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PORTFOLIO POINT: There are as many challenges as opportunities for investors in Australia’s strong dollar. Here’s a guide.

Australian dollar strength has prompted many investors to take overseas holidays, however relatively few are inspired to take advantage of their newfound investment firepower.

The macroeconomic arguments for leaving our money at home are well documented but what they don’t take into account are the benefits that broader diversification, currency hedging and counter-cyclical investing can offer investors over the long term.

Currency markets today are largely dominated by speculators and if you needed any proof then look no further than today’s lower-than-expected CPI numbers, which sent the Australian dollar from US99.68¢ to US97.41¢ in just 48 hours.

The Australian dollar is now the fourth most traded currency in the world, which means news like this has the potential to devalue the currency by more than 2%, even though the outlook for the economy is largely unchanged.

The good news for investors is that your newly enriched buying power produces just as many opportunities as it does challenges.

Why you should invest offshore

Apart from monetary muscle, there are two main reasons why Australian investors should consider investing offshore.

In the first instance, it’s important to recognise that the Australian market is not representative of the global stockmarket. It is highly concentrated and without active management of these risks the quality of your retirement is sensitive to the fortunes of and demand for a handful of stocks, especially in mining and banking.

The graphic below compares the sector breakdown of the Australian and global stockmarket. Australia is dominated by financials and resource companies, which together account for 60% of our market. In the global market these two sectors total only 29%. The global stockmarket is offers much larger exposures to IT (25 times larger), utilities (five times larger), healthcare (three times), energy (two times) and consumer spending (1.5 times).

This is just as powerfully reflected by comparing the largest companies on the ASX and the largest companies globally. On the local bourse, BHP dominates the index, accounting for 14% of the local market whereas the largest listed company in the world, ExxonMobil, makes up a little over 1% of the global market.

Investors should always remember that bigger doesn’t always mean safer. Canada’s version of BHP, telecommunication supplier and ex-phone company Nortel, recently went bankrupt, unable to pay its pension liabilities. During the 2000 dotcom bubble, Nortel represented nearly one-third of the value of the Toronto Stock Exchange TSE index.

By assembling your own direct stock portfolio you can undue this industry bias. About 30–40% of the earnings from ASX-listed companies come from offshore, but you are going to struggle to access the profits of industries not well represented here. If you don’t invest offshore then you won’t be able to make money each time your friend buys an iPhone, iPad, iPod or other “iProfit” device '¦ Conversely the good news is you don’t need to go offshore to find diversified miners or robust financial institutions.

The second reason you need to think about offshore investing is because about a third of your expenditure is on items priced offshore. If you don’t have an exposure to offshore currencies then you are at risk when (yes when, not if) the Australian dollar falls in value and your purchasing power is weakened.

Given that the volume of Australian dollars traded is about 100 times our annual GDP, realise the certainty of how much it costs you to put petrol in your car, a Miele appliance in your kitchen or simply have a holiday overseas is in the control of speculators, not you. To guard against this you can simply hold cash on deposit, locally in a foreign currency account or card, or in an offshore bank, where you’ll find interest rates range from nil to not much.

How to invest offshore

The easiest way to invest offshore and establish a diversified exposure is through Australian managed and domiciled funds that buy stocks on international exchanges. These are most commonly available as unlisted managed funds, available in their hundreds.

You can also buy into funds listed on the ASX, either actively managed listed investment companies (LICs) or newer passively managed exchange traded funds (ETFs). A selection of both are listed below.

You can also buy individual stocks traded on foreign exchanges through an Australian full-service or internet broker. Most brokers offer these services today and charge as little as 1% or $100 per purchase. Details are available on the CommSec and E*Trade websites.

Many Australians who have spent part of their professional lives overseas have share investments, deposits or other facilities overseas, which produces yet another option. However, the tax compliance burden of investing offshore using an Australian-domiciled fund is much simpler than investing directly.

As I discussed back in July (see Expats and tax), when you invest offshore you are generally classified as a non-resident, which means you may have tax withheld on your investments there which you might be able to claim back here where a tax treaty exists.

