The decision to sell the Australian dollar (AUD) and buy foreign currency to purchase overseas assets, or to defend against Australian dollar strength by hedging currency risk, is an important one which has had a significant impact on returns – and will probably continue to. Looking at returns in the 12 months to the end of February, the S&P500 index returned just shy of 23 per cent in US dollar (USD) terms. The decision to sell Australian dollars and not to hedge against AUD strength would have shrunk those gains to just under 5 per cent. Similarly, an unhedged exposure to the FTSE 100 index in the UK would have generated 5 per cent returns, versus a local currency return of just shy of 20 per cent.
Now, as the AUD currently sitting within a hair’s breadth of all-time highs against the USD, is it the time to re-enter the international markets on an unhedged basis? Since March 2001, the total return of holding a long AUD versus USD forward position, including carry, has been an average of 9.81 per cent each year. Holding a passive long AUD/USD exposure as a standalone investment strategy would have generated a Sharpe ratio of 0.69, a number that would compare well with many active funds managers’ returns and risk profiles. Within this period of positive long-term returns, there have been times of extreme volatility. During the financial crisis of 2008, the AUD dropped spectacularly in a 37 per cent peak-to-trough decline against the USD (see chart 1).
Structural supports The primary reason for the trend of AUD outperformance in the last decade is attributable to the huge improvement in the terms of trade and the generally higher level of domestic interest rates in Australia. The terms of trade mirrors the movement in the real effective exchange rate (see charts 2 and 3). The Reserve Bank of Australia (RBA) frequently uses these two factors as justification for a sustainably higher AUD. It’s true that trend appreciation of the AUD can’t be attributed to relative productivity differentials: with regard to AUD/USD, Australian productivity has generally been weaker than the US at least for the last decade or so. In order for the AUD to continue posting positive returns (and therefore require hedging by Australian investors), several conditions need to continue to be satisfied.