We discuss the unpredictability of currency movements and the importance for investors to treat currency hedging as a way to manage risk, not add return.

When your portfolio includes international shares and bonds chances are you will have spent some time considering what, if any, hedging you should use to counteract the impact of currency movements.

There's no doubt, investing in international shares and bonds is a great way to diversify. Managed funds and ETFs present investors with straightforward ways to access overseas markets.

But with this diversification comes decisions and challenges, and one of the more complex and difficult to manage is the impact overseas currencies may have on your returns.

Investing abroad is no different than holidays abroad; the exchange rate matters, and it's one of the hardest markets to predict. Investors often have the option to “hedge” against currency risk in the managed funds and ETFs that invest overseas. By hedging, fund managers essentially know the exchange rate they'll pay in the future by using derivatives. They trade taking a chance on where the actual exchange rate will be (in a month's time, for example) using the exchange rate that the market forecasts for that point in time.

Vanguard's Investment Strategy Group suggests a good framework for reviewing whether or not to hedge your currency exposure is to consider first your appetite for risk and your investment time horizon and then to understand the individual nuances of international bond and equities exposures.

A good starting point is to determine your risk/return profile - how much risk are you comfortable having in your portfolio given your time horizon and objectives.

If you have a long way to go to retirement, you may be comfortable taking on the currency risk and accept the short term currency volatility that unhedged exposures to international shares can bring understanding that research studies show currency movements tend to be neutral over the longer term.

Those closer to retirement, and those who are just more risk averse than others, will likely have a greater allocation to fixed income (bonds) already. Bonds are an effective ballast against equity market declines; international bonds are no exception.

It is generally accepted that in order to maintain international bonds' defensive characteristics in a portfolio, they should be hedged, as their benefits would otherwise be overwhelmed by currency movements.

The decision on whether to hedge international equity exposures is not so straightforward, however.

Consider when global equity markets fall and the Australian dollar weakens. If unhedged, you may experience smaller losses than a hedged portfolio. If the opposite scenario unfolds (markets rise and the dollar strengthens), the hedged portfolio appears “better” than the unhedged version.

Currency's movements (and how they move with equities) are incredibly difficult to predict, so investors should treat currency hedging as a way to manage risk, not add return.

It is not a one size fits all decision – and one that should be made after building a plan, establishing an asset allocation, and managing cost. In the end it may be that a position of least regret – often favored by financial advisers - which is to hedge 50 per cent of the portfolio.

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