SQM Research Ratings Update

As previously mentioned, the SQM Research team has been hard at work conducting its Global Property and Infrastructure Sector Review. It has been a gruelling month, with the team travelling across Australia and Asia meeting with the investment/management teams.

Interestingly, one of the key issues observed during the review was the effect of currency hedging on distributions. Like during the Global Financial Crisis (GFC), many funds were unable to pay distributions in 2013 â€“ a result of losses on their currency hedges.

In light of recent events, SQM Research will explore the question of â€˜to hedge or not to hedgeâ€™ in the context of Global REIT and Infrastructure funds.

Ultimately, the answer to the question depends on what an investor is seeking.

If an investor is seeking to minimise the risk of currency fluctuations, then they would be suited towards a hedged fund*. Under a hedged strategy, Global REIT/Infrastructure funds typically use forward contracts to eliminate the volatility in the spot exchange rate. Over the last decade, hedged strategies have generally outperformed unhedged strategies, although it is important to note that a 5 to 10 basis point premium is typically charged for the additional hedging service. Moreover, currency hedging may affect a funds ability to pay distributions, particularly during times when the Australian dollar is highly volatile.

Should an investor seek regular income streams, SQM Research believes that an unhedged exposure would be more ideal. This is because, despite income being subject to currency movements, the ability for a fund to pay distributions will be predominately driven by income dividend and gains/losses from the sale of underlying assets, net of fees.

SQM Research also recommends that investors who wish to use Global REIT/Infrastructure funds in their portfolio in order to lower volatility, are better off investing in unhedged funds. Empirical evidence suggests that overall, unhedged funds exhibit lower volatility than hedged funds.

Excess Return - UBS Global Investors NR Hdg AUD vs UBS Global Investors NR AUD

Source: SQM Research, Bloomberg

The above chart compares hedged returns to unhedged returns by analysing a commonly used Global REIT Index, the UBS Global Investors Index. In the long-term, the hedged version of the index outperforms the unhedged version of the index.

The above chart also demonstrates that the hedged index typically outperforms when the value of the Australian dollar (relative to the US dollar) is increasing, while the unhedged index typically outperforms when the value of the Australian dollar is decreasing. This trend was clearly evident during the GFC when the Australian dollar deteriorated sharply and resulted in hedged funds halting their distributions as their hedging losses exceeding income. During this time, the hedged index significantly underperformed the unhedged index.

Given the recent fall in the Australian dollar and the recent halt on distributions, the number of unhedged offerings in particular in the Global REIT/Infrastructure space has increased.

However, investors should also be aware of an alternative solution that has been offered by a small number of Managers which enables a fund to have more consistent distributions as well as utilise currency hedging â€“known as TOFA Hedging . A number of funds have been able to make a TOFA Hedging election, which has enabled them to better match the gains/losses from their currency hedges to gains/losses of the underlying assets.

Whether an investor should go hedged or unhedged is dependent on what an investor is seeking to achieve. However, the ability of some Managers to make a TOFA hedging election will allow investors a bit of the best of both worlds.

*Minimising currency risk does not necessarily mean minimising overall volatility. Whether hedging results in lower volatility also depends on the covariance between the exchange rate and underlying assets.

In Other News...

Head of European Listed Real Estate Hugo Machin departed AMP earlier last week. This follows on from the departure of Portfolio Manager/Analyst (Europe) Nikita Johal in August 2013. The Manager has advised SQM Research that they have commenced a global recruitment process to find a replacement for the role. In the near term, the AMP Capital Global Property Securities Fund will be leveraging of their secondary coverage capability with Charles Wong, Head of Asian Listed Real Estate, Dominic Cappellania, Chicago-based Portfolio Manager, and Ryan Watson, Australia-based Portfolio Manager, spending time in London from next week to assist Tom Walker, Deputy Head of Global Listed Real Estate, in maintaining seamless European coverage. SQM Research is in the process of reviewing the AMP Capital Global Property Securities Fund and is expecting to release the Fundâ€™s final report and rating in June 2014.

Also, earlier last week, Folkestone Limited successfully acquired Maxim Asset Management - the Investment Manager of the Maxim Property Securities Fund. Folkestone Limited is listed on the stock exchange (ASX: FLK) and is a specialist funds manager which pursues a diverse range of Australian real estate opportunities across investment types, capital structures and sectors. SQM Research will be reviewing the Maxim Property Securities Fund in its 2014 Domestic Property Securities review and is expecting to release the report and final rating in August 2014.

TO HEDGE OR NOT