To Hedge or Not to Hedge: Global Shares

My last article Looking Beyond Australian Shares looked at the role of global shares alongside Australian shares, which has long been the default option for Australian portfolios. With the benefits of franking credits, strong dividends and a history of good returns, it is not surprising that many investors in Australia are happy holding Australian shares as the lion share of their sharemarket exposure in their portfolios. However, holding them exclusively at the expense of global shares might not be the best strategy going forward.

Out of the Frying Pan into the Fire

One of the arguments made in favour of global shares was that their recent record of 13.69 per cent per annum in the 10 years to the end of February 2023 outperformed Australian shares over the same period, which returned 7.83 per cent pa.

(As an aside, a 10-year return of 7.83 per cent pa in Australians shares over a period that included the COVID-19 downturn and was generally a period of low inflation is not too bad. A sum of $10,000 invested at the start of that period would still have turned into $21,251.)

The argument to consider adding global shares to a portfolio should not be one of returns – it is just as easy to find periods of time where Australian shares have outperformed global shares. It is an argument of diversification – adding exposure to market sectors beyond the financial and material stocks that dominate the Australian sharemarket, accounting for 50 per cent of the market.

Chasing returns, switching from Australian shares because they have performed worse over 10 years, might see you load up on global shares just prior to a period when they underperform. Making a decision to switch on the basis of past performance could easily see you jumping out of the frying pan into the fire.

That said, if you are thinking about building the global holdings in your portfolio, motivated beyond just chasing returns, there are likely to be three readymade options that are easy to access – global shares, hedged global shares and emerging market shares. Most investors are likely to use a managed fund, index fund, ETF (exchange traded fund) or LIC (Listed Investment Company) for global share exposure, although it is increasingly possible to hold overseas shares directly.

The question then is which is the better fit in a portfolio: currency hedged global shares, unhedged global shares or emerging market shares?

Hedged, Unhedged and Emerging

The primary decision that needs to be taken is the question around whether global exposure should be currency hedged or unhedged.

The headline difference between these two options is that an unhedged portfolio is impacted by both overseas returns and currency exposure. For example, if the Australian dollar falls compared to overseas currencies, that will add extra returns to an unhedged global share portfolio. If the Australian dollar rises, that will reduce the returns from an unhedged global share portfolio.

It would almost seem intuitive to favour a hedged portfolio and get rid of challenges from currency movements in portfolio, however, there remain important reasons to favour unhedged over hedged global portfolios.

Costs and Taxes

The first argument is around costs. Usually a hedged fund has a higher cost, as there are costs and complexities associated with the currency hedging in a portfolio. As an example, the Vanguard MSCI Index International Share fund has a cost of 0.18 per cent pa and the hedged version 0.21 per cent. To be fair, neither are expensive, however the unhedged version is a little cheaper and, all else being equal, would be expected to have slightly higher returns.

The second argument is around tax-effectiveness. With a unit price trading between $75 and $85, the Vanguard International (hedged) ETF has had occasionally very large distributions including $6.50 (30 June 2021) and $3.05 (31 Dec 2020). Large distributions tend to create tax obligations. While the unhedged international index fund has more reliably paid distributions, the maximum distribution over the last three years has been an 81c distribution.

The third argument for favouring unhedged over hedged shares is in the diversification effect. In both the GFC (end of 2007 to 2009) downturn, and through periods of the recent COVID downturn Australian shares performed poorly. At the same time, as this chart below shows, the Australian dollar tended to fall, which leads to increased performance for global shares that are not hedged – offsetting some of the falls in Australian shares.

We can see recent evidence of this in the 5-year return for global shares to the end of March 2023. The unhedged fund had a return of 11.11 per cent per annum over this period, whereas the hedged version only had a return of 7.69 per cent per annum. The extra return over the period that included the COVID downturn has an important diversification benefit, while returns from Australian shares were volatile.

Of course, the decision between unhedged or hedged shares does not have to be absolute – and there is certainly an argument for further diversification by including both currency hedged and unhedged global exposure. That said, the lower costs, less likelihood of large distributions and associated tax, and the extra diversification from currency movements suggests that international shares without currency exposure are likely to make sense as the larger portion of global shares.

That brings us to emerging markets.

The returns from holding emerging market shares through an index fund have been poor for some time. Indeed, the 10-year return to the end of March 2023 is a lacklustre 6.15 per cent per annum, lagging both global and Australian shares. The longer-term returns are no more attractive, in fact, going back to 31 December 1997, the MSCI Emerging Markets fund has returned 6.1 per cent per annum.

These returns may make investors cautious, which is no bad thing in itself. However, if the aim is diversification in portfolios, the five largest markets in the emerging market index at the moment are China, Taiwan, India, Korea and Brazil and provide diversification both from the Australian market and large international markets in the MSCI index (US, Japan, UK, France and Canada).

An exposure to emerging markets within the global shares in a portfolio provides another source of risk and return. Despite the poor returns from emerging market shares over time the Future Fund, as an example of a professionally managed portfolio, still chooses to have 5.7 per cent of the portfolio invested in this asset class as at the end of December 2022.

Conclusion

If you are looking to build global share exposure in a portfolio, a key decision is around currency hedging. The arguments for holding global shares without currency hedging include costs, tax-effectiveness and diversification, although some currency hedged global exposure for further diversification is worth considering in a portfolio. The long-term returns from emerging markets shares have been underwhelming, however the diversification argument in portfolios still makes it an asset class worth considering.