Since the value of the krone is at an all-time low relative to other currencies, several clients have asked us if they should invest in a currency-hedged fund. In general, I don’t advise clients to hedge their currency exposure, but I do see an opportunity to do so today for clients who are actively transacting.
Fewer than ten percent of international mutual funds actually employ currency hedging. Nowadays, that is something for which the unit owners might be ecstatic. It follows that the total return of the fund is the sum of the returns on both the underlying shares and the underlying currencies (changes in the krone exchange rate). The value of your foreign currency will rise in krone terms if the krone declines, as it has in recent years, and fall if the krone strengthens.
If you hedge the mutual fund’s currency risk, you can focus just on the fund’s share return instead of variations in value due to exchange rates. The return on the fund is unaffected by fluctuations in the value of the currency.
Weekly and annual variations in currency tend to be rather small. Due to the corona crisis, stock market drops, and the flight of minor currencies like the Norwegian krone to safe havens like the dollar, exchange rates this year have gone “rampant.” The following graph (from Morningstar) depicts the value evolution of two similar global equities funds, KLP AksjeGlobal Indeks, one with currency hedging (II) and the other without, making the point very evident (IA).
This year, the stock market has dropped by about 20% worldwide (as of 26.3.20). The currency-hedged fund would have returned -20% during the time period. In contrast, the return would be merely -5% if you had invested in the “normal,” non-currency-hedged fund. 15 percentage points of that difference can be attributed directly to the krone’s decline in value. There was a gap of more than 20% at its highest (19.3.20).
Currency-hedged mutual funds are not an investment strategy I typically advise customers to pursue. The benefits of a currency-hedged mutual fund over an identical fund without currency hedging should not materialise over the long term. The reason for this is that currency hedging comes at an additional expense and has no net benefit in the long run. Naturally, the volatility in a currency-hedged share fund are larger than in a non-hedged fund, and we’d like to limit those if possible.
Currency hedging, as a strategic wager in the forex market, might, nonetheless, pay out in the short and medium run. This is due to the fact that the value of the Norwegian krone is currently at an all-time low, and “everyone” anticipates that it will rise in value in the next months and years, both against the US dollar and the Euro. However, a year ago, most analysts also predicted that the Norwegian krone would increase, and the reverse happened. There’ll be more on this in a minute.
Please disregard “wise” advice on currency hedging, market timing, investing in one region over another, etc. if you are a long-term little saver who, for instance, has a monthly savings agreement in a global mutual fund and pays little attention to the stock market. You should stick to your financial goal and not waste time on tactical gambles. If you try to be clever, you’ll find that the chances are stacked against you.
Using A Currency Hedge When Investing In A Fixed-income Fund
Currency-hedged bond funds are my go-to investment recommendation. This is because, unlike the bank rate, an interest fund should provide a consistent (although modest) return. Here, however, foreign bond fund currency fluctuations pose a threat to this hope.
This is a good place to pause. Our PR team favours snappy blog entries. However, for the benefit of readers keenly interested in this matter, I expand upon it below.
Currency Exposure Is A Cushion In Downturns
Having exposure to multiple currencies through an international mutual fund can provide as a form of built-in protection against market volatility. For one thing, the Norwegian krone tends to rise in times of rising stock markets and weaken in times of falling stock markets, as the present. Reason being, the Norwegian krone is viewed as a hazardous currency in these uncertain times since Norway has a small, open, and commodity-dependent economy.
Therefore, the effects of changes in the exchange rate and the stock market tend to work in the opposite direction for Norwegian savers, and the volatility of their stock portfolios expressed in Norwegian kroner is typically reduced when they don’t hedge their currency exposure.
An alternative way of looking at it is that the weakening of the Norwegian krone will cushion the blow of economic downturns. The unemployment rate and economic growth both increase if the Norwegian economy weakens, for instance because of dropping oil prices. This leads to a decline in the value of the krone (which also helps Norwegian export companies).
Because of this, when times are rough in Norway, the value of your fund shares abroad will rise. When the Norwegian economy is thriving, however, you can anticipate a little less return on your foreign funds expressed in Norwegian krone.