Unhedged outperforms. Hedged outperforms -40%

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1 Realinsight Currency hedging for international equity portfolios November 2014 With recent volatility in the value of the Australian dollar (AUD), investor attention is again drawn to the topic of currency hedging. This Realinsight looks at the impact of currency on international equity investments and discuss some of the factors that influence the decision to hedge currency exposure. We will examine two practical considerations that managers face when evaluating the performance of a currency hedge. The impact of currency risk Currency risk is typically a significant proportion of the total risk of an unhedged international equity portfolio which can have a large impact on returns over specific time periods. For example, over the 12 months to February 2009, unhedged investors were ~2 better off than their hedged counterparts, while over the 12 months to March 2010 they were ~4 worse off (Chart 1). Over the long term, the difference between hedged and unhedged returns is less dramatic because currencies have a tendency to fluctuate around a long-term average. However, hedged investors have been better off by an average of 1.2% 1 per annum over the 26 years since The hedged portfolio has had the added benefit of lower volatility (on average) than the unhedged (14. vs 14.8%). Chart 1: Rolling 12mth difference between hedged and unhedged MSCI All Country World Index (ACWI) Hedged outperforms -4 Chart 2: Rolling 12mth volatility of MSCI ACWI (hedged and unhedged) Unhedged outperforms 4 35% Unhedged volatility lower than hedged volatility 3 25% 2 15% 5% Unhedged (AUD) equity volatility Currency hedged equity volatility 1 Ignoring hedging and carry costs 1

2 Currency Risk (%) Total Risk Currency Risk Total Risk Correlation Volatility Realindex Investments The relationship between currency and equity returns In the aftermath of the Global Financial Crisis, the volatility of a currency-hedged ACWI portfolio rose above that of an AUD unhedged ACWI portfolio; an unusual situation that persisted until mid-2013 (Chart 2). In other words, it became more risky for an investor to hedge their AUD currency exposure than to not hedge during this period. This somewhat counter-intuitive phenomenon was the result of a significant increase in correlation between the AUD currency basket and international equity returns as shown in Chart 3). During this period the currency exposure of an AUD ACWI equity portfolio became a diversifying position. From a total risk perspective it was hard to justify hedging currency risk during this period because it increased overall risk. However correlations have now returned to more normal levels and hedged volatility has again dropped below unhedged on a trailing 12 month measure. One thing this event clearly illustrates is that relationships between financial assets are not guaranteed to remain stable and any assumptions that are made as part of the investment process need to be monitored. Chart 3: Correlation of AUD/international currency basket with international equity performance % 2 15% 5% -0.4 Optimal currency hedge ratios Correlation (LHS) To illustrate the impact of this correlation change we calculate the optimal currency hedge ratio for an investor trying to minimise the total volatility of their global equity portfolio by adjusting the currency hedge (Chart 4). The grey lines in this chart show the total risk of equity and currency combined, while the light blue line shows the currency risk in isolation. The optimal total-risk hedge level will be the lowest point on the grey line. We see that in June 2012 the optimal total-risk position was to leave AUD exposure completely unhedged, while the current optimal position is to be ~5 hedged. A hedge level of 5 implies that half of the total currency exposure is hedged. Of course if your objective is to eliminate as much currency risk as possible then the optimal choice is always to be fully hedged, regardless of total portfolio volatility. Chart 4: Impact of currency correlation on combined equity and currency volatility Currency volatility (RHS) Optimal Hedge Ratio June Hedge Level (%) Optimal Hedge Ratio October Hedge Ratio (%) Currency Risk (LHS) Total Risk (RHS) 2

3 Realindex Investments Hedging returns cost of carry Some investors may not be aware that there is a return associated with a currency hedge that is independent of currency and market movements. This return is the cost of carry which reflects interest rate differential between the base currency and foreign currency exposures which are being hedged; it is priced into the currency forward points. A currency hedge effectively earns the domestic interest rate and pays the foreign rate; for AUD investors this has historically provided a benefit, as illustrated in Chart 5. This benefit would reduce if, for example, US interest rates were to rise while AUD rates remain on hold. You will notice there is variability in the hedging return, which means that it is not risk free, however the variation in forward returns is typically much lower than the variation in the currency returns which are being hedged. Chart 5: Monthly return from an international currency hedge to AUD 0.5% 0.4% ZAR USD TWD TRY THB SGD SEK RUB QAR PLN PKR PHP 0.3% PEN NZD NOK MYR MXN MAD 0.2% KRW JPY JOD INR ILS IDR 0.1% HUF HKD GBP EUR EGP DKK 0. CZK COP CLP CHF CAD BRL -0.1% ARS AED Why hedge currency exposure So does it make sense to hedge currency exposure? There are several reasons investors might want to consider currency hedging, including: 1. Prior to 2008, hedging currency exposure reduced the total volatility of an AUD based international equity portfolio. Now that correlations have returned to more historically normal levels this may be the case again going forward (though of course this is not guaranteed). 2. If a view is held on the AUD, this can be reflected in the level of currency hedge. If there is no view on the currency then arguably it is unwise to take exposure to a source of risk from which you have no expectation of return and therefore we would argue that currency hedging should be considered in this scenario too. 3. Historically there has been a carry benefit to hedging the AUD due to the prevailing interest rates. As long as interest rates in Australia are higher than the weighted average rates of international markets, then this may remain the case. Measuring hedge performance The relevant metric for evaluating currency hedge performance depends to some degree on the purpose of the hedge. If the intention is to protect the value of your portfolio against a move in the AUD then the appropriate measure will be hedged vs unhedged return over the period (compared to the currency exposure return over the same period). If the aim was to neutralise currency volatility then the acid test will be the volatility of any residual currency returns. Ultimately most managers compare themselves against a published hedged benchmark as an objective measure. As with all published benchmarks there are built-in assumptions that need to be understood. The global index vendors provide hedged versions of their equity benchmarks, but what if a portfolio has large active currency exposure compared to the published benchmark? At Realindex we address this by calculating an adjusted theoretical hedged benchmark that reflects the active currency exposures we are taking. There may be other intentional reasons that our hedge performance will deviate from this theoretical benchmark, so this approach allows us to separate the active currency allocation effect from these other effects. The magnitude of the difference will of course depend on the size of the active currency bets that portfolio takes, and also the currency volatility. 3

