What is Currency Risk?
You might have experienced a form of currency risk when travelling overseas. If the Australian dollar (AUD) drops in value relative to the local currency, when you exchange your Aussie dollars you get less of the local currency.
In a similar fashion you’ll also be exposed to currency risk if you invest in share markets outside of Australia, either buying international shares directly or through an exchange-traded fund (ETF), or indirectly via your superannuation fund or other managed funds.
For example, the price of ASX-listed international ETFs is quoted in Australian dollars (AUD). But the underlying investments in the fund, such as US shares, can be traded in another currency.
Exchange rate movements will affect the value of your investments which could have a positive or negative impact on your overall investment returns.
First, what is Currency Hedging?
Currency hedging reduces the impact of exchange rate fluctuations on your investments traded in another currency, such as the US dollar (USD). It’s used all the time by investors and businesses with significant cash and investments in a foreign currency.
Think of hedging as an insurance policy against the impact of foreign exchange risk.
How Does Hedging Work Then?
Let’s keep it simple…
Imagine you if bought A$10,000 worth of an ASX-listed ETF that tracks a US share market index (e.g. iShares S&P500), and assume the US dollar was worth the same as the Australian dollar (A$1 = US$1), you would get US$10,000 worth of units (ignoring brokerage fees).
If the Australian dollar strengthens (USD weakens) to be worth AUD/USD $1.20 by the time you sell your investment, you will only get back A$8,333, assuming no change in the value of the underlying fund holdings.
If the Australian dollar weakens (USD strengthens) to be worth AUD/USD $0.80 by the time you sell your investment, you’d get back $12,500, assuming no change to the value of the underlying fund holdings.
You will also be exposed to exchange rate movements if you invest directly in international shares or in individual Australian companies that derive a lot of their earnings from overseas, like BHP and Rio Tinto for example.
NOTE: A good rule of thumb when unhedged is to remember that a falling $AUD is generally good for your international holdings, and a rising $AUD is generally not so good.
Hedged or Unhedged?
There’s no doubt, investing in international shares is a great way to diversify your investment portfolio. Managed funds and exchange-traded funds (ETFs) present investors with straightforward ways to access overseas markets. But with this diversification comes decisions and challenges. One of the more complex and difficult risks to manage is the impact currencies may have on your returns.
To alleviate currency risk, some ASX-listed international ETFs and super funds with heavy exposure to international shares are ‘hedged’ on your behalf. Other times it is up to you.
Ultimately, to hedge or not to hedge depends on your risk profile and your situation and what you’re currently invested in.
If you are overexposed to a rising $AUD, then it might be worth hedging your portfolio. Otherwise, it is healthy to have exposure to the US dollar and other foreign currencies in the name of diversification.
To find out more about your currency risk, feel free to speak with one of our Advisers.
Call us on 1300 242 700 or visit our website at www.muirfieldfs.com.au to find out more.
If you’d like to discuss your investment needs further, we encourage you to call out qualified financial planning team on (03) 5224 2700.