Advisers spend a lot of time on strategic asset allocation decisions, particularly the choice between growth and defensive assets. But in the current environment of low rates and high volatility, we think that advisers need to spend more time on another aspect of clients’ portfolios: their exposure to currencies.
Not only does currency exposure have a ‘whole of portfolio’ impact, it can have a significant bearing on both a client’s wealth accumulation and the delivery of a sustainable income.
Currency has always been significant for Australian investors. But as clients increase their exposure to international assets, and as policy makers commandeer currencies as de-facto policy levers, managing currency exposure has never been more important.
Hedging: too cautious?
There is a defensible view among some people that a client’s portfolio should be fully hedged. They may make a theoretical case that currency risk isn’t rewarded in the same way that credit risk is, for example, and therefore it shouldn’t be in a portfolio.
They would no doubt also emphasise the past few decades when hedging foreign currency has boosted returns for Australians. From 1988 to 2015, hedging foreign currency exposure of global shares increased returns by 2.2 per cent per annum relative to being unhedged.
That return enhancement, of course, broadly represents a return premium from Australia’s higher real (inflation-adjusted) cash rates.
But we could caution against simple extrapolation of historical experience. The world has changed.
In a low-yield environment, it is likely Australia’s real cash rate premium will be lower, cutting the benefits of hedging.
We also believe the fully hedged view is myopic because Australia is a small, open economy. Currency movement impacts cash flows from local assets, and the prices clients pay for goods and services.
Protecting clients against downturns
Hedging also removes a key benefit of foreign currency exposure: diversification during periods of share market weakness; and particularly when an Australian economic downturn triggers that weakness, which could seriously impact a heavily Australian-biased portfolio.
Holding some of our exposure in foreign currency provides a natural safety valve for economic downturns. This pattern has repeated many times. We believe that, because Australian dollar depreciation is normally associated with an economic downturn, there is a case for introducing a naked foreign currency position to reduce the volatility of any equity portfolio.
That could also go one step further and include an Australian-only portfolio. The effectiveness of such a position will vary with changing conditions however, including the cause and location of the downturn.
Currency exposure
Advisers need to consider the trade-off between diversification and return drag from foreign currency exposure.
Our modelling supports the view that in the current environment there are benefits to having some foreign currency exposure in your clients’ portfolios.
If we look at a typical balanced fund, expected volatility of the total portfolio falls as the exposure to a foreign basket of currencies rises.
At the same time the fund’s expected return is also falling, as the net yield on the fund falls as foreign currency rises.
The expected Sharpe ratio (a measure of expected return relative to risk) overall is falling slightly. That is, the risk-adjusted return becomes less attractive as the return drag of currency exposure is outweighing the volatility reduction of diversification. So, if a client wants to minimise risk, then more foreign currency should be held.
But if a client wants to maximise returns against risk, then there is an argument for holding no foreign currency that is being fully hedged. These expectations however assume that everything stays as is and we receive the additional yield from hedging.
There is an additional potential benefit from holding foreign currency as crash protection, where the payoff from the FX exposure is actually more beneficial in severe events rather than day-to-day fluctuations.
The typical balanced fund has 20 per cent of its value exposed to foreign currency, which represents, on average, a step towards risk reduction.
Going beyond 20 per cent
What if advisers want to consider the currency decision beyond the position of leaving 20 per cent of foreign currency unhedged?
If the Australian dollar is pro-cyclical (it appreciates in good times), shouldn’t we be short other pro-cyclical currencies with similar characteristics? Performance drag could also be reduced by holding currencies with better valuations and that are cheaper to hold.
Additionally, advisers could identify more targeted safe-haven currencies in addition to just pro cyclical currencies.
Our modelling shows that targeting a broader set of currency pairs that provide diversification and a valuation premium has offered both diversification and a much healthier positive return premium of 2.7 per cent than from just being outright short the Australian dollar.
A structured approach
All up, we believe advisers can marry the essential components of what currencies can bring to a portfolio:
- Treating currency as a separate investment decision;
- Targeting currencies to be short that offer diversifying characteristics such as those of cyclically driven economies (and vice versa);
- Favour those that offer deviation from value; and
- Be aware of the cost of holding currency exposures.
Advisers need to employ a structured approach to managing foreign exposure for their clients’ portfolios and to consider their clients’ objectives, the potential diversification benefits of foreign currency exposure, and particularly their potential to act as a hedge during large market events.
Matthew Hopkins is a senior portfolio manager at AMP Capital.
