Robin Bowerman, Head of Retail at Vanguard Investments Australia.
Robin Bowerman, Head of Retail at Vanguard Investments Australia.

Currency and risk of diminishing return

THE Australian dollar is both friend and foe to investors.

Being a minnow in terms of world sharemarkets Australian investors are almost forced to look overseas by sound investment logic – diversification and exposure to industries and companies that are not available through our local markets.

But while investing in the world’s best companies has strong appeal it brings with it exposure to currency risk and the Australian dollar is at times seemingly a plaything in the hands of the world’s currency traders.

We may well bask in a little nationalistic pride as our Australian dollar climbs higher on the nightly TV news screen against the giants of world currencies like the US dollar. But for overseas investments that are not hedged against currency movements an upwardly mobile dollar is bad news.

Take an investor in a broad international share fund over the past 12 months. The MSCI all-world index (ex-Australia) is representative of the world’s major developed economy sharemarkets. It comprises about 1600 companies from 22 of the world’s developed sharemarkets.

In the 12 months to the end of January the index return on an unhedged basis was -3.3%. But if an investor had hedged out the currency movement the index return was +32.4% - a massive difference over the past year and more in line with what you would have expected given the strong recovery in global sharemarkets after the global financial crisis.

While it has been one-way traffic in terms of the dollar’s direction for most of the past year it can of course work in an investor’s favor if the Australian dollar slides.

Reverse last year’s situation so assume sharemarket returns are flat and the dollar falling in value and an unhedged investor would have benefited from the currency drop.

Investment research studies show that over long time periods currency movements are likely to cancel themselves out. But while institutional investors like large super funds can sensibly manage their currency exposure with a view to the long-tem for individual investors and advisers it is as much about the journey as the final return.

When you look at a chart of our dollar’s movement versus the US dollar or the Japanese yen the range of possible outcomes in any one year is very wide ¬¬–from +40% to -40%. But over longer time periods like five years the range narrows considerably and when you are looking at 20-year time periods the currency impact has indeed largely cancelled itself out. So just like sharemarket volatility time does dampen down currency returns.

A key lesson from the past year is that if you decide against hedging away your currency risk then you should be investing with a longer time horizon in mind.

For investors currency is really a question of risk – how much are you prepared to take on? And at the centre of the issue is your asset allocation to international shares or international fixed interest. If your allocation to international shares is, for example, less than 10% of the total portfolio the risk is clearly a lot more manageable than for someone with 20% or 30% of their portfolio invested offshore – as some major super funds do.

With the clarity that only hindsight brings hedging the currency risk was the right thing to do for the past decade but no-one can predict what the next 10 years will bring.

What investors can do – perhaps in consultation with an adviser – is consciously decide what level of currency risk they are comfortable with and hedge the portfolio accordingly.

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Robin Bowerman, Vanguard Investments Australia's Head of Retail, has more than two decades of experience in the finance industry as a writer, commentator and editor.

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