4 Net exposure (%) Gross exposure (%) Realindex Investments Chart 6 below illustrates the monthly hedge return adjustment for the Global Fundamental Index portfolio. Chart6: Monthly hedge contribution from Fundamental Index active currency positions 0.4% 0.3% 0.2% 0.1% % -0.2% -0.3% -0.4% Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Frequency of hedging Most global benchmarks assume that the currency hedge is rebalanced on a monthly basis. There are practical reasons for this assumption, however hedging on a monthly basis will not eliminate all currency risk. This is because currency exposures can vary during the month due to market movements. In other words, the currency amounts hedged at the start of the month will not correspond exactly to the foreign currency exposures at the end of the month. If markets move down, the portfolio will be overhedged; if markets move up the portfolio will be under-hedged. Even if the total portfolio value is unchanged, the relative proportions of currency exposures may have changed since the hedge was set. Chart 7 shows the residual currency exposures that can occur in between monthly hedge rebalancing for an MSCI ACWI portfolio. In times of extreme market volatility, large intra-month currency exposures can result. Chart 7: Intra-month currency exposures when hedging monthly Over hedged Under hedged An obvious solution to this problem is to hedge more frequently, however there is a trade-off; increased frequency of hedging is more operationally intensive and incurs higher cost. At Realindex we employ a threshold approach, hedging currency exposures intra-month as they breach thresholds. Specifying thresholds allows control over the trade-off between cost and currency risk. A side-effect of hedging more frequently than the benchmark is that hedge returns will deviate from benchmark returns. From a performance measurement perspective, this effect also needs to be understood and attributed when comparing performance against a published benchmark. 4

5 Realindex Investments Summary At Realindex we always encourage investors to take a long-term view on their investment. If an investor holds a long term view on the AUD then it is a sensible to implement a hedging strategy that reflects that view (be it hedged or unhedged), and stick to it. If no view is held on the currency, then there are still very valid reasons to consider hedging currency exposure. In either case, it is important to ensure that any performance benchmark is aligned with the strategic hedging decision, and that the risk and cost implications of this decision are fully considered. For further information Realindex Investments Pty Limited Realindex-ClientServices@cba.com.au Investment Analyst Business Development Associate Iain McLear Sanja Popovic For further information please contact: Head of Sales Head of Institutional Client Relationships Harry Moore Peter Weldon Business Development Melbourne Institutional Relationship Management Peter Heine Daniel Bristow Rose Lor-Kershaw Business Development Sydney Hazuki Nojiri-Kenny Jeannene O'Day Ross Crocker Head of Wholesale New Zealand Hugh O Neill Matthew Laing Bachar Beaini Edward Tighe Disclaimer Product Disclosure Statements (PDS) and Information Memoranda (IM) for the funds issued by Colonial First State Investments Limited ABN (CFS) are available from Colonial First State Global Asset Management. Investors should consider the relevant PDS or IM before making an investment decision. Past performance should not be taken as an indication of future performance. No part of this material may be reproduced or transmitted in any form or by any means without the prior written consent of Realindex Investments Pty Limited ABN AFSL (Realindex). This material contains or is based upon information that we believe to be accurate and reliable. While every effort has been made to ensure its accuracy none of CFS or Realindex offers any warranty that it contains no factual errors. We would like to be told of any such errors in order to correct them. This material has been prepared for the general information of clients and professional associates of CFS and Realindex. You should not rely on the contents. To the fullest extent allowed by law, CFS and Realindex exclude all liability (whether arising in contract, from negligence or otherwise) in respect of all and each part of the material, including without limitation, any errors or omissions. This material is intended only to provide a summary of the subject matter covered. It does not purport to be comprehensive or to render specific advice. It is not an offer document, and does not constitute a recommendation of any securities offered by any of CFS or Realindex. No person should act on the basis of any matter contained in this material without obtaining specific professional advice. Colonial First State Global Asset Management is the consolidated asset management division of the Commonwealth Bank of Australia ABN Copyright Colonial First State Group Limited 2014 All rights reserved. 5