Over recent months, I have explained why we are currently underweight Australian shares. Australia represents only a small part of global developed markets; its index is concentrated in a few sectors, and we question its capacity to generate acceptable future returns relative to current valuations.
Therefore, we believe that investors should allocate more to global developed markets. These markets offer better diversification and stronger growth prospects, but they also introduce foreign currency risk.
What is currency hedging?
An international investment has two return drivers: the performance of the underlying market such as growth plus income, and movements in the Australian dollar.
For example, if the S&P 500 returns 10% and the Australian dollar is unchanged against the US dollar, an unhedged Australian investor will also earn approximately 10%.
If the Australian dollar strengthens by 7%, the investor’s return falls to approximately 3% because their US dollar investment converts into fewer Australian dollars. Conversely, if the Australian dollar weakens by 7%, their return increases to more than 17% (it’s more than 17% because currency returns can compound).
The reason an investor might want to hedge is because they want to remove currency risk so that future returns are driven by the performance of the underlying market. If we want to invest in an index because its fundamentals are attractive, we do not want that investment thesis to be derailed by adverse currency movements.
Remember, our goal is to invest in equities, not speculate on foreign currency markets.
Why hedging never removes 100% of currency risk
A common misconception is that hedging eliminates foreign currency risk entirely. Hedged managed funds and ETFs materially reduce this risk but rarely eliminate it completely.
Fund managers use instruments such as currency forwards, futures, options and cross-currency swaps to remove foreign currency risk. However, their foreign currency exposure changes daily due to contributions, withdrawals, dividends and portfolio rebalancing. This can leave the fund temporarily underhedged or overhedged. Therefore, it may also be uneconomical to try to hedge 100%.
As such, whilst hedging is not precise or absolute, a hedged product should protect investors from any material currency movements.
The most misunderstood aspect of hedging
Most investors do not realise that interest rates largely determine whether hedging adds to or reduces the cost of hedging.
To hedge a US investment, a fund manager agrees to sell US dollars and buy Australian dollars at a future date. The difference between Australian and US interest rates largely determines the cost or benefit of hedging.
If Australian interest rates are higher than US interest rates, hedging can generate a positive return for investors. This is known as positive carry. If Australian rates are lower, hedging comes at a higher cost and reduces returns, which is known as negative carry. As I write this towards the end of August 2026, the effective US federal funds rate is approximately 3.63%, compared with Australia’s cash rate target of 4.35%. Therefore, an Australian investor hedging US dollar exposure should currently earn a modest positive carry.
Therefore, the return from a hedged fund will not exactly match the underlying index. It will be the index return, plus or minus the impact of the interest rate difference (cost of hedging). This can affect returns by up to one or two percentage points in either direction.
In my view, this is the single most misunderstood aspect of currency hedging.
The pros and cons of hedging
The case for being unhedged
The first reason to remain unhedged is that you believe the potential currency downside is limited. This may be the case when the Australian dollar is trading near its long-term average and appears relatively fairly valued. Your main risk is that it appreciates, reducing the value of your international investments when converted back into Australian dollars. But if you think that risk is low and unlikely to be permanent, then you might be happy to remain unhedged.
However, there is another important reason to remain unhedged. The Australian dollar is considered a risk currency, which means it tends to fall during periods of heightened uncertainty. Australia is a relatively small, open economy, and demand for our currency is heavily influenced by commodity prices and the global economic outlook. During a crisis, investors typically favour safer currencies, particularly the US dollar.
For example, when Covid struck in early 2020, the Australian dollar fell from approximately 67 US cents to around 57 US cents within a few weeks. It declined again during 2022 as interest rates rose and the US dollar strengthened and concerns about global growth intensified.
Therefore, an unhedged global share portfolio may experience a smaller decline during a crisis. As the Australian dollar falls, foreign investments become more valuable when converted back into Australian dollars, partially offsetting falling share prices. In this way, the Australian dollar can act as a shock absorber during risk-off markets.
The case for hedging
There are two main arguments for hedging.
Firstly, the purpose of investing globally is to capture the growth and income generated by international markets, not necessarily to take currency risk. We might be correct that a market will perform well, but a significant appreciation in the Australian dollar could reduce or even eliminate those gains.
Secondly, hedging may be appropriate when the Australian dollar is trading well below its long-term average. Whilst this does not guarantee that it will appreciate, the potential currency downside is greater.
Therefore, if the Australian dollar is trading near 60 US cents, hedging may protect against an appreciation that would otherwise reduce the value of your international investments.
