That is the question.
What am I talking about? I’m talking about whether or not the offshore investment assets you hold should be insured (or hedged) against a rise in the value of the New Zealand dollar. Your hedging strategy can make a significant difference to your investment returns.
In an unhedged example, say you hold a US investment worth US$100 dollars which over a year goes up in value by 10% to US$110. But at the same time, the NZ dollar v the US dollar also appreciates by 10%. Your effective return in New Zealand dollar terms is zero! In other words the negative change in currency has offset the growth in your investment.
Of course it can go the other way too. In the same example, if the value of the New Zealand dollar depreciates against the US dollar by 10%, then the effective return in New Zealand dollar terms is 20% (10% investment return + 10% currency return)!
In other words, changes in currency can help or hinder the overall returns from your offshore investments, depending on which way the NZ dollar moves v the currency of the offshore investment.
Hedging effectively removes the currency ups and downs by having insurance in place (often via futures contracts) that can be exercised if the New Zealand dollar does indeed increase in value. This effectively takes currency movements out of the equation, so that the returns you get in New Zealand dollar terms are the same as the returns from the investment in its local currency.
Hedging does have a cost. For example, the popular Vanguard International Shares Select Exclusions fund offers a hedged and unhedged option for NZ investors, with management fees of 0.26% and 0.20% respectively. The difference in fee is entirely due to the costs of currency hedging.
So should you aim to have your international investments hedged or not? Opinion in the financial world is divided, but I won’t sit on the fence. For international fixed interest investments, yes. For international equity or property investments, no.
For international fixed interest investments (eg bonds/bond funds), these fall into the defensive part of a portfolio – they are there to provide a steady return with low levels of volatility. You are defeating the defensive purpose of these investments if you layer on currency exposure, and potentially ramping up the volatility significantly.
For international shares and property, I prefer unhedged investments. For a start, you save on the cost of the hedging. Also, in my experience, falls in overseas markets often go hand in hand with a fall in the New Zealand dollar – which helps to offset the negative investment returns. Likewise nasty unexpected geo political events often can see a flight to safe haven currencies (like the US dollar) and a fall in the New Zealand dollar. These movements help the value of your international assets in New Zealand dollar terms.
But the currency factor can, and at times will, go against you. But overall I’m comfortable with accepting a currency risk in the growth area of a portfolio (shares and property).
Finally, when you are looking at NZ$ returns from international investment assets, its always worth asking what proportion of the returns are due to investment performance, and what proportion are due to currency movements (I split this out in performance reports for my managed clients).