International shares: To hedge or not to hedge?

Strong Aussie dollar wipes out international share gains …

In our recent article, “Should you hold international shares in your investment portfolio?”, we argued that there are diversification or risk reduction benefits from holding international shares as part of a share portfolio. To keep it manageable, we did not directly address the exchange rate risk that comes with owning shares denominated in another currency.

However, with the Australian dollar (AUD) appreciating 36% against the US dollar (USD) and 25% against the Reserve Bank’s trade weighted basket of currencies over the six months to September 2009, we are concerned that some poor decisions are being made in response.

The past six months has seen strong local currency gains in international shares almost completely offset by exchange rate losses when converted to AUD. This has resulted in some investor disenchantment with international shares. The knee jerk reaction has been to either reduce the international share allocation and/or to choose share funds that are protected against exchange rate movements i.e. hedged.
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Should you hold international shares in your investment portfolio?

Invest in international shares for reduced risk …

Many individual investors, particularly do-it-yourselfers, do not hold international shares in their investment portfolios. Why would you, they ask – returns have been poor for almost a decade now.

But the argument for allocating part of your share portfolio to international shares is not based on returns. Returns cannot be reliably predicted – past performance does not provide a guide to future performance.

As part of your portfolio, international shares offer the prospect to reduce risk without affecting expected return i.e. increasing your risk adjusted rate of return. This is partly the “don’t put all your eggs in one basket” idea. But also because global share markets do not go up and down in tandem with the Australian market, international shares can reduce the variability of your share portfolio’s returns.

The risk reduction effect, or diversification benefit, is sometimes called “the only free lunch in finance”. But if this argument for holding international shares is accepted, how much should be allocated to them?
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