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Hedged or unhedged? The trick to mastering international share trading
Planning to diversify your portfolio by investing internationally? Here's everything you need to know about managing risk via hedged and unhedged international equities.
International share trading accounts have made it easier for you to access overseas stock exchanges and trade shares in some of the world’s biggest companies such as Facebook, Amazon, Google and Apple. However, unlike investing in local companies listed on the New Zealand Stock Exchange (NZX), the New Zealand dollar’s continually fluctuating rate can positively or negatively impact your overseas investments.
You can choose to protect yourself from currency risk by purchasing hedged international shares.
This guide helps you through the complexities of currency risk and answers all your questions about purchasing hedged and unhedged international investments so you can invest overseas worry-free.
What does currency have to do with my international unhedged investments?
When you purchase shares in an New Zealand company, whether or not your investment made a profit will largely depend on the change in the company’s stock price. If the price goes up 3%, the value of your investment will also be up 3%. However, that’s not necessarily the case when you trade shares on the international markets.
When you invest internationally through shares or an exchange traded fund (ETF), your investments will be impacted by changes in the New Zealand dollar. This type of investment is called “unhedged” because it is not protected against currency movements.
Let’s take a look at a hypothetical situation
Let’s say you decide to invest in a US-based company called America Corp which trades on the New York Stock Exchange (NYSE). You purchase 50 unhedged shares in the company at USD$50 per share when the exchange rate is USD$1 = NZD$1.10.
To work out how much this transaction costs you in New Zealand dollars you start with the amount of shares purchased (50 shares) and multiply it by the cost in US dollars (USD$50 per share), 50 x USD$50 = USD$2,500. Then you take that amount and multiply it by the price of the New Zealand dollar (NZD$1.10), USD$2,500 x NZD$1.10 = NZD$2,750. Therefore the value of the shares in New Zealand dollars is NZD$2,750.
Jump forward 12 months and the price of America Corp stock has risen 20% to USD$60 per share, meaning the 50 shares you purchased are now worth USD$3,000 (a gain of USD$500). You decide to cash in on your investment.
However, over the same 12-month period, while shares in America Corp rose by 20%, the value of the Kiwi dollar also rose against the US dollar. Let’s say it rose by 20%. That means that the exchange rate is now USD$1 = NZD $0.88. Therefore, when you go to exchange your USD$3,000 dollars for New Zealand dollars, you only receive NZD$2,640 (or USD$3,000 x 0.88). Given that you originally invested NZD$2,750, that represents a loss of $110.
Not such a great investment in the end. Don’t lose hope because by the same logic, the effect of currency fluctuations on your unhedged investments makes it possible for you to make money if the value of NZD compared to USD has decreased. No matter what, you can’t afford to ignore the currency variation effect when investing internationally.
SummaryPurchasing unhedged stocks and ETFs can be a good thing if the New Zealand dollar falls. However, if the New Zealand dollar increases in value relative to foreign currencies, the value of your portfolio would decrease when converted back into New Zealand dollars, delivering you low returns even when your investments have performed well.
How can I protect my international investment against currency fluctuations (hedged investments)?
To alleviate the risks of currency movements, investment managers use “currency hedging” to protect themselves when investing internationally. The object of hedging is to ensure that the only factor influencing your returns is the gain and losses generated by the underlying investments – not currency movements as well.
The process is quite complex, but generally speaking investment managers will enter into a foreign currency option or a cross-country swap to protect themselves against unexpected changes in currency exchange rates. Think of it like an insurance policy, protecting your investments from foreign exchange risk.
However, it is important to remember that while hedging your stocks and ETFs can protect you from currency movements, they won’t benefit you financially if the New Zealand dollar falls relative to the currency in which your investments are held.
What hedging options are there?
International shares can be fully hedged, partially hedged or unhedged:
- Fully hedged – where all of your investments are protected from the effects of currency movements
- Partially hedged – where your investments are partially protected from the effects of currency movements
- Unhedged – where your investments are not protected from the effects of currency movements
To hedge or not to hedge: What to consider?
The decision on whether to hedge or not to hedge your international investment ultimately comes down to one key question: what are you trying to achieve?
