To hedge or not to hedge?

It has been a mixed year for the Australian dollar. If you hold an exchange traded fund (ETF), you can hedge your investment to help protect yourself against currency volatility.

Although this may seem a safer option, Alex Saika, from BlackRock's iShares, says there are a few things that investors need to consider before hedging their bets.

The first is their asset class. Saika says a hedged option may appeal more to investors in fixed income, who are traditionally relying on a steady income for their retirement. If this is you, it's important to make sure that your fund has made an election through the tax office under the Taxation of Financial Arrangements (TOFA) rules to ensure that your income is consistently distributed over time.

"If a bond was paying out a 5% income and we had currency hedging in place, and the Australian dollar was to continue falling, you would make a loss on your hedging. That loss could wipe out your entire distribution, which is not an experience that a retiree would want," he says. "

It becomes really important that the ETF issuer has made an election under TOFA because it would smooth out the income. You won't see massive distributions or no distributions - it'll be a consistent distribution."

For ETFs invested in equities, it all depends on how you expect the dollar to trend. Saika says if you think it will fall you should remain unhedged but if you think it will improve you should consider moving towards a hedged position.

"Over the last five years, since September 2011, the Aussie has fallen from $US1.04 to US76c. That represented a 26% fall. If you were unhedged, you would have benefited from that fall - you would gain 26% on your investment," he says.

"But if we look at the past 12 months in isolation, the Australian dollar has actually increased from US70c to US75.75c, so over that period it has appreciated by more than 8%. So if an investor over the past 12 months was unhedged, they would've lost more than 8% without the investment moving."

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