This article was published on 11 November 2008. Some information may be out of date.

To hedge or not to hedge?

There are two key questions around investing overseas: Should you do it? And if you do, should you hedge your investment, so it’s not affected by movements in the New Zealand dollar. The first answer is “Yes”. The second is trickier.

My last column was about how Joe and Joanne Saver could learn from what’s happened to the NZ Super Fund — or Cullen Fund — which was set up to help pay Baby Boomers’ future super payments.

I argued against National’s proposals to have at least 40 per cent of the fund invested in New Zealand, giving several reasons why most of the money should be invested offshore.

One major reason is much wider diversification, which reduces risk. When one country’s markets are performing badly, often other countries are performing well. I added:

“Also, offshore investors get some protection from the effects of a fluctuating New Zealand dollar.

“When our dollar falls, that pushes up the price of imports and overseas travel. But the value of overseas investments also rises, making it easier to pay for the expensive imports and travel.

“And when our dollar rises, the opposite happens. The value of offshore investments falls, but investors are not too worried, as imports and travel are cheaper than they would otherwise have been.”

A reader has pointed out that, while this applies to Joe and Joanne if they invest offshore unhedged, it doesn’t apply much to the NZ Super Fund, which is largely hedged.

This surprised me. I thought the fund would be mainly unhedged. If our economy was struck by foot and mouth disease or a major earthquake, having unhedged overseas investments would be a blessing. They would hold their value even if local assets plunged.

Nonetheless, the NZ Super Fund is about 90 per cent hedged, says Tim Mitchell, the fund’s general manager corporate strategy. Why? And can Joe and Joanne learn from this?

Let’s take this a step at a time. There’s a theory that if Country A pays higher interest that Country B, A’s currency is likely to depreciate against B’s currency, so the returns end up about equal.

However, Mitchell says, this hasn’t been the New Zealand experience. “There has been a fairly persistent interest rate differential in favour of New Zealand — largely since the currency floated in about 1985 — averaging about 1.5 to 2 per cent a year.” This might be because New Zealand seems more vulnerable, and so investors expect extra reward for investing here.

When the NZ Super Fund hedges its overseas investments, it keeps that extra return — whilst still benefiting from worldwide diversification.

“For hedging to be unprofitable for us, our currency would need to depreciate by 1.5 to 2 per cent a year,” says Mitchell. And while it sometimes falls more than that — as in recent months — on average over time it hasn’t fallen that much.

How does this translate for Joe and Joanne? If you have at least ten years before you plan to spend your savings, investing in a hedged KiwiSaver or other fund is probably a better bet than an unhedged fund. Some providers offer one or the other; some give you a choice.

However, as you approach retirement, you might switch to an unhedged or partly hedged fund, especially if you plan to spend a fair bit of your savings on overseas travel and/or imports such as electronic goods, cars, books, clothes and so on. As explained above, being unhedged helps to smooth the payment path for travel and imports.

One final point: What about the NZ Super Fund and the foot and mouth disease threat? “That a very low probability event,” says Mitchell. Here’s hoping he’s right.

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Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.