A very important consideration: TOFA election
Another important consideration when choosing a hedged fund is how it treats currency gains and losses for tax purposes. This can materially affect both distributions and tax.
Some funds make a Taxation of Financial Arrangements hedging election, commonly called a TOFA hedging election. This allows the timing and tax treatment of hedged gains and losses to be matched more closely with the underlying investments. As such, it should reduce tax mismatches and produce more consistent distributions.
Without this election, hedged gains and losses are generally recognised as income or expenses when they accrue or are realised. This can create two undesirable outcomes.
If the Australian dollar rises sharply, the hedge will generally generate a gain. This may create an unexpectedly large taxable distribution.
Conversely, if the Australian dollar falls sharply, the hedge will generally generate a loss. This may offset the fund’s other income, resulting in a small or nil distribution. Any remaining tax loss may also be carried forward, potentially reducing future distributions.
Neither outcome necessarily changes the fund’s overall pre-tax return. However, it can materially change when income is distributed and how much tax investors pay.
Therefore, investors should review the fund’s PDS, or ask the fund manager directly, to confirm whether it has made a TOFA hedging election. A quick search using AI can also be helpful.
Fees
Often, managers will charge a higher fee for a hedged version of a product, but the fee premium has reduced over time and tends to be negligible in most situations. Of course, investors should check this, but often fees aren’t a material consideration.
What the long-term evidence shows
To make an informed decision, it helps to understand how the Australian dollar has behaved against the US dollar over long periods, and what the academic research says about whether hedging affects long-term returns.
The Australian dollar over time
Since the currency was floated in December 1983, the exchange rate has moved through wide cycles rather than trending steadily in one direction. The table below shows the trailing average exchange rate and its volatility over several periods.
| Trailing period | Average AUD/USD rate | Annualised volatility |
| 10 years | $0.71 | 10% |
| 20 years | $0.79 | 12% |
| 30 years | $0.75 | 11% |
| 40 years | $0.75 | 11% |
Since the Australian dollar was floated in 1983, it has averaged around 75 US cents, although it has experienced significant swings. It rose to approximately US$1.11 in July 2011, near the peak of the mining boom when Australian interest rates were well above US rates. It fell to approximately US48 cents in April 2001 and briefly reached around US55 cents during the COVID liquidity crisis in March 2020.
Estimating fair value is not an exact science. Purchasing power parity compares relative price levels between countries, whereas other models consider factors such as the terms of trade and interest rate differentials. Taken together, these measures generally suggest that the Australian dollar is reasonably valued somewhere between the high 60s and low 70s.
We use this broad range, rather than a precise figure, to assess whether the Australian dollar appears relatively cheap or expensive. More about how we use this below.
What academic research says about hedging and long-term returns
Research suggests that hedging can materially affect short to medium term returns, but this effect tends to diminish over longer periods. Long-term investors should therefore place less weight on whether their international shares are hedged or unhedged.
The academic literature broadly supports this view: currency hedging is primarily a tool for managing risk and volatility, not for improving long-term returns. Perold and Schulman (1988) argued that investors should not expect a reliable long-term return from taking on currency risk. It follows that hedging reduces portfolio volatility without meaningfully changing expected long-term returns, aside from implementation costs.
Subsequent research has refined this view. Campbell, Serfaty-de Medeiros and Viceira show that the benefits of hedging depend on how currencies behave during periods of market stress, which means no single hedge ratio is optimal across all environments.
Currency movements can add to or detract from returns over multi-year periods, and exchange rates can remain misaligned for extended periods. The practical implication is that hedging decisions are better framed around managing volatility and the path of returns, rather than around improving long-term expected returns.
A different approach for bonds
This blog is primarily concerned with investing in share markets. However, hedging becomes much more important when investing in international bonds and other defensive assets.
The purpose of these investments is to provide greater capital stability, lower volatility and reliable income. Currency movements can undermine all three objectives and may overwhelm the relatively modest returns generated by bonds.
Therefore, international bond investments should generally be hedged into Australian dollars. It is also preferable to use a fund that has made a TOFA hedging election, as this should reduce tax mismatches and produce more consistent distributions. However, hedging costs and interest rate differentials can still affect returns.
Our approach to hedging is…
For international shares, our default position is to remain unhedged unless there is a compelling reason to hedge.
The main reason to hedge is when we believe the Australian dollar is materially undervalued and the risk of appreciation is too significant to ignore. Our assessment may change over time, but we will generally begin considering hedged investments below US65 cents. At around US60 cents, we will most likely favour a hedged option for new investments.
