You will be able to decide whether to hedge currency for stocks and bonds, and what the hedge costs.
About S$74,150 of Marcus's portfolio is in US dollar assets: most of his world ETF and all of his chip designer, as lesson 3.5, The dollar cycle and what a strong dollar does to Asian assets, worked out. That's a little over a third of everything he owns. A 10% fall in the US dollar against the Singapore dollar would cost him about S$7,400 in SGD terms, even if every share price stayed put. His colleague asked the obvious question: why not hedge it?
The answer depends on what you hold, since a hedge usually pays for itself on bonds and usually doesn't on shares held for many years. This lesson explains why, what a hedge costs and how to write a currency policy for the whole portfolio, with made-up figures throughout.
A currency hedge fixes the current exchange rate for a future date, usually with a forward contract, so that moves in the rate stop affecting your return. A fund's hedged share class does this for you and renews the contracts each month. Build and run an ETF portfolio explains hedged share classes in lesson 5.3, Hedged share classes: when they help. This lesson sets a policy across all your holdings rather than choosing one fund's class.
A hedge removes currency gains as well as losses. In 2022, when the US dollar rose against most currencies, an SGD investor holding unhedged US shares saw part of the share price fall offset by the stronger dollar, a cushion the hedged investor gave up.
High-quality government bonds are held to provide steady returns and to cushion the portfolio when shares fall. Their price swings are usually small. Exchange rates swing much more. So for a foreign bond fund held unhedged, the currency often decides most of what happens to your return in a given year.
Take a made-up global government bond index with a volatility of 4% a year in its own currencies. Held unhedged by an SGD investor, its volatility might rise to around 7%, most of the extra coming from exchange rates. The bond fund stops behaving like a bond fund. In a year when shares fall and the Singapore dollar strengthens, the currency loss can wipe out the cushion the bonds were meant to provide.
That's why many investors hold foreign bonds hedged back to their own currency, or hold bonds in their own currency to begin with. Marcus's bond fund is an SGD fund, so this decision was made when he chose it. If he ever added a global bond fund, his policy would say hedged to SGD.
For shares the picture changes. Share prices swing far more than exchange rates do, so currency adds a smaller share of the total volatility. Over long periods, currency moves between major economies have tended to partly even out, while the cost of hedging is paid every year.
The cost of hedging comes from the gap between the two currencies' interest rates. A forward contract to sell US dollars for Singapore dollars in a year is priced so that neither side gains from the rate gap. If US dollar rates are higher than SGD rates, the forward rate for US dollars sits below today's rate, and the hedged investor gives up roughly the difference in rates each year.
With made-up rates of 4.5% for US dollars and 2.5% for Singapore dollars, a hedge of US assets back to SGD costs roughly 2 points a year. Paid every year for ten years, a 2-point drag leaves you with about 18% less than you'd otherwise have, compounding at 0.98 a year. When the gap reverses and SGD rates are the higher ones, the hedger earns that difference instead.
You can see the real figure in two places. Fund houses that offer hedged and unhedged classes of the same fund report both returns, and the gap over a period when the currency barely moved is mostly the cost of hedging. And MAS publishes interest rate data for the Singapore dollar, which you can set beside US rates published by the Federal Reserve. Check these at the time you write your policy, and date the figures.
A currency policy covers each type of holding, with a reason and a place to check the cost.
Marcus wrote: "Shares are held unhedged. My horizon is over fifteen years, currency moves add little volatility to shares over that time, and the hedging cost, which depends on the gap between USD and SGD interest rates, would compound against me. Bonds and cash are held in SGD or hedged to SGD, because currency swings would overwhelm their returns and undo their job as a cushion. I check the cost of hedging once a year, from the gap between hedged and unhedged classes of a world equity fund and from MAS and Federal Reserve rate data."
Two other currency exposures sit outside the hedging question and belong in the same note. The currency you'll spend in matters: someone planning to retire abroad has a different home currency from someone retiring in Singapore. And conversion cost is separate from currency risk, as Investing in US and global markets from Singapore explains in lesson 2.3, Currency risk is not the same as conversion cost. A hedge does nothing about the spread you pay each time you convert, which lesson 12.3, The full cost stack: commissions, spreads, FX, custody and withholding tax, adds to your costs.
Before you write your own policy, list your foreign currency holdings by type, shares or bonds, with their value in SGD.
Write your currency policy for shares and bonds, with a reason for each and where you will check the current cost of hedging.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).