Hedging Decisions for Equities

Australian investors commonly look to international equity markets to improve portfolio diversification and expand their investment opportunity set. While investing beyond the Australian coastline offers many benefits, investors often want to know whether they should implement currency hedges to offset the impact of foreign exchange rate changes on their non-domestic stock returns. To help answer this question, we explore how currency movements affect investment outcomes and examine how returns and volatility vary across hedged and unhedged global equity asset allocations.

Our analysis shows that hedging may be useful for investors who are sensitive to short-term changes in currency returns but is unlikely to impact their portfolio returns over the long term.

Shifts in currency values can have positive or negative impact on foreign investment returns. Investors with international investments benefit when their home country denomination depreciates relative to foreign currencies. The opposite is true when the local currency appreciates. As a result, periods in which the Australian dollar weakens provide a boost to investor’s international equity returns, while times that the Australian dollar strengthens will result in negative currency translations.

The appreciation or depreciation of an investor’s home country currency can be expressed as a currency return. Exhibit 1 provides a historical look at annual currency returns from the perspective of an Australian investor who has exposure to four major developed markets currencies, the US dollar (USD), euro (EUR), Japanese yen (JPY), and British pound (GBP). Overall, the realised currency returns across the different developed markets were positive and negative at a similar frequency. As a result, currency returns tended to provide a benefit to Australian investors just as often as they detracted from performance historically.

While currency movements can impact investment returns at shorter investment horizons, there is little evidence that future foreign exchange rates can be reliably predicted.¹ For example, Exhibit 2 illustrates that investors should avoid extrapolating past currency returns given there is not a strong relation between currency returns from one year to the next. Regression analysis on current- and subsequent-year currency returns tells the same story. Exhibit 3 shows the slope coefficients across the current year currency returns are small in magnitude and the t-statistics are between -0.19 and 0.61, which suggests this year’s currency return is not helpful for predicting the currency return one year ahead. In addition, the R² values were close to zero, implying that most of the variation in currency movements is unexplained by the prior year returns. These results highlight that investors should be cautious about making short-term hedging decisions designed to time future currency movements.

Next, we examine the impact of currency hedging on return outcomes for a developed markets equity portfolio. Exhibit 4 shows the average monthly returns of a developed markets equity portfolio with different currency hedge ratios over the full sample period. The hedge ratio is the percentage of the portfolio’s value that is hedged, with HR=0% representing an unhedged portfolio and HR=100% representing a fully hedged portfolio.

Overall, the average monthly returns for unhedged, partially hedged and fully hedged developed markets equity portfolios tend to be similar, ranging between 0.96% and 0.98% per month. The implication for investors is that currency movements are not expected to be a driver of returns over the long term. However, for investors who are sensitive to the short-term changes in currency returns, hedging part or all of their portfolio back to the currency in which they consume may help reduce exchange rate risk.

Hedging can reduce uncertainty around currency returns, but the impact on overall portfolio volatility depends on the magnitude of asset volatility relative to currency volatility. Equities tend to be more volatile than currencies (Dai and Schneller, 2020); therefore, the volatility of an unhedged global equity portfolio is generally dominated by the underlying equity volatility rather than the currency movements. As a result, unhedged and hedged equity portfolios tend to have similar volatility characteristics.

Exhibit 4 shows the annualised standard deviation across different hedging ratios. The volatility is similar whether an investor is fully hedged, partially hedged or unhedged across developed markets equities. For equity portfolios, hedging currency exposure is not an effective way to reduce volatility.

As shown, there is little evidence showing that future exchange rate movements can be predicted to help inform hedging decisions. The lack of predictability suggests that investors should be cautious about making tactical hedging decisions based on the past or forecasted performance of the Australian dollar.

Similarly, the decision to hedge or not hedge should not be based on the goal of reducing equity volatility. Unhedged and hedged equity portfolios tend to have similar volatility.

For investors sensitive to short-term currency movements, hedging part or all of their portfolio back to the currency in which they consume may be an effective way to reduce exchange rate risk. Depending on their individual goals and objectives, some investors may want to consider hedging a portion of their portfolio and leaving the other portion unhedged.