged global equities also exhibit higher volatility to unhedged equities. This may sound counterintuitive, but it’s a result of the correlation between the NZD and equity risk. E.g., when there’s a global sell off, typically the NZD falls and so when your underlying equities are falling, you’re also getting losses on your hedging contracts. Conversely when markets are in bull mode, the NZD is often strong and so the hedging can supercharge the returns. Obviously, this correlation isn’t always in place and things bounce around, but over time it leads to higher volatility in hedged equities.

Over the longer term, we don’t expect either a hedged or unhedged portfolio to materially outperform the other. You’d only deviate from this if you believed that you could say that strategically, you can call the overall direction of currency over the next few years, and/or you believe you can time the currency markets and tactically allocate into/out of the unhedged portfolio. We don’t believe we can do that successfully on a repeated basis.

We do however expect hedged and unhedged portfolios to behave differently throughout time, and so having some exposure to each provides a better overall risk adjusted return and avoids some of the wild swings of the two ends of the spectrum. In a growth portfolio for example, global equities form a large portion of the total allocation (often 40% or even more), so if all the exposure was unhedged then 40%+ of the portfolio could be exposed to foreign currency which is likely to be regarded as too much for many investors. And in a more defensive (conservative type) portfolio, the rationale is that hedging provides more certainty (in NZD terms) as it removes some foreign currency risk, whilst leaving a small amount in the portfolio for some beneficial diversification.

In summary, our thoughts are that as part of a diversified portfolio there are good reasons and benefits for having both hedged and unhedged assets.

Q2: Do you believe that all funds, which have currency exposure, should be offered in both the hedged and unhedged forms – if not, why not?

Ideally, it would be great to choose the degree of currency hedging across all sectors in this way. However, the practical considerations are not immaterial, and in particular the cost and complexity of running two structures for every offering that has overseas (or foreign currency assets) in it.

In reality, the affected sectors which are the largest in most people’s portfolios would be global bonds and global equities. On the equity side hedged and unhedged global equity funds are now available. Global bond funds are typically fully hedged, and so if an investor did want some additional foreign currency exposure, they could adjust for this at the overall portfolio level through their split between hedged and unhedged global equities. If having done that, and the investor still believes they have too much NZD risk in their portfolio, then the chances are they have too high an allocation to NZ sectors altogether.

The type of investor who currently has limited options is someone who wants to be solely or predominantly invested in longer duration fixed income securities and have some foreign currency exposure – that’s not a position that’s currently well catered for in the funds management industry in NZ.

Q1: Why do you offer both hedged and unhedged versions of the same funds?

Hedged and unhedged versions of the same funds provide clients with choice and flexibility in implementing their investment strategy. For example, by providing both currency hedged and unhedged global equity funds clients can implement their strategic currency hedged allocation which may rest between 0% and 100% currency hedged, depending on their or their client’s objectives and investment approach.

In addition, the offering of both hedged and unhedged currency versions provides the opportunity to implement a dynamic or tactical currency hedging position around the strategic currency hedged allocation determined above. This provides the opportunity to add value or manage portfolio risk as part of the overall investment process for clients.

Q2: Do you believe that all funds, which have currency exposure, should be offered in both the hedged and unhedged forms – if not, why not?

It is not always appropriate to offer hedged and unhedged currency versions of a fund. From an investment perspective, being 100% currency hedged is most appropriate where currency movements would likely undermine the desired investment strategy of a fund. The prime example of this is global fixed income funds. On this occasion, currency exposure movements have the potential to detract from the defensive characteristics of a global fixed income allocation, often just as these characteristics are needed.

Another example of when only offering a 100% currency hedged version of a fund is appropriate, for similar reasons, would be absolute returned focussed funds e.g. liquid alternatives and absolute multi-asset strategy funds.

In both examples, if wanting to add value from currency exposure it is arguably more efficient, and rewarding, to appoint an underlying manager(s) who can add value through active currency management. In this instance, by keeping a strategic 100% currency hedged position in place at the fund level the value added from active currency management can be captured, rather than being swamped by random currency movements if the strategic currency exposure is unhedged.

Q1: Why do you offer both hedged and unhedged versions of the same funds?

Many of the international equity funds in our range offer both hedged and unhedged versions, to provide investors choice in our offering and allow them to tailor their portfolio with currency hedging decisions that align to their objectives, which we think should be based on their risk appetite rather than driven by prospective returns.

All of our fixed income funds are currency hedged.

Q2: Do you believe that all funds, which have currency exposure, should be offered in both the hedged and unhedged forms – if not, why not?

We believe that the decision to hedge or not should be a long term asset allocation decision, made in accordance with an individual investors objectives, and should be based primarily on risk-related objectives rather than return-related.

Although the Australian dollar has over the long term moved in step with global equities, shorter term timeframes have seen much more variation. However not all investors will be better off by being exposed to currency fluctuations throughout their investment time horizon, so we would suggest that hedging a component of foreign currency over the long term can reduce volatility for an equities portfolio versus moving in and out of currency hedging positions or having a fully hedged or unhedged position.

The hedging decision is more straightforward in fixed interest portfolios which benefit more from being fully or substantially hedged than equity portfolios because bonds typically have lower volatility than shares. Unlike the case for currency exposure within equities, if bonds are left unhedged, currency volatility will significantly add to risk, compromising the defensive characteristics of the underlying bonds.

Q1: Why do you offer both hedged and unhedged versions of the same funds?

