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Aon Retirement and Investment Blog

Currency hedging in New Zealand

Executive Summary

New Zealand investors typically invest on a global basis, using overseas assets to diversify. While this is beneficial, it does expose investors to exchange rate movements.
Investors in New Zealand are well aware that currency movements can have a significant impact on portfolio volatility and can dominate returns at times. It is important therefore to consider tolerance for currency risk when determining the investment strategy for a diversified portfolio.
We believe currency hedging back to New Zealand Dollars (NZD) will reduce portfolio volatility for some asset classes, but may increase volatility for others. Therefore, the appropriate hedging level may vary depending on the asset class. Our view is that investors should consider:

  • Hedging the full currency risk for asset classes with relatively stable underlying values, such as overseas fixed interest or absolute return strategies.
  • A pragmatic approach of hedging half of the currency risk associated with overseas shares.
Why is currency hedging important?

The chart below shows the depreciation or appreciation of the NZD versus two currencies, the US dollar and the UK pound, on an annual basis over the last 20 years. Large movements are common – the NZD appreciated or depreciated by at least 10% versus the US dollar in 10 of the 20 years, and movements of more than 20% are not uncommon. Thus without currency hedging, even those overseas assets which have low volatilities in their home markets may experience significant price movements in NZD terms.
NZD annual appreciation/depreciation

Hedging global bond exposure
For lower volatility asset classes, such as overseas bonds and most absolute return strategies, currency contributes a significant proportion to risk. Therefore, currency hedging considerably reduces volatility. The chart blow shows how the historic volatility of a global bond portfolio varies with the level of hedging. We used data from the end of 1990 to the end of 2016, hedging a global bond index back to NZD.
Global bond volatility across different hedge ratios

As the chart demonstrates, volatility continues to fall as hedging rises towards 100%. Therefore for overseas bonds we support full currency hedging.
The data also shows that for a ‘Balanced’ Portfolio (50% Global Shares and 50% Global Bonds), overall portfolio volatility is reduced if the Global Bond exposure is fully hedged - unless the Global Shares are also fully hedged (see below). Some currency exposure at the portfolio level is desirable from a volatility reduction perspective, but in our view that should come from the Global Shares allocation, rather than Global Bonds.
In New Zealand most global bond funds are fully hedged by the investment manager.
Hedging global shares exposure
Global shares are more volatile than bonds so it would be expected that a lower portion of the overall risk comes from currency than is the case in global bonds. Looking historically, risk reduction is achieved by increasing the level of hedging from zero up to around 40%, but beyond this level volatility starts to increase when currency exposure is reduced.

Global share volatility across different hedge ratios (1997 – 2017)

Over the time period used in this analysis, risk was minimised with a currency hedge ratio of around 40%, but repeating this historical analysis over different time periods shows that this optimal point varies.

Global share volatility across different hedge ratios

The following chart shows the hedging level which would have minimised volatility over rolling 5-year periods with data beginning in 1997. While the minimum volatility level of hedging does average around 40%, it varies significantly. In the lead up to the Global Financial Crisis (GFC), volatility could have been reduced by removing most currency exposure, and hedging also had the added benefit of increasing returns, as the New Zealand dollar was strengthening during the period.
Optimal (minimum volatility) hedging ratio – global shares

However, the optimal hedging level drops significantly during and immediately after the GFC as the New Zealand dollar and share markets moved in the same direction – sharply downwards initially, and then back up.
While volatility reduction is important, some investors, particularly those with long investment horizons, can afford to accept some additional volatility if it means increasing returns. Therefore if additional returns can be achieved through taking active currency decisions this needs to be taken into account when determining the optimal hedging level.
Of course there will be periods when being unhedged will increase returns (when the NZD is falling versus overseas currencies) and other periods where investors will improve returns by being hedged (when the NZD is appreciating). Unfortunately, forecasting currency movements is at least as difficult as, if not more difficult than, forecasting share market movements. Even if overvalued or undervalued currencies can be identified, they often stay overvalued, or undervalued, for a very long time.
So achieving additional investment returns through active currency decisions is very difficult. But additional returns can be reliably achieved through currency hedging by capturing some of the ‘hedging premium’. This premium arises because currency hedging effectively involves investors borrowing cash overseas (where interest rates are typically lower than they are in New Zealand), and investing that cash at a higher rate of interest in a New Zealand Bank account. The hedging premium has varied over time, as the interest rate differential has varied, and is lower today than it has been for some time, but it has persisted for many years. Cross currency basis usually provides an additional return from hedging, compared to looking purely at interest rate differentials.

There may be some additional costs associated with hedging, which also need to be taken into account, but these are typically small. Managers in NZ often offer hedged and unhedged versions of their global share funds for the same fee, allowing investors to select their own hedging ratio. Alternatively, a currency overlay, from a third party, will usually cost only a few basis points.
In order to reduce volatility, both at the asset class level and at the overall portfolio level, we favour some currency exposure within Global Shares. However we also note that a hedging premium exists, and therefore hedging can provide additional returns. We believe that this hedging premium justifies a hedging level in excess of the 40% which has historically been optimal from a risk reduction perspective.
The analysis presented here is backward looking, varies across different time periods, and may not hold in the future. There is therefore no single optimal hedge ratio applicable to all investors at all times. The appropriate hedging decision will depend on investor risk tolerance, and should also take into account the level of overseas exposure in the portfolio. If hedging is implemented through an overlay, then cash flow management may also be a consideration.
As a general rule, we favour a base position of 100% hedged for Global Bonds (and other defensive asset classes) and 50% hedged for Global Shares. This ensures that volatility is minimised where it needs to be (i.e in bond portfolios), but also allows for some currency exposure which should reduce overall portfolio volatility. This strategy also allows investors to capture at least some of the hedging premium. Those investors who believe they can add value through taking active currency positions can increase or decrease the hedging level around the neutral 50% position.

Guy Fisher is an Investment Consultant in Aon Hewitt’s Wellington, New Zealand office.

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs. Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal, tax or investment advice. Please consult with your independent professional for any such advice. The information contained within this blog is given as of the date indicated and does not intend to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information since the date of publication, or any obligation to update or provide amendments after the original publication date. The blog content is intended for professional investors only.

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