Winding down from the parity party

Eight years after the Global Financial Crisis investors are still facing bumps in the road with currency exposure. However, a new wave of advisers could help smooth the tracks as the Australian dollar continues its slide from parity, Hope William-Smith finds.

Considering the current low interest rate and high volatility environment, experts have said that advisers may need to allocate their time to their clients’ currency exposure.

Not only does currency exposure have a whole of portfolio impact, strong returns could have a significant bearing on both overall wealth accumulation and help deliver a much-desired sustainable income if investors are willing to think and invest for the long-term.

According to the Reserve Bank of Australia (RBA), the Australian dollar has yet to appreciate above 80 cents to the US dollar in the last 24 months, and the real exchange rate plateaued below that same amount between May 2015 and July 2017.

With the value of the Australian dollar now seemingly on the rise, AMP Capital senior portfolio manager, Matthew Hopkins said advisers should marry the essential components of what currencies can bring to a portfolio. He said this could be done by working as a strategy translator between investor and fund manager.

 

Strategising

Tempo Asset Management principal, Joe Bracken said investors had moved naturally toward more flexible strategies around currency in recent years, which meant assistance on the adviser side would be welcomed to help resolve any transparency issues. 

“[Currency] is an almost a perennial discussion topic, it waxes and wanes and has been a very hot topic since the Global Financial Crisis with the extreme moves in the Aussie dollar,” he said.

“Investors are looking to put in place a more dynamic approach where they can adjust the to take advantage of these periods of under and overvaluation and add a little bit more return to their international equities portfolio.”

Within a typical balanced fund, the expected volatility of the total portfolio falls as the exposure to a foreign basket of currencies rises, which State Street Global Advisors head of portfolio strategists, Jonathan Shead, said should encourage investors to look to currency.

“Now is a really good point in time to review what you’re doing in currency and to set rules and set a strategy because the Australian dollar was a long way away from fair value against a whole range of currencies a few years ago [and now] we’re much closer to the middle of the range in currencies,” he said.

“Take more of a medium-term approach looking at currency and on more of a medium-term basis…look at longer term currency valuations, they are probably the most powerful and common models.”

Investors with a healthy appetite for risk should also be able to look beyond the traditional 20 per cent margin for hedging in their strategy, according to AMP Capital senior portfolio manager Darren Beesley.

“[20 per cent] just developed over time to be the sweet spot where if there is a global equity sell-off, you’ve got a reasonable amount of foreign assets to give you support and risk management,” he said.

“At the adviser and SMSF [self-managed superannuation fund] level, it’s something people need to pay more attention to [as] it can really shape your returns and being unaware of your asset exposure is dangerous.”

For sophisticated funds, such as multi asset funds, there are other more complex levers you can pull within a currency strategy which can mitigate against risks. 

“You can use derivatives to be more selective on which currencies we wish to expose ourselves to and what we need to hedge,” Beesley said.

Finder.com.au insights manager, Graham Cooke said a sizeable consideration to take into account was the difference between the value of the dollar and the cash rate as the difference showed the potential one way or the other to exposure. 

“While the cash rate hasn’t moved for a year, the Aussie dollar certainly has, affected by international markets and US Federal Reserve movements,” he said.

“In other words, there’s certainly money to be made in the foreign currency markets.”

 

Cautious hedging

Even in a low-yield environment where it is likely Australia’s real cash rate premium will be lower and hedging will lose popularity, Hopkins said investor tendency toward a defensible view that portfolios should be fully hedged remains.

“The fully hedged view is myopic because Australia is a small, open economy [and] currency movement impacts cash flows from local assets,” he said.

“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.”

With exchange traded funds (ETFs), Shead said a long-term view on currency should take into account the naturally volatile nature of the asset class, so investors should not be hasty in hedging as it may limit downside risk in falling equity markets.

“If you were going to take a two-year view on a currency and you had to pick being hedged or unhedged, I would pick being unhedged,” he said.

