Dollar helps US dreams come true

Thanks to the high dollar, investors could strike it rich by investing in American stocks, but they need to watch out for currency fluctuations, writes Barbara Drury.

Thanks to the high dollar, investors could strike it rich by investing in American stocks, but they need to watch out for currency fluctuations, writes Barbara Drury.

The high Australian dollar has not only given Australians greater purchasing power on overseas trips, but it also provides an opportunity to buy overseas assets on the cheap. Now that Wall Street is running with the bulls, Australian investors are clamouring to join them.

US shares have recently outpaced the Australian market as signs of economic recovery begin to emerge.

Not only has the US market pushed through its pre-crash high, it offers better value. The Dow Jones industrial average is valued about 12.5 times earnings, while the local market is trading about 14.5 times expected earnings.

"If the currency is strong and there is an improvement in the global economy, then that is a double whammy in your favour," CommSec chief economist Craig James says.

But what if you buy now and the Australian dollar falls? Even better. That is the punt the so-called smart money is taking at the moment, buying overseas shares in the hope of capturing market gains plus currency gains when dividends and profits are converted back into Australian dollars.

But this is a high-risk strategy because if you think timing sharemarket moves is difficult, timing currency movements is like wrestling with jelly.

After briefly pushing above $US1.10 in 2011, the Aussie dollar has traded in a US13¢ range between US95¢ and $US1.08 (see the Australian dollar graph, right). James thinks this trend is likely to continue, with a trading range of US98¢ to $US1.10, but there is a growing view in the investment community that the next big move will be down.

"A lot of people don't believe the Australian dollar will be higher than the US dollar in two to three years' time," BetaShares head of investment strategy Drew Corbett says.

History supports this view. Since the dollar was floated in 1983, it has spent most time in a trading range of US75¢ to US80¢. No one is tipping a fall back to these levels soon but a retreat below parity looks increasingly likely.

The Australian dollar is hovering just above parity, with the US dollar near $US1.02. It is being held in suspended animation by conflicting forces.

"The Aussie dollar is stuck between a rock and a hard place," AMP Capital chief economist Shane Oliver says. He thinks the dollar is unlikely to go higher because of concerns about commodity prices easing and sluggish economic growth, but it's unlikely to go lower, at least in the short term because of quantitative easing and global economic problems.

But Oliver says a surprise uptick in the global economy or an early end to quantitative easing could put downward pressure on the currency.

Quantitative easing in the US, Japan and Britain has kept their currencies artificially low against the Australian dollar - or our dollar artificially high, depending which way you look at it. Quantitative easing refers to the policy of printing money while keeping interest rates near zero in an attempt to stimulate economic activity.

But against that, Australia's economic growth has stalled about 2.5 per cent during the past nine months and the Reserve Bank has cut interest rates substantially, reducing the differential with overseas rates that has attracted foreign investors and helped keep our dollar high.

All of which leaves investors in a quandary. The high Australian dollar opens opportunities for Australian investors in overseas markets, whether through direct investment, a managed fund or exchange-traded fund (ETF). The decision is whether to hedge the currency risk or not to hedge.

People are told they should invest in overseas shares for diversification because Australian shares represent just 2 per cent of the global market. But once you invest overseas, you are not only taking on sharemarket risk but currency risk as well.

"You can generate extra performance [from overseas investments] if you get the currency right," Vanguard head of market strategy Robin Bowerman says.

But that's a big if. Investors need to be honest with themselves, not only about their ability to read a crystal ball but also their risk tolerance and time frame. In the long term, currency moves are often neutralised.

But if you are thinking of investing for one to three years, the currency risk is higher; if you value a good night's sleep, it makes sense to hedge.

"The key question is, do you want to take a position on the currency or buy international share exposure and take currency risk off the table, in which case you hedge," Bowerman says.

Some advisers suggest clients hedge half their investment and leave the rest unhedged - the position of least regret. "If the dollar moves aggressively one way or the other, you won't miss out completely or get whacked," Bowerman says.

Most fund managers with international investment products offer them in hedged and unhedged versions. The choice you make can have a significant impact on returns.

In the past 10 years, Vanguard's international share fund generated an average annual return of 9.05 per cent hedged but only 2.11 per cent unhedged. In the past year, the return has been 20.2 per cent hedged and 18.4 per cent unhedged, reflecting the rise in global equities and a halt in the rise of the Australian dollar.

"Over the last decade there has been a strong case to hedge back to Australian dollars when investing overseas," Oliver says. "Now the pressure to hedge is far less."

There is also a compelling case developing for Japanese equities. While there are signs the US central bank is wavering in its commitment to quantitative easing, the new governor of Japan's central bank has pledged to do whatever it takes to stimulate economic growth.

Oliver says this will boost Japanese exports and could add another 20 per cent to sharemarket gains.

The Australian dollar buys about ¥99, the highest since 2008, and Oliver says this could rise to ¥110.

There is also speculation that Britain may print money again, which would further strengthen the Aussie against the pound. If this is the case, then investors may want to hedge their Japanese or British investments.

Whatever your view of the currency, it is important to keep decision-making about equities separate from currency. Oliver advises making a decision about which markets offer the better investment and then deciding whether to buy hedged or unhedged.

How hedging works

Hedging might sound like a gardening term, and that is how it originated. In finance speak, hedging is when a metaphorical hedge is placed around overseas investments to protect them from adverse currency movements.

Hedging protects against currency losses with a rising Australian dollar, but reduces gains if the dollar falls. The easiest way to do this is to buy a hedged version of a managed fund and let the professionals handle the currency hedging for you.

Local investors can also buy currency-hedged gold, commodity and agriculture exchange-traded funds (ETFs), which can be bought and sold on the Australian Securities Exchange like shares, but there are no hedged versions of bond or international shares ETFs.

However, State Street Global Advisers will launch one in coming weeks. The SPDR S&P World

ex-Australia will provide access to about 350 large and mid-size international companies in hedged and unhedged versions, which is a first for the Australian market.

$A risk insurance

An alternative to hedged managed funds for investors who want to protect themselves against a fall in the Australian dollar, or cash in on a rise in the US dollar, is the BetaShares US dollar exchange-traded fund. This offers a simple, low-cost exposure to the performance of the US dollar relative to the Aussie dollar and is backed by holdings of physical US dollars with J.P.Morgan Chase. If the Australian dollar falls 10 per cent, then the US dollar ETF is designed to go up by 10 per cent, minus fees of 0.45 per cent a year.

BetaShares head of investment strategy Drew Corbett says people are using the fund to lock in the high Aussie dollar in the belief it will normalise to historic averages.

Corbett says a popular strategy is to buy the US dollar ETF based on a potential pick-up in the US economy in the second half of this year. If that happens, there is a view that the US Federal Reserve will end quantitative easing in 2014, prompting a rise in the US dollar.

Another strategy is to use the ETF as a natural hedge against exposure to the Australian resources sector. Many local investors have substantial holdings in resource stocks but the sector has been lagging the overall market based on fears the mining boom has passed its peak.

As the graph below shows, in recent years the US dollar has followed an inverse trajectory to local resource stocks.

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