I learned some painful investment lessons in the 1990s. Convinced US equities would outperform Australian equities, I invested in several international equity funds offered by my employer at the time, a star investment bank.
The first lesson was about investing based on past performance. I chose funds that had delivered years of stellar returns, not realising I was buying at the top. As often happens, the active manager couldn’t sustain that performance.
The second lesson was about currencies. The Australian dollar rallied against the US dollar for a few years, reducing the value of my US investments when converted to our dollar. Currency movements became a huge headwind for my portfolio.
I suffered a triple-whammy of problems: an underlying asset class that at the time was underperforming; adverse currency movements; and an asset manager that lost its mojo and underperformed its peers. Suffice it to say, the value of my international equity funds shrunk, and I eventually sold, incurring losses.
The lesson that sticks with me today is the importance of currency hedging for long-term investors with global asset exposure.
There are, of course, different views on this issue and currency hedging has pros and cons. My main argument for currency hedging is that unhedged global funds require investors to have a view on the underlying asset, and the currency.
It’s hard enough trying to pick the right underlying global asset, let alone having to forecast currency directions. Long-term forecasting of currencies is a mug’s game because currencies are affected by many factors.
In my opinion, long-term investors are better off eliminating currency risk by using hedged Exchange Traded Funds (ETF) in the portfolio core, even if their fees are a little higher due to hedging costs.
Yes, returns from global funds can be supercharged when the underlying asset and the currency both move in the right direction. The iShares Core S&P 500 ETF (unhedged) (ASX: IVV) has returned 33% over the year to end-October 2023.
But losses can be magnified when the underlying asset and currency (for unhedged ETFs) move in the wrong direction. With US large-cap equities making record highs and the US dollar rallying after Trump’s win in the US Presidential election, hedging US equities exposure where possible makes sense.
Currency considerations
Currency changes have rapidly become a bigger consideration for Australian investors with global investments since the US election. The widely watched ICE US Dollar Index, which tracks the US dollar against a basket of major currencies, is up about 6% in November, in a remarkable rally for the Greenback.
Chart 1: ICE US Dollar Index
Source: CNBC
Markets expect Trump’s proposed policies, such as tax cuts, deregulation and faster project approval times, could stimulate US economic growth. Sharply higher tariffs, if they happen, could lead to higher prices in the US.
The upshot is more capital returning to the US and greater investor confidence and risk appetite, which would support the US dollar. And also, potentially higher inflation and higher rates for longer, again supporting the Greenback.
I’m not convinced Trump’s policies will be as inflationary as the market expects. With Trump, it pays to focus on what he does, not just what he says. In true deal-making, he engages in a lot of ‘jawboning’ and tough talk to get a better deal in negotiations, be it with China or on European security matters.
The implementation of sharply higher tariffs would face several legal and political hurdles, not to mention significant resistance from some US trading partners. Tariffs will rise, but I suspect middle ground between sanity and lunacy in the US will be found, to avoid a new inflation breakout.
So, too, with mass deportation of illegal US immigrants. That could also be inflationary if it disrupts the US labour market, reduces labour supply and leads to higher input costs that are passed on to US consumers. If that happens, mass deportations will face enormous resistance and legal challenges.
To summarise, I expect the US dollar rally to continue over the next months. It might lose some steam in the next few weeks after the initial market reaction to Trump’s win, but his inauguration in late January and more updates on his intended policy reforms should stoke further risk appetite and a higher US dollar.
Over the next 12 months, however, expect higher US dollar volatility and possibly falls as it becomes clear Trump’s policies are not as inflationary as initially expected, and the US Federal Reserve continues to cut US rates.
Traders and active investors who want to back their short-term view on the US dollar rally to continue over the next few months could consider the US Dollar ETF (ASX: USD). The currency ETF aims to track the performance of the US dollar against the Australian dollar, before fees and expenses.
The USD ETF is designed to rise if the US dollar rises against the Australian dollar, and vice versa. A 10% increase in the Greenback against the Australian dollar, should be reflected in a 10% increase in the USD ETF, and vice versa (before fees).
USD is up 8% since October 1. From a charting perspective, it looks poised to break out of a sideways pattern over the past few years if the US dollar rally continues into the new year. The annual fee for USD is 45 basis points.
Chart 2: Betashares US Dollar ETF
Source: Google Finance
As mentioned earlier, long-term retail investors are better off with hedged currency exposure in their portfolio core. For them, it’s about protecting the value of their global assets in what could be a period of significant currency volatility.
It will be interesting in 2025 if the Trump administration cuts the US corporate tax rate and implements an aggressive agenda of industry deregulation, streamlined approvals for new investment, and higher tariffs that encourage greater ‘reshoring’ as US companies manufacture more goods domestically.
As the US economy gathers more momentum, Australia’s economy could limp along in 2025, burdened by high rates, persistent inflation, awful productivity growth and reckless Federal and State government spending. A high US dollar also provides headwinds for Australia and other key commodity producers.
Again, I’m reluctant to forecast currency movements in the medium term. Suggesting the US dollar rally will continue in the next few weeks and months in the lead-up to Trump’s inauguration in January is as far as I go. What I am comfortable suggesting is there will be more currency volatility for the US/AUD in 2025 given uncertainties with the Trump administration. And more reasons for long-term Australian investors to eliminate currency risk through hedging.
For US equities exposure, the iShares S&P 500 (AUD hedged) ETF is a consideration for those seeking to eliminate currency risk (ASX: IHVV). It provides access to the 500 largest US companies while minimising the impact of Australian dollar volatility on returns. IHVV has returned 35% over one year to end-October 2024.
IHVV’s annual management fee of 0.10% compares to 0.04% for the unhedged version of that ETF (ASX: IVV). That’s a low fee in the scheme of things, and especially so if heightened Australian dollar volatility against the Greenback in 2025 has a greater impact on investment returns.
Chart 2: iShares S&P 500 (AUD hedged) ETF
Source: Google Finance
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 20 November 2024.