Level of risk
If you’re trying to reduce your overall portfolio risk by purchasing short-term investments such as international bonds, then you may want to consider hedging as part of your strategy. A fixed-interest oriented portfolio will benefit from hedging more than share-based portfolios because currency movements are typically more volatile than bonds. Hedging will enable you to gain exposure to foreign companies with the currency risk removed.
However, if you’re trying to maximise returns, then gaining exposure to foreign companies and foreign currency via unhedged international shares and ETFs can be beneficial, especially when the New Zealand dollar is falling relative to the US dollar.
One other important aspect to consider when deciding to hedge or not to hedge is the cost. While both types of investments come with investment management fees and indirect costs, the cost of a hedging strategy will typically be higher and you’re incurring an additional expense. Generally speaking you can expect to add an additional fee of five to ten basis points to the cost of an unhedged version. For a hedging strategy to be successful, the benefits must outweigh the costs.
The country, its economy and political risk
Every international investment you make will be subject to country-specific political, economic and regulatory risk, and while you might find it easy to keep track of what’s going on in New Zealand, it’s much harder to keep up with what’s happening overseas. If you’re investing in a developed country which has a relatively stable market and economy, the risk of the currency rapidly moving in any direction in low. However, if you’re investing in a developing country whose currency is highly volatile and fluctuates often, then you may want to consider hedging your investments.
The pros and cons of hedging
- Exchange rate locked in
- Won’t be affected by currency movements (one less thing to worry about)
- Benefit if the value of NZD has increased relative to the currency you’re trading in (compared to if you had bought unhedged shares/ETFs)
- Potentially more expensive
- Won’t benefit if the value of NZD has decreased relative to the currency you’re trading in
Six key factors that affect exchange rates
“Exchange rate” is defined as: “the price of a nation’s currency in terms of another currency”. The exchange rate of the New Zealand dollar may fluctuate daily due to several factors that go into its valuation. When deciding to invest internationally, it is important to understand what factors determine exchange rates:
A country with high government debt is less likely to attract foreign investment, leading to inflation. As a result, a decrease in the value of its exchange rate will most likely follow.
As a general rule of thumb, a country with a consistently lower inflation rate will generally see an increase in the value of its currency, while a country with higher inflation typically sees a decrease in its currency.
A country with a low risk of political unrest is more attractive to foreign investors. Increased foreign investment, in turn, leads to an increase in the value of the domestic currency. However, a country susceptible to political unrest may see a depreciation in foreign investment and its exchange rates.
Increases in national interest rates will generally cause a country’s currency to increase because higher interest rates give higher rates to lenders, attracting more foreign investors, which causes a rise in exchange rates.
If the value of a country’s currency is expected to rise, investors will increase demand of that currency in order to make an expected profit in the near future. As a result, the currency value will rise.
When a country goes through a recession, its interest rates are likely to fall, depressing its chances to gain foreign investment. As a result, its currency weakens in comparison to that of other countries, thereby lowering the exchange rate.
How can I buy hedged / unhedged international shares?
You can trade international shares from New Zealand with an online share trading account from one of the big banks or online brokers. These brokers provide an online platform you can use to conduct trades 24/7. Most providers even have mobile apps for when you’re on the go.
Like all types of investing, there are risks involved with international share trading in addition to currency risk including fluctuating market conditions, and complex tax legislation. (Read more about international share trading accounts in our comprehensive guide here).
You can apply for an international share trading account online in less than 15 minutes if you are over the age of 18, have an New Zealand residential address and a valid contact number.
Make sure you also have on hand photo ID such as your passport, driver’s licence or proof of age card, and your IRD number.
How can I buy hedged/unhedged ETFs that track international markets?
An international exchange-traded-fund (ETF) is a simple and affordable way for you to access multiple international shares in a single trade.
In basic terms, an ETF is a collection (or “basket”) of tens, hundreds, or sometimes thousands of stocks or bonds, which is designed to go up or down in value in line with the index it is tracking. Unlike a managed investment fund, an ETF trades like a common stock on a stock exchange like the ASX, the New York Stock Exchange or Nasdaq. An international-share ETF works much the same way, allowing you to invest in multiple international companies in a single trade.
In New Zealand, the main provider of ETFs is Smartshares.
If you’ve researched international ETFs benefits and risks and you’re ready to get started, you’ll need to sign up for an online trading account. Read more about ETFs in our comprehensive guide here.
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