For the first time in almost two decades NZ investors in unhedged offshore assets have enjoyed a multi-year run of outperformance against currency-protected options.
According to the latest BNZ survey of local fund managers, going unhedged proved a winning strategy over the 2017-18 calendar years in what was “the first period since the beginning of the century where there’s been two consecutive years of unhedged returns exceeding hedged returns”.
“… from 2001-2016 there had only been two years (2008 and 2015) where remaining unhedged would have been superior from a currency returns perspective. This reflects a long period where the NZD was widely considered overvalued,” the BNZ report says.
“On a year-by-year basis there can be wide swings between outperformance and underperformance, with 2008 (-20%) to 2009 ( +23%) being the best example. Since then, the swings have been much less dramatic but still highlight the significance of the currency impact on returns.”
Report author and BNZ head of FX sales, Craig Cooper, said the trend also carried through 2019 in a period that lay outside the scope of the biennial industry survey.
Historically, NZ investors have benefited from the ‘forward points’ garnered in currency hedging, buoyed by relatively high local interest rates. But the forward points return advantage fell “significantly” since 2017 as NZ interest rates dropped faster than most offshore jurisdictions.
“This has significantly reduced the ‘carry’ pick-up of hedging foreign investments which has recently been approaching zero,” the BNZ report says.
The carry drop-off, though, explained only a small part of the hedged asset underperformance that the survey says was largely attributable to the “relatively weak” NZ dollar over the period.
Despite the collapse of the carry trade, NZ investor currency strategies barely budged during the two-year stretch covered by the survey with the average hedge ratio falling “slightly from 73% in 2017 to 71% in 2019”.
“The fall was more significant for KiwiSaver providers and charitable trusts (both 67% from 75%), with superannuation schemes increasing to 83% from 69%,” the report says. “With the NZ dollar down about 8% since the 2017 survey, one might have expected the hedge ratio to increase as investors look to protect foreign investments from a potential future recovery in the NZD.
“However, more respondents expect the NZD to fall than rise and that might explain some of the reluctance to increase hedge ratios, as might a view that less hedging was a way to protect investment portfolios from a deterioration in risk sentiment.”
The BNZ survey also found ‘dynamic’ currency hedging continued to fall out of favour with just 19 per cent of respondents adopting the practice – down from 36 per cent two years ago and 45 per cent in the 2015 study.
“Dynamic hedging would require buying and selling currency on an ‘as-needs’ basis, typically after significant movements in asset prices or currencies. The low volatility environment may have made these significant moves less common, which could have in turn dissuaded the use of a dynamic method,” the report says.
“Our survey shows KiwiSaver providers (35%) and fund managers (29%) are the most likely to adopt dynamic hedging, which is not surprising given they are generally larger and more sophisticated.”
Nonetheless, about 40 per cent of those surveyed had currency hedge ‘tilting policies’ – allowing minor shorter-term adjustments – compared to 28 per cent in the 2017 report.
“Nearly all funds that use an external manager to implement their currency strategy require them to adopt a ‘passive’ strategy, with only two allowing the external manager to be ‘active’,” the report says. “The most common reason for adopting a passive strategy is the belief that an active hedging strategy by an external manager doesn’t enhance returns.”
While FX strategies remained stable over the survey period, 60 per cent of respondents said a change in currency values would trigger a hedging policy review, more than double the proportion in the previous report. A growing number of investors also said an increase in allocation to offshore assets would prompt hedging policy changes.
The NZ funds captured by the survey allocate 60 per cent to offshore assets compared to just 41 per cent in the Australian superannuation sector (where BNZ parent bank carries out a similar FX survey) – although the balance is changing quickly.
“What is a little more surprising, perhaps reflecting the higher starting point, is the fact far fewer NZ respondents (17%) expected their offshore asset allocation to increase over the next two years – in Australia it was 72%,” the report says. “The vast majority (69%) are expecting it to remain broadly unchanged, with 13% expecting a decrease. The low number expecting an increase is driven by charitable trusts and superannuation schemes at only 2% combined, again reflecting their higher starting point. This compares to 41% of KiwiSaver providers and 29% of fund managers.”
Cooper said the result could also reflect the fact that many NZ funds class Australian assets as local investments.
The BNZ survey would include a question next time specifically covering Australian dollar hedging, he said.
Among a raft of other findings, the BNZ report found:
- the majority of investors benchmark currency exposure against the MSCI All Country World Index that takes in emerging markets;
- investment committees are increasingly in charge of currency decisions; and,
- three-month hedging prevails over one-month exposures.
The ninth biennial BNZ FX survey covered 52 investment entities including fund managers, KiwiSaver schemes, superannuation funds and charities, representing about $110 billion– or just over half of the almost $200 billion (excluding Crown Financial Entities) of assets under management in NZ.