“Foreign currency tends to be a long-term risk reducer but the problem is most of the clients we speak to don’t have a 20-year horizon, they have a three to five-year horizon, and over a three to five-year horizon, valuation changes can completely swamp those diversification benefits from owning foreign currency.

“We tend to find hedged fixed income products predominating, then within the equity space, product issuers will have a hedged or an unhedged, and people choose the product according to the hedge ratio they want to achieve.”

 

Risk mitigation

 

Because the Australian dollar depreciation is normally associated with an economic downturn, the introduction of a naked foreign currency position not hedged from market risk could mitigate against volatility.

 “The effectiveness of such a position will vary with changing conditions however, including the cause and location of the downturn,” Hopkins said.

“That could also go one step further and include an Australian-only portfolio.”

However, Bracken said there was no key to complete protection, and that the most effective way to construct a portfolio with balanced risk management practices was one that took consideration for market movements both expected and unexpected.

“You can get some really extreme moves in currency since the rise in commodity prices really fuelled the Aussie dollar’s appreciation, and when that came off, the Aussie dollar reacted to that and fell again,” Bracken said.

“Now it’s on the other side, it’s not really about Aussie dollar strength as much as it is about US dollar weakness.”

 

Advice and planning 

 

Commenting on the RBA’s decision to hold the cash rate unchanged at 1.5 per cent last week for the 14th consecutive month, Aberdeen Standard Investments head of Australia macro, David Choi said central banking intervention in Australia remained low comparative to the “hawkish tunes” overseas.

“This faces three main headwinds: low wage growth, low consumer confidence and high energy prices,” he said.

“Until we see a sustainable pick up in consumption, higher cash rates remain a long way off.”

As a major influencer of the behaviour of investors and general economic activity, the stability in the cash rate means investors need to stay abreast of market nuances rather than show complacency. 

“What should come to the table in those conversations… is how much FX [foreign exchange] exposure do we want in your portfolio,” Beesley said.

“When an adviser sits down to put together a strategy with their client, FX needs to be up there as one of those conversation points.”

Looking more closely, Hopkins said advisers should favour currencies that offer deviation from value when providing options to clients, and consider the trade-off between diversification and return drag from the foreign currency exposure.

“Some advisers will have limited ability to implement a currency overlay and will revert to the more passive position of leaving a proportion of foreign assets unhedged,” he said.

“This approach has been found to be effective historically, with reason to expect a small drag on returns over time.”

 

Forecasting 

 

While experts agreed on the importance of risk management structures which protect portfolios’ interests in volatile periods, it is also crucial to consider in a forecast or outlook that not all currencies work as well as others in a stressed environment against the Aussie dollar. 

“USD, Yen and Swiss franc are all currencies that have appreciated in stressed environments but there are obviously currencies that don’t do so well such as emerging market currencies like the Brazil real, the South African rand,” Beesley said.

“These tend to sell off just as much as the Aussie dollar, so having assets based in those currencies isn’t really going to help you in a time of crisis.”

“The Norwegian krone and the Swedish krona also have been too good to support you in a time of crisis because of the heavy oil reliance in those economies.”

Investor sentiment would also continue to play a major part in a well strategised forecast.

“There may be certain assets that investors will avoid buying in certain currency climates, however this is relatively specific and can be affected by hedging,” Cooke said.

“Fund managers and advisers should be keeping a close eye on… economic indicators.”

Looking forward to the appreciation or potential depreciation of the Australian dollar, Shead said a continuation of the current climate could be expected.

“We’re not expecting really big moves of the Aussie against the US one way or another in the next year or so, as opposed to some other currencies where we see slightly big valuation divergences like the yen which is just looking incredibly cheap or the Swiss franc which still looks expensive,” he said.

Proceed sensibly and with an appreciation for the newness of currency as an asset class remained the overarching sentiment from experts.

“The problem with currency is if you go back three years, it’s the opposite,” Bracken said. 

“All of our models tell us that you’re essentially at fair value at the moment but the trend is down and there’s very little holding up the Aussie dollar at the moment.”