Unhedged or Hedged ETFs?

Most Aussie investors building ETF portfolios are aware of home bias. They have a decent allocation to international shares via global ETFs. Within BetterWealth Community Portfolio, International Shares allocation is about 45% of the portfolio.

These investors are faced with the question of whether to hedge their International Shares or not. With more and more hedged ETFs coming to market, it seems like hedging is a good idea. After all, the idea of hedging is to reduce risks. Hedging out currency risk should reduce the risk of our portfolio right? Emmm …. Maybe not for long term investors.

Read about how Hedged ETFs work here.

 

AUD is negatively correlated to International Shares

Portfolio diversification is about reducing risks by holding assets that are negatively correlated. The Aussie dollar (AUD) just happens to be a negatively correlated asset to international shares. In the 20 years to June 2015, the AUD was -0.46 negatively correlated to International Shares (represented by MSCI World Index). This means when International Shares fall in value, the AUD also fall in value. This has the effect of reducing the volatility of Australian portfolios holding International Shares.

This happened in 2015. International Shares (MSCI World ex-Aust Index) dropped by 2.4%. Vanguard’s MSCI World ex-Aust ETF (VGS) gained 9.5% in price. This was mainly caused by a 10% weakening of the AUD vs the USD.

Exchange rates are volatile. The relationship between AUD and International Shares is also volatile. The correlation between the AUD and International Shares have fluctuated over the last 20 years. On a 5 year rolling basis, correlation between the two fluctuated between -0.08 to -0.72. It was narrowing in the years leading up to the GFC, then significantly widened following the GFC towards range of -0.60 to -0.70.

Despite this volatility, the long term relationship between AUD and International Shares looks set to remain negatively correlated. This implies that unhedged positions in International Shares would have lower long term volatility than hedged positions.

 

Hedged ETFs are more volatile than unhedged ETFs

Currency hedging is suppose to reduce risks of an investment. But in the case of USD dominated assets (ie Global ETFs), hedged International Shares ETFs are more risky than their unhedged counterparts (when measured in standard deviation).

If we compare the closing price of four pairs of hedged / unhedged ETFs since inception, we’ll find that the hedged ETFs carry higher standard deviation for each pair.

The chart below shows the % of extra standard deviation (ie extra risk) of the hedged ETFs in each pair.

 

Paying extra for currency hedging

Of course, hedged ETFs have to buy forward FX contracts. This means the funds have higher operating costs. These costs are passed to investors in the form of higher management fees. On average, hedged ETFs carry a 0.03% to 0.06% higher MER than their unhedged counterparts. Whilst this doesn’t sound like a lot, in term of their relative MER, we are talking about an extra 10%+ in fees vs unhedged ETFs.

For cost conscious investors, looking at you lot Bogleheads, this might be meaningful amount to consider. But over 20 years, 0.06% difference in fees will only generate a ~1.1% difference in your final investment balance.

 

USD returns are higher than AUD converted (unhedged) returns

If AUD has been a natural hedged to International Shares, does it mean that unhedged returns is lower than USD returns?

Well, yes. But only slightly.

If Aussie investors held MSCI World Index over 20 years to June 2015, average annual return is 7.28% per year once the assets are converted to AUD.

In USD terms, the MSCI World Index returned 7.66% per year over that period. This means if you hedged out AUD / USD over the 20 years, you would achieve a higher rate of return for your International Shares. After all, if it only costs 0.06% to hedge, you'd still be up ~0.30% per year.

 

Risks and returns in a portfolio context

As long term buy-hold, portfolio theory investors, we know that single asset risk / return isn't the whole story. The question is risk / return in a portfolio context.

There are endless combinations of asset allocations to consider. To make this simple, we compare the risk / return profiles of portfolios holding only Australian Shares and International Shares.

The three scenarios is that Australian equities allocation is 60%, 50%, and 40%. International Shares allocation is either unhedged or hedged - where returns reflect USD index returns. In all three cases, the unhedged portfolio generated lower returns and lower risks (standard deviation). The unhedged portfolios carried a higher Sharpe Ratio - greater returns for every unit of risk.

The same theme is played out if you add Australian bonds allocation to the portfolio.

 

So should you hedge or not hedge?

There doesn’t seem to be a clear call on this. Even Vanguard is sitting on the fence on this one. They suggest you should hedge your bets on hedging. Maybe hold 50% of your international shares hedged, and 50% unhedged they say.

It looks like AUD and International Shares will keep their negative correlation. So unhedged International Shares exposure is likely to have lower risks (standard deviation) in the short and long term.

By the same token, hedged International Shares is likely to drive higher long term returns. This is especially so when cost to hedge is low.

The differences in risks and returns of the alternatives don't seem to be significant. Maybe it comes down to personal preference at the end of the day?

About the Author

jeremykl

Cofounder & CEO of BetterWealth (@jeremykwonglaw). Former investment banker turned technology entrepreneur. muru-D alumni (Telstra startup accelerator). Passionated about leveraging technology to provide better financial products & services to consumers. Coffee snob, business book reader, and fitness fan.

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