Make sure you speak to your accountant first before investing offshore via non-Australian-domiciled funds. Those investing in international ETFs should also read the PDS fine print, including about how these funds are regulated offshore, policies for securities lending and whether any additional paperwork needs filed such as a W8-BEN form with the US Internal Revenue Service.

When it comes to property, it is easy to invest in commercial property offshore through any of the dedicated offshore property trusts or REITs (real estate investment trusts). Many REITs, such has Westfield, have portfolios where overseas holdings far outweigh any local exposure. (But be careful, this sector has experienced many problems during the GFC and some believe they are not fully resolved).

If you want to buy property directly you’ll need to consider your purchase carefully and seek expert tax and legal advice both here and in that country (more on this topic next week).

While many institutional investors invest in global bonds, for themselves or you, I am not sure it is necessary or easy or safe enough for Australian direct investors to do so. The main argument for investing is diversification given the small size of our domestic bond market. But while interest rates are much lower outside of Australia, bond funds hedged back into Australian dollars earn an additional margin which allows the fund to earn about the same if it invested here.

To hedge or not to hedge

For investors who want the exposure to different industries and companies than those available here without worrying about currency fluctuations, simply invest in a low-cost currency-hedged fund. On the other hand you want to be rewarded if the Australian dollar weakens (and don’t mind losing if it strengthens), then seek out an unhedged version.

While it is difficult and expensive for investors for individual investors to hedge out currency risk, it’s not the case for large institutional investors. The cost of hedging can be as little as 0.1% of return.

The only difference in between a hedged and unhedged version of the fund is the superimposed movement of the Australian dollar, which has been substantial in recent months.

With the Australian dollar strong now, then backward-looking returns favour having invested in the hedged version. Had we done this comparison when the Australian dollar was at US67¢, then the opposite story would be told.

The table below summarises the returns from Vanguard Australia’s International equity index fund in hedged (currency neutralised) and unhedged (currency affected) flavours. What this shows is that over the long term, investing in Australia has produced a superior outcome However, it also shows that over the past 12 months a hedged version of the International share fund has delivered equally considerable outperformance.

It should not be surprising that in the middle of a commodity boom Australian shares would outperform, but how long will this boom last? From a risk manager’s perspective, with the Australian dollar considered a “risk currency” or play, it is a defensive strategy to invest unhedged in other currencies; and with the Australian dollar strong it’s not too painful to do so now perhaps.

Issues to consider

Several studies have shown that the optimal amount of hedging in a portfolio is about 50:50 over the long term if you want to smooth your returns (see Should you hedge international shares?). While this is derived from statistical experience, it is really saying have an each way bet.

When investing in emerging markets, note our currency holds its value more closely to those making hedging perhaps not necessary, which is good because not all funds come in hedged versions.

Note also the media has an obsession with reporting the Australian dollar against the US. How it is performing versus the euro, pound and yen is also important for you an investor.

When investing in a global fund, read the PDS closely because you might also find you are surrendering the decision about hedging to the fund manager who may choose when to hedge and when not to.

With perfect hindsight you would have invested new money in a currency hedged international fund when the dollar was in the US50–60¢ range seven to 10 years ago, and in an unhedged fund when it was in the US80¢-plus range.

While the current “currency wars” make foresight difficult, I remain sceptical that our dollar will remain stronger for longer and suggest now might be a good time to invest more unhedged.

If we are to suffer a long period of fluctuating currency movements, then an important consideration is to make sure you periodically rebalance your exposure between hedged and unhedged funds. Should the Australian dollar weaken, simply sell more of your appreciated unhedged fund to buy more of the hedged version.

When the reverse happens, do the opposite. If you find picking the highs and lows of currency are too hard, instead have a fixed mix of, say, 50% and periodically trim holdings to maintain this ratio, knowing that over time this should generate an extra source of return as well.

Doug Turek is the principal adviser of independent wealth advisory and money management firm Professional Wealth.