Emerging markets (EM) account for nearly 80% of global economic growth, almost doubling their share from 20 years ago. As a result, emerging market equities and bonds have become an important source of attractive, diversified returns for financial advisers and their clients. Often neglected is the fact that a significant part of emerging market asset returns can be derived from currency exposure. However, Australian dollar (AUD) based investors typically haven’t captured these currency gains due to the economic links between Australia and Asia, and the impact of changes in commodity prices. Simply put, when EM currencies are doing well, so is the Australian dollar.
By separating the currency exposure into its three component parts and actively managing the part which provides unrewarded risks, Australian investors can better capture the available returns from emerging market currency exposures, enhancing their overall return potential from emerging market investments.
Many advisers and investors view the emerging markets as an attractive source of investment returns. Regardless of whether these returns are accessed passively through index funds or through hiring skilled portfolio managers, the impact of volatility in the investor’s base currency on the overall return of emerging market bonds and equities, is often ignored.
In the case of active emerging market portfolios a portfolio manager is making active decisions on which currencies to favour or avoid. However, typically, they do not consider an investor’s base currency-specific risk.
When looking at the overall emerging market currency return relative to an investor’s base currency, it can be separated into three components:
- The active portfolio manager’s currency selection relative to the emerging market currency market in general (emerging market currency-specific risk)
- Overall emerging market currency moves relative to the developed market currency market (the emerging market versus developed market currency beta)
- An investor’s base currency movement relative to the developed market currency market (the base-currency- specific risk)
An investor will typically retain the first component as this is where active portfolio managers aim to add value. We believe the second component will also be attractive for many investors as this element has historically added value. However, investors can benefit from actively managing the third component; base-currency-specific risk – as this is unrewarded risk exposure that can dilute the performance outcome. For AUD-based investors this base-currency-specific risk has resulted in the lowest returns from emerging market currency exposure compared to investors from other developed markets over the past 20 years.
AUSTRALIAN INVESTORS HAVE BEEN MISSING OUT
Emerging market currency returns can vary significantly depending on the investor’s base currency – in other words, their base-currency-specific risk. The currency returns from investing unhedged in emerging market bonds has ranged from 1.9% for Australian dollar-based investors to 6.1% for Japanese yen-based investors. Similarly, Japanese yen-based investors in unhedged emerging market equities have gained 4.4% from the currency, whilst Australian dollar-based investors have only had a small positive contribution from emerging market currency exposure.
Why did investors around the world experience such different outcomes? The answer is inextricably tied to movements in investors’ base currencies – the third component of emerging market currency risk described above. The AUD has a high historical correlation with the MSCI Emerging Markets Index currency basket. This is due to the both the economic links between Australia and its largest trading partners in Asia, and the impact of changes in commodity prices on the Australian economy and the economies of other commodity exporting countries (many of which are emerging markets).
Australian investors are exposed to two unmanaged currency risks in emerging markets. The first component represents the performance of the basket of emerging market currencies versus developed market currencies – this is the long-term risk premium which we expect to be positive and relatively stable and can be captured passively and remain unhedged. The second component arises from the behaviour of the investor’s base currency, in this case the AUD, against a basket of developed market currencies. As investors typically do not expect this component to generate a long-term positive return, we believe it is appropriate to diversify the base currency exposure. This logic applies to investors of any base currency, but the case for doing so may be amplified in the case of the AUD due to the currency’s high historical correlation with emerging market currencies.
APPROACH TO MANAGING EMERGING MARKET CURRENCY RISK
We believe AUD-based investors can benefit from emerging market currency appreciation with a more sophisticated approach to currency management, which seeks to reduce their base-currency-specific risk.
An unhedged AUD-based investor effectively has a single, concentrated, short position in the AUD. By moving from this to a more balanced short position across a basket of the most liquid developed market currencies (which might consist of the US dollar, euro, Japanese yen, British pound, Swiss franc and Canadian dollar), AUD-based investors can diversify their base-currency-specific risk. This currency diversification approach maintains the desired long emerging market currency exposure, while reducing the short AUD exposure by purchasing AUD currency forward contracts against the other G7 currencies.
For MSCI Emerging Markets Index equities, applying an equally weighted short base currency position across the G7, this diversification strategy would have generated a positive return of 2.1% pa from currency exposure), compared to -0.8% annualised for the period January, 1999 to December, 2018.
Diversifying the base-currency-specific risk has also significantly reduced the volatility of currency returns from 10.7% to 6.1%. The result of applying the strategy would have been a substantial reduction in overall currency risk, leading to greater confidence that emerging market currency returns will be captured.
Importantly, this approach maintains exposure to emerging market currency selected by an investor’s emerging market portfolio manager, and so avoids the costs of directly trading emerging market currencies.
At Insight, we believe that through an actively-managed currency strategy, which seeks to diversify the concentrated short AUD exposure implicit in an emerging market allocation, Australian investors can access the additional investment returns that emerging market currency exposure can offer.
Adam Kibble is investment specialist at Insight Investment.