Senior Portfolio Manager, AMP Capital
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 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.
The smart adviser now sees currencies as more than a risk to manage; they can use currency exposure as a powerful tool to navigate this complex investment landscape and to manage risk and return of their clients’ portfolios.
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’s 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. For example, during the extreme period of the GFC, from December 2006 to 2009, the realised volatility of an MSCI World (ex-Australia) equity index hedged into Australian dollars was 20.2 per cent. But volatility of the unhedged index was just 14.5 per cent.
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.
Why clients should have currency exposure now
But how should advisers decide the specific level of foreign currency exposure for their clients’ portfolios?
History suggests that, as mentioned, holding some foreign exchange has provided protection in downturns and market dislocation. But the trade-off is that we are expecting to earn a lower interest rate when we hold that foreign currency, a drag on returns. Advisers need to consider this 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.
A detour: bonds versus currency exposure
As a brief aside, an interesting question facing many advisers is the defensive nature of bonds in their client’s portfolio. Record-low yield, and the potential damage to a portfolio from rate rises, means many are questioning bonds’ usefulness in their traditional role as a ‘defensive’ asset.
Interestingly, our modelling shows that in today’s environment the defensive benefits of bonds remain reasonably like FX, but that both work in different ways. Bonds offer slightly better yield levels, but not as much diversification benefit. Importantly they also appear to offer less benefit in severe market falls, particularly from today’s starting point.
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
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. This approach has been found to be effective historically, with reason to expect a small drag on returns over time.
Advisers will also have access to funds that have the scope to implement a more holistically managed currency program where currency decisions play an important role in managing the risk profile of the fund, such as the AMP Capital Multi Asset Fund.
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
- 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.
Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.