Where to seek shelter in a global currency storm?

The currency market can often feel like a brewing storm. For Australian investors with overseas holdings, currency fluctuations are a significant source of concern, and potentially, rewards.

Imagine sailing on the ocean on a peaceful day when suddenly, seemingly instantly, everything changes. A cold front rapidly moves in, and the idyllic scene turns chaotic.

The currency market can often feel like this. Following a decade long rally of more than 120% from the 2001 lows below 49 US cents, punctuated by a short lived 30% drop during the GFC, the past two years have delivered further wild gyrations in the Australian dollar. The AUD/USD exchange rate fell more than 15% in the middle of 2013 before stabilising in the mid 90-cent area, only to fall another 15% in the last 6 months of 2014. The Australian dollar’s decline at the end of 2014 was a result of multiple factors, including expected interest rate hikes by the US Federal Reserve (the Fed), shrinking yield spreads, a recovering US dollar, falling commodity prices and verbal intervention by the Reserve Bank of Australia. To make things even more complicated, the Australian dollar rose for large parts of this period against other major currencies such as the Euro and Japanese yen.

For Australian investors with overseas holdings, currency fluctuations are a significant source of concern and potentially, rewards. That’s because there are two ways to earn returns from international investments, namely:

• The value of the investment. For example, if you own a German stock, you hope the price – in euro terms – will rise.
• The exchange rate. This stock return can be enhanced by a decrease in the Australian dollar/euro exchange rate. Conversely, a rise in the value of the Australian dollar against the euro cuts into an Australian investor’s earnings from European assets.

Depending on the asset class, the currency impact can potentially swamp the return from the underlying assets. This is why some asset classes are more typically invested in a way that removes the currency impact completely (or partially), leaving only the local currency underlying return. This activity is typically referred to as ‘currency hedging’. The degree to which the currency exposures from offshore investments are hedged will depend upon the investor’s appetite to accept currency gyrations. Some believe they are likely to profit from currency volatility or seek diversification benefits from exposure to foreign currencies. Alternatively, others are uncomfortable with foreign exchange risk and would prefer to avoid it entirely.

Both types of investors can use hedging techniques to help manage currency risks.

What does it mean to ‘hedge currency risk’?

Hedging involves selling foreign currencies and buying the domestic currency, say the Australian dollar. By selling a foreign currency, you lock in its price. For example, if you own German stock valued at 100 euros, you could sell up to 100 euros and buy Australian dollars. Then you would own 100 euros’ worth of stock, but since you sold an equal amount of euros and received dollars in exchange, the movements of the common currency are very unlikely to affect your investment. Of course, there is a potential risk of loss with currency hedging, just like any other investment.

What are some of the ways investors can hedge their currency risks?

Institutional investors often hire a specialist to help them with their hedging needs. Individuals lacking the necessary skills and experience, can access the benefits of currency hedging solutions as part of a globally diversified multi-asset or sector fund, or exchange-traded fund (ETF). In such products, the investor buys a currency-hedged strategy that invests in overseas shares, but hedges (either passively or dynamically) the currency risk, helping to obtain a similar outcome that institutional investors might get by working with a specialist. Some of these products may have ‘$A Hedged’ in their names or describe currency hedging in their Product Disclosure Statements, for example.

Are there some reasons to consider currency hedging in 2015?

Some of the key investment themes driving financial markets, including currencies, at present include:

• Greater projected US economic growth compared to other regions;
• Differences between global central bank policies. The US and several other countries plan to tighten monetary policies (e.g. by raising interest rates), while most others are easing monetary policies (e.g. lowering interest rates or continuing ‘quantitative easing’ programs);
• Collapsing energy prices (especially oil); and
• The global search for yield (which may lead investors into higher-risk sources of yield, such as high-yield bonds rather than investment-grade bonds.)

On balance, these factors point to a strengthening US dollar, as the Fed eventually moves to raise interest rates while the RBA is lowering them, putting further downward pressure on the AUD/USD exchange rate. As we move closer to the Fed’s expected tighter monetary policies, one can reasonably expect periodic ‘storms’ to hit the currency market, creating up drafts and down drafts. Hence, although one could conclude that investors with offshore investments should remain unhedged, there are still valid reasons for including a degree of currency hedging.

Many investors with offshore holdings have at least some degree of diversification across markets, and therefore currencies. So while the case to reduce or remove hedges on US assets might be stronger, the case for unwinding hedges on European and Japanese assets is less so, given that these major currencies are also expected to remain under pressure against the US dollar (potentially, the Australian dollar could rise against the Euro and/or the yen).

Similarly, even if the Australian dollar continues to fall further against the US dollar, there will come a time (and a level) when hedging to lock in at least some of the currency gains on US assets becomes an attractive proposition. Clearly, the decision to hedge – or not to hedge – is entirely dependent on the offshore asset exposures in a portfolio, objectives and risk tolerances of the investor, skills and experience of the investor, and the investment vehicle used to access the offshore assets (e.g. direct or via a managed fund/ETF).

Seasoned investors know that currencies move up and down, overshoot and undershoot. Expect 2015 to be no different. In light of this expected volatility, and given the significant impact currency can have upon total portfolio returns, it is wise for any investor with offshore assets to look again at the level of currency hedging in their portfolio, to ensure that the portfolio remains on track to deliver the required rate of return, but at a level of risk that can be tolerated ... and committed to. Be deliberate about your currency exposures by engaging a professional currency hedging program. This will lower the risk of your overall investment objectives being compromised by ‘unintended’ currency risks.