Currency exposure: how much is too much?

The strength of the Australian dollar may be beneficial to clients, but as Janine Mace points out, it also means financial advisers need to think carefully when it comes to currency exposure.

With the Australian dollar remaining strong, what to do about currency exposure for clients with international investments is something advisers need to consider.

Although the local unit is rarely a smooth ride, this year its gyrations have been even more dramatic than usual, which has made the decision about whether to go naked or to hedge international investments even more important.

As if financial planners and clients didn’t have enough to cope with when it comes to sorting out whether or not to invest offshore — now there are more issues to exercise their minds.

This is highlighted by investment returns, according to Aberdeen Asset Management senior investment specialist Stuart James. “Over the past 12 months currency has had a huge impact on investor returns.”

HSBC’s head of wholesale distribution, Geoffrey Pidgeon, agrees currency has been a key factor. “Fully hedged managers have clearly outperformed, but the performance of unhedged managers has been eaten away,” he says.

“Currency and hedging can impact performance quite significantly.”

In fact, currency is more important for Australian investors than in many other countries, according to Vanguard Australia chief investment officer Joe Brennan.

“Currency has been a big story for Australia. It has been a big return factor, but it is also a big risk and financial planners need to talk to their clients about it,” he says.

“Unhedged or hedged exposure has made a huge difference on what an investor received. In Australian dollars, returns have been quite handsome at 49 per cent if they were hedged, but for unhedged international equities, investor returns have only been 14.5 per cent, so it is not as robust a return.”

James believes advisers need to think about the impact of renewed global growth on the local currency. “Looking forward, the main driver for the Australian dollar is global growth, and if Chinese growth continues, we will see the Australian dollar remain around the 90 cent level and up toward parity,” he says.

“But if growth concerns come to fruition, we could see a sell-off in the Australian dollar. Being unhedged is not a bad thing at the moment.”

Ric Spooner, market strategist with CMC Markets, agrees economic growth prospects will influence the performance of the Australian dollar.

“If you have the view there will be growth in emerging markets, then this will lead to a firm to strong Australian dollar due to improving economic growth and increasing interest rates,” he says.

According to Pidgeon, if investors feel the Australian dollar will reach parity they should be hedged; but if they feel it will fall to its long-term average, the best bet may be to go unhedged.

Chad Padowitz, head of boutique international equities manager Wingate Asset Management, believes an unhedged approach is best for long-term international equity investors, as mean reversion should neutralise the effect of currency over time.

He questions the value of taking on the various risks involved in hedging for no expected return.

“It’s hard to justify a diversification from Australia and then, by locking in a conversion rate, retaking sovereign risk, which is what hedging would accomplish,” he says.

“The Australian dollar is very strong currently, so from a tactical viewpoint it makes sense to invest globally.”

Which path to take?

Another significant issue for advisers and clients is which benchmark or approach to use when investing in international equities.

The traditional approach of investing in a fund benchmarked to the MSCI World index is being questioned in light of its limited exposure to the fast growing emerging markets.

With developed markets predicted to underperform over the next few years, some asset allocation strategists believe a better approach may be through a blend of regionally-based funds, or to use a fund with a heavier weighting to emerging markets.

Brennan remains committed to the traditional approach. “I believe a broad market exposure and weighting approach is the appropriate one to take,” he says.

“The problem with a sector approach is you need a basis to make a blend of sectors and reweight as needed, and few investors are able to do that.”

Principal Global Investors portfolio manager Mark Nebelung also believes there are benefits from taking a broad rather than regional approach.

“A global type strategy is more efficient as it leads to a broader opportunity set and consistent management style, which provides stable long-term performance. A regional strategy can be more volatile and there is also increased cost,” he says.

“With the best-of-breed brought together you may get a higher return, but it also leads to overlapping risks, and you may not be able to manage the risks well unless you have access to the individual managers’ exposures. A single manager can manage the overall risks and provide long-term stability to the portfolio.”

Padowitz also favours this approach, but for different reasons. “We do not favour regional investing as countries and companies are globally integrated — and to focus on a specific region usually results in unforeseen risks being taken or opportunities forgone. Why limit the opportunity set?”

While the MSCI All Country World Index has emerging market exposure and is often suggested as an alternative approach, it also has limitations, according to Pidgeon.

“If you are going through a broad approach to international equities, then even those funds that include emerging markets are mainly providing exposure to the big globalised companies, such as Hyundai. You are not getting access to those companies with the best growth potential,” he says.

Nebelung agrees this is a problem: “The core MSCI indices tend to be large cap heavy.”

Pidgeon believes clients are becoming more sophisticated in their understanding of these issues. “Growing client knowledge means they are increasingly interested in investing in specific regional funds,” he says.

“As planners and clients become more comfortable with investing in other countries, we are likely to see a move to more specialised funds.”

For James, the current investment climate means good stock picking is vital, rather than a focus on geographic labels or particular benchmarks.

“As much as possible, investors need to strip away labels such as ‘emerging market stock’ or ‘UK equities’,” he argues.

“The index approach may not be the best place to be. In this environment, stock picking will be very important and you need a good active manager which can sort through the balance sheets and other issues.”

This means looking at the investment qualities of a particular company rather than its geography. For example, although good companies such as Vodafone and Shell are listed in the UK, a significant allocation to UK equities is unattractive at the moment.

The same is true of emerging markets, according to James. “You need to strip away their emerging market status. Indian banks, for example, are less risky than some of those in developed markets,” he says.

“You need to find managers which are willing to do the work to find the best opportunities, regardless of where they are in the world.”

Spooner believes there is another approach experienced investors may like to consider.

“For direct investors it is becoming increasingly easy to access information on international stocks, just as they do on the Australian stocks in their portfolio,” he explains.

“The same trading strategies used in Australia with stocks can easily be applied elsewhere, such as with Hong Kong stocks.”