It seems that almost every day there is a business article which discusses the New Zealand dollar, commenting on what its fair value is and making predictions of future trends. Currency exchange rates affect everyone in New Zealand, including the globally diversified investor.
All else held constant, as the New Zealand dollar falls in value, assets held in foreign currencies appreciate in New Zealand dollar terms. Conversely, when the New Zealand dollar appreciates, assets held in foreign currencies depreciate in New Zealand dollar terms. To reduce the impact of such fluctuations, investors have the option of hedging their exposure to currency in their overseas investments. By doing so, investors are protected against the downside resulting from New Zealand dollar appreciation, but also forgo the opportunity to benefit from New Zealand dollar depreciation.
In practice it is generally accepted that New Zealand investors should fully hedge the currency exposures of their global fixed interest and global listed infrastructure investments. This is due to the reduction in portfolio volatility that can be achieved from eliminating movements in foreign currencies.
Therefore, we only offer global bond and global listed infrastructure funds that are 100% hedged to the NZ dollar, the Russell Investments Global Fixed Interest and Russell Investments Global Listed Infrastructure NZD Hedged funds.

For other global asset classes, however, there is a diverse range of opinions as to the appropriate hedge ratio (an offshore investment can be unhedged, fully hedged, or partially hedged. The proportion of the investment that is hedged, called the hedge ratio, can be between 0% and 100%).

Russell Investments has conducted extensive research over the last 20 years into this area for New Zealand investors.

After conducting a cost-benefit analysis in today’s environment, considering factors such as the diversification benefits of currency and the impacts of global interest rates, we believe that a 50% hedge ratio is appropriate as a default strategy for investors in other global asset classes, including equities. However, the optimal hedging strategy depends on the objectives of each individual investor. Therefore, we offer unhedged and fully hedged to NZ dollar global shares funds and let the investor or their adviser decide on the appropriate hedge ratio for their circumstances. The hedged ratio can easily be implemented through holding the desired allocation between the unhedged Russell Investments Global Shares and the fully Hedged Global Shares funds.

Q2: Do you believe that all funds, which have currency exposure, should be offered in both the hedged and unhedged forms – if not, why not?

Investors usually buy offshore equities and bonds to gain exposure to the underlying international firm. They include international securities in their portfolio to amplify returns, reduce risk, or both. Because foreign currency effects may distort returns, currency exposures are sometimes perceived as an unintentional and unrequired. Furthermore, the effect of co-mingling the two exposures can fundamentally undermine the characteristics of the underlying return streams of asset classes. This is especially the case for global bond investors, who typically seek to achieve stable and low risk returns and is the reason that they usually fully hedge currency back to the New Zealand dollar. If currency exposure is added, the risk profile of bond funds often substantially increases. If this is the case for bonds, what about equities?

We believe that New Zealand investors who only want exposure to their global shares should be fully hedged. This is based on the view that for these investors, currency exposure is an unwanted extra. By investing in a fully hedged fund, they allow their portfolio to be invested purely in the return streams from that asset class, which can then be used to meet their requirements. Further, our research has shown that investors have historically earned an additional return of 2-3% per annum from hedging. While this ‘hedging premium’ changes through time depending on relative interest rates, its historic persistence indicates that any reduction in the hedge ratio might mean that investors forego some of this return.

However, hedging may not be as attractive to some investors. We consider that there can be investment and behavioural arguments for accepting some exposure to foreign currencies if investors:

• expect the hedging premium to disappear,
• have some liabilities denominated in foreign currencies, and/or
• anticipates that such a position will provide protection during market declines, and therefore expects portfolio diversification will be improved.

Hedging premium

The hedging premium is a direct function of relative interest rates, however rates in the post-COVID world are grim. To combat the economic fallout of the virus, many central banks have cut rates and investors have flocked to low risk assets, pushing yields lower. As a result, even if any interest rate differential between NZ and international countries does re-emerge, it may be very small.

Liabilities in foreign currencies

Financial risk is introduced when an investor’s assets and liabilities are unmatched. If an investor has some liabilities denoted in foreign currencies, currency exposure within their assets may be appropriate. For example, an investor aiming to invest with the goal of purchasing overseas property can invest in assets denominated in the same foreign currency to offset the consequences of currency fluctuations.

Currency as a return diversifier and disaster insurance

Historical evidence and forecast estimates show that portfolio volatility is usually reduced when currency exposure is added. However, the amount of diversification that currency provides varies considerably over time, and it is not always present at times when it might be expected. Having currency exposure was clearly beneficial during the global financial crisis of 2008/9, and during the recent Covid-19 related sell-off. However, during the fourth quarter of 2018, when global equity markets fell sharply, the NZ dollar actually strengthened. As a result, the case for currency exposure necessarily improving portfolio diversification does not always hold.

As a small Pacific economy highly exposed reliant on two economic sectors, Agriculture and tourism, NZD appreciation / depreciation tends to perform in-line with positive / negative performance of the global economy. A portion of a portfolio denominated in foreign currency can serve to diversify and fundamentally reduce portfolio risk.

Current recommendation for global shares.

Given the lack of interest rate differential between New Zealand and foreign markets at present and the diversifying effect of an element of currency exposure, we currently recommend a 50% hedge ratio for global shares. This can be implemented through holding the desired allocation between the unhedged Russell Investments Global Shares and the fully Hedged Global Shares funds.

There are also non-investment reasons why some currency exposure can be accepted by investors (or providers). These reasons are typically driven by behavioural biases. Investors anticipate regret if they make a wrong choice, and they seek to minimise this regret by not fully acting on a decision. Regret aversion may result in a “neither here nor there” type of investment decision. For instance, hedging 50% minimises the expected regret relative to both a fully hedged or a completely unhedged position. Both the upside and the downside are always halved.

The case for global fixed and listed infrastructure remains the same with a fully hedged allocation through the Russell Investment Hedged Global Fixed Interest Fund and the Russell Investment Global Listed – NZD Hedged Fund.

To keep up to date with Russell Investments latest research and products visit www.russellinvestments.com/nz

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