The problem arises when cheap Australian dollars are used to buy an international asset and then the dollar goes up sharply, as happened last year.
For example, buying a US stock valued at US $ 20,000 while the Australian dollar is at 65 ¢ will cost A $ 30,769 (20,000 / 0.65). If the stock price rises 10 percent over the next year and the currency remains unchanged, the investment will be worth AU $ 33,846 (22,000 / 0.65).
However, if on the contrary the Australian dollar had appreciated by 20 percent, to 78 ¢, the investment would be worth only 28,205 Australian dollars (22,000 / 0.78). The currency effect more than wiped out the benefits of the rising share price.
Any unhedged international investment purchased in Australia will have underperformed a hedged version by the same amount over the same period.
The way to overcome this potential problem is to “hedge” the currency, which eliminates the impact of currency fluctuations. A hedge acts as a form of insurance, so the return will only reflect the change in the value of the underlying investment.
As an example, VanEck has an exchange-traded fund (ETF) listed in Australia that is based on the MSCI World Quality Index (“quality” is a filter that targets higher growth), which comes in a hedged version. and not covered.
From the trough in global equity markets in March 2020 to the end of April of this year, the hedged version (ASX: QHAL) has risen more than 73%. The uncovered version of the same portfolio only increased by 32 percent. The difference was entirely due to the impact of the rising Australian dollar.
This is because any unhedged international investment purchased in Australia will have underperformed a hedged version by the same amount during the same period.
The opposite can also happen. In 2011, taking advantage of the Australian dollar at US $ 1.10 to buy unhedged international investments provided a multi-year tailwind as the currency gradually retreated towards its long-term trading range.
There are three solutions to deal with the currency effect on a portfolio. First, if the Australian dollar looks cheap, consider buying international investments in a hedged version.
Second, there are ETFs that can act as a kind of insurance cover for an entire portfolio. For example, the BetaShares Strong Australian Dollar Fund (ASX: AUDS) is designed to rise more than 2 percent if the Australian dollar rises 1 percent against the US dollar. Its Strong US Dollar fund does the opposite.
Third, don’t do anything. Research claims that the long-term effects of currency fluctuations are negligible because they tend to hover around the mean. So, those times when the Australian dollar looks cheap just compensates for the times that seem expensive.