At these levels, the Australian dollar’s benefit as a risk currency is reduced because it has less room to fall before approaching historical lows. Conversely, a recovery from US60–65 cents to US65–75 cents, which is a reasonable expectation given historic trading ranges, would materially weigh on unhedged returns. Hedging at these levels is not a short-term currency prediction. It reflects our view that the balance of risk has become asymmetric.
There are two important points regarding implementation.
Firstly, we do not change an entire portfolio whenever our currency view shifts. Hedging decisions apply only to new capital: when investing, we choose hedged or unhedged products based on where the Australian dollar is trading relative to fair value. This allows the portfolio to adjust gradually, without unnecessarily selling existing investments.
Secondly, we are reluctant to switch existing investments between hedged and unhedged products. Doing so requires selling one investment and purchasing another, which may trigger capital gains tax liabilities and incur transaction costs. We would only consider switching if the case were exceptionally strong and the expected benefit clearly outweighed all costs and tax consequences.
The key takeaways
Research suggests that hedging can materially affect short-to-medium-term returns, but its impact tends to diminish over longer periods. Therefore, long-term investors should not place too much emphasis on whether their international shares are hedged or unhedged.
Our preference is generally to remain unhedged because the Australian dollar is a “risk currency” which means it often devalues during periods of market stress/volatility which cushions any declines in global share markets. We are attracted to this attribute.
However, when the Australian dollar falls below US65 cents and approaches US60 cents, we may favour hedging new investments because the risk of a subsequent appreciation becomes more significant.
Outside these circumstances, we believe remaining unhedged is the more appropriate approach.
Hi Stuart, thanks for the article/episode – I’ve been waiting for this one.
It should be noted that when calculating CGT on a share sale, the ATO taxes us on the AUD buy/sell values at the time.
And I would like to know if there are tax consequences on occasional currency conversions – for example moving $5-10k between AUD and GBP a couple of times a year (using Wise).
Thanks, Dano
Hi Dano, yes, that’s correct regarding the shares. The purchase price and sale proceeds are separately converted into Australian dollars using the applicable exchange rates on each transaction date. Therefore, the capital gain or loss incorporates the currency movement that occurred while you owned the shares.
There can also be tax consequences when converting currency. For example, if you convert AUD into GBP, hold it while the exchange rate changes and later convert it back into AUD, any realised foreign-exchange gain will generally be assessable income and any corresponding loss may be deductible.
Thanks, Stuart, fantastic post.
Understanding that there will be, statistically, an advantage for new purchases to be hedged when the AUD is substantially “undervalued” (well below historical mean)…
Will this advantage progressively become smaller and approach zero the longer you hold the hedged assets?
Say we buy a hedged asset when the AUD:USD is $0.60, and future disposals of that hedged asset is presumed to be at an averaged FX of AUD:USD $0.75 (statistically) – the average benefit is fixed at that delta of $0.15. The price uplift according to the currency factor has this ceiling.
However, hedging has a cost (and the considerations you’ve described above), that introduces a price drag year-to-year, compounded. So retarding your return, even if small in the short-term, does not have a ceiling and compounds larger over time.
So, do you think there’s an argument to say that a consideration of hedging (only when looking at long-term return only) can be eliminated over a long enough time-frame?
The next question would be, what is that time-frame, and you’d have to be specific to the product, hedging cost, and degree of undervalued AUD, to attempt to model that. But if I’m considering this question for, say, my super portfolio, and the time-frame is multi-decades, and may still be many years after preservation age, the time-frame could be considered ultra-long and I feel like the effect of hedging become mute even at very low AUD values.
Yes, I agree that the longer you hold an investment, the less consequential the initial decision to hedge or remain unhedged becomes.
For example, if an investment earns 10% in its first year, a currency movement of approximately plus or minus 10% could either double that year’s return or wipe it out. However, over a 20-year investment period, a one-off 10% currency movement would alter the annualised return by only around 0.5% p.a. Because protecting capital at the beginning of the investment term is disproportionately more important. That said, the longer the investment period, the less consequential short-term currency movements become when measured against the investment’s annualised return. But arguably, there’s still a reasonable rationale to consider this decision carefully – 0.5% p.a. is a reasonable improvement.
The main risk (and reason to hedge) is that you need to interrupt the strategy and sell the investment before it has had sufficient time to run its course – either due to a change in circumstances or markets.