7 tips for managing currency risk
While most of us are inherently alert to risks in many areas of our lives, such as driving a car or crossing the street, currency risk within an investment context is often not considered.
While most of us are inherently alert to risks in many areas of our lives, such as driving a car or crossing the street, currency risk within an investment context is often not considered.
While we don’t give these everyday risks a second thought, when it comes to investing most of us pay very, very close attention to risk. Or do we? Currency risk sometimes goes the way of last Friday’s leftovers, and that is not wise.
Currency and investing offshore
Much as I love Australia and still call it home, our local share market is dominated by financials and resource companies. There is precious little opportunity to invest in IT or healthcare and the list of telecommunications or utilities companies is limited. Domestic equity portfolios are often dominated by a handful of companies, leaving investors exposed to nasty surprises from just one or two names. Similar problems arise in domestic fixed income portfolios or domestic Real Estate Investment Trust (REIT) portfolios. Investing offshore improves portfolio diversity and opens the door to a host of new investment opportunities.
However, offshore investing comes with a very particular risk; that of currency fluctuations. Currency fluctuations have the ability to turn a profitable overseas investment into a loss making one. Although conversely, they can also turn an overseas loss into a profit.
Currency “hedging” is a mechanical process where the impact of currency fluctuations is removed from returns; a “currency hedged” portfolio has little or no exposure to these fluctuations. One of the most significant decisions you can make for your offshore investments is whether or not you “hedge” the currency risk.
Currency fluctuations are as fickle as the weather, and I don’t believe there is a single “right” approach to this difficult issue. While the weather is difficult to forecast, no one chooses to deal with this uncertainty by spending their entire life indoors. Furthermore, the “right” weather strategy for Sydney, Australia is unlikely to be the right strategy for Anchorage, Alaska. Sometimes a great currency hedging strategy for a US investor is not great for an Australian investor.
This point brings me to my first two tips for managing currency risk and it’s all about strategy:
1. Playing short-term currency movements is difficult, even for the experts. Unless you are particularly skilled in foreign exchange, design a long-term strategy and stick to it.
2. Choose a strategy that suits your base currency. A strategy that suits a US or UK investor may not suit an Australian investor.
But how do you go about setting a strategy? I like to break it into two pieces; risk (or volatility) and return.
The first piece: Currency and risk
Perhaps the most common currency hedging strategy I have seen among investors is to fully hedge their offshore bond portfolio. This strategy is based on two simple observations; first, bonds have usually been included for their defensive properties and, second, a fully hedged bond portfolio typically has much lower risk than an unhedged bond portfolio.
Unfortunately, things aren’t so clean cut when you look at risky assets like international shares or REITs. First, these assets are often included for growth rather than for their defensive properties. That means reducing volatility may not be the top priority. Second, historically international shares have been risky regardless of whether or not you hedge the currency exposure. In fact, when measured over long periods, hedging currency exposures in international share portfolios can often increase risk for Australian investors. Over 10 to 20 year periods, currency hedged portfolios for Australian investors have tended to have slightly higher volatility than unhedged portfolios.
Which brings me to the next two tips:
3. Investors commonly hedge 100per cent of currency risk for defensive international investments like government bonds. For these assets, history suggests that removing currency fluctuations can dramatically improve the stability of returns.
4. In contrast, Australian-based investors who focus solely on reducing volatility should only hedge a small part, if any, of their international share investments.
The second piece: Currency and Returns
While volatility of returns is important, it isn’t everything – if variability of returns was the only important consideration then we’d all just happily invest in cash. At the risk of stating the obvious, it is just as important to consider the size of potential returns when setting a strategy.
But forecasting the size or direction of future currency movements is notoriously difficult, right? Well that depends on your time frame, and I think the key is to be genuinely long term. Think about a currency strategy that reflects where the Australian dollar is trading compared to its long-term averages. We believe that while currencies do move away from their long term economic fair values, they do normally return to those fair values at some point. Of course, it can take years in some cases, but we still expect those reversions to occur.
If you want to be precise, the ‘long term fair value’ of a currency won’t necessarily be the middle of its historic range, although that is often a good starting point. Our research finds that the long term fair value exchange rate between two currencies will be driven by economic factors like inflation, terms of trade and changes in productivity.
So when investors are thinking of the size and direction of currency returns:
5. Be aware of whether the Australian dollar is at long-term highs or lows when setting a strategy. Remember to consider the GBP, EUR and JPY exchange rates as well as the USD – and be aware that ‘long-term’ in this case means a decade, not a year.
6. Be patient. Currencies can move away from fair value for long periods of time and picking short term currency movements is notoriously difficult. Currencies can move quickly in both directions. Unless you are a foreign exchange expert, avoid rebalancing too often or too quickly in response to currency movements.
Finding the right exposure and exploring ETFs
It is all well and good talking about ‘strategy’, but at some point you have to decide which ETFs or funds or securities to actually buy or sell. The final tip is about implementation, and it comes from what we have observed experienced institutional investors doing. These most sophisticated investors think about currency exposure across their entire portfolio, not just a single asset class. They decide how much currency exposure they want across the whole portfolio, and then hedge individual asset classes to meet that target.
I think individual investors can benefit from thinking this way as a simple example will demonstrate. Say you want to have half of your international growth assets hedged. For simplicity let’s say your preferred mix is 50 per cent international equities, 25 per cent international REITs and 25 per cent international high dividend yield. You don’t have to find hedged and unhedged investments for each asset class. You could easily implement 50 per cent in a hedged international equities investment and then use unhedged investments for the other two. That would achieve your preferred asset class mix and would be pretty close to your preferred currency exposure.
7. Understand how much foreign currency exposure you have across your entire portfolio. Consider the impact of exchange rate movements at the portfolio level, rather than just within individual asset classes.
I think the emergence of exchange-traded funds (ETFs) listed on the ASX that provide exposure to offshore markets has been a very positive development for investors. ETFs are baskets of securities that can be traded on the ASX, just like a single security. They provide a simple, cost-effective and transparent way to access new markets and sectors. Even better, there are now a number of currency hedged ETFs available on the ASX. These are ETFs where the exposure to foreign currencies has been removed as part of the ETF design, and they provide a simple way to implement a currency strategy for your portfolio.
Currency risk is an inherent part of international investing, however with the right strategy in place investors can manage volatility to their advantage.
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Jonathan Shead is head of portfolio strategists, Asia Pacific, State Street.
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