Is currency exposure an unwanted risk or source of returns?

Australia is a small, open economy which compels superannuation funds, fund managers and other large investors to look offshore for investment opportunities. In round terms, the market cap of the Australian Securities Exchange is $2 trillion and superannuation assets alone are almost $3 trillion.

Australians investing overseas

There are three main rationales for expanding investment horizons beyond domestic markets:

• To uncover and exploit a much larger opportunity set to add to returns
• To add diversification to the portfolio as a way of reducing risk
• To move more ‘invisibly’ in offshore listed markets compared to the relatively small Australian market where large investors are liable to leave a ‘footprint’ and push market prices unfavourably as they place large trades into the market (the technical concept of investment strategy ‘capacity’).

Investing offshore, of course, brings a new portfolio dimension into play:  currency risk. Generally, any offshore asset in which an Australian investor invests is actually a bundle of two exposures – the risk/return of the asset itself, measured in the currency in which the asset is denominated (‘local currency’), and the value by which the investor’s ‘base currency’ (AUD) moves in relation to this local currency over the holding period – the currency exchange rate movement.

Here’s how this breaks down over the past decade for an investment in index-tracking (passive) international equities:

Source: MSCI, Parametric. Reflects Accumulation Index returns (net), pre-tax, annualised over performance periods ended 31 August 2020. It is not possible to invest directly in an index.

Major impact of currency return

The ‘currency movement’ contribution to returns (capturing the difference between the portfolio’s local currency and actual AUD experience) are meaningful, especially over shorter time periods. Data informing investment decisions should always reflect the investor’s base currency – what is actually relevant to the investor.

To illustrate this, the comparable 1-year return for Developed Markets (only) equities was 14.39% in local currency terms, which lags the 14.63% All Countries return noted above, making it look like adding Emerging Markets was a good tactic. However, the AUD Developed Markets return was 6.39%, outperforming the AUD All Countries return of 6.16%

It shows in fact that expanding to Emerging Markets was a losing bet from an Australian perspective.

Of course, a sophisticated investor can currency-hedge the portfolio to reduce or remove the currency risk and isolate the particular exposure offered by the underlying assets (the ‘local currency’ performance). To currency-hedge, large superannuation funds typically use a series of ongoing trades in currency forwards (derivative contracts) whose pay-offs move in the opposite direction to the exchange rate movement of the underlying asset.

This does not quite mean that a fund fully currency-hedging its international equities over the last decade would have received 10.67%, though the fund’s AUD return should have been similar. Why? Because few currency hedges perfectly offset the underlying exposure and, even if they do, currency hedging comes at a cost.

For example, the Emerging Markets component of the above All Countries equities portfolio would have been difficult to currency-hedge in practice due to the limited liquidity in hedging instruments and regulatory restrictions on trading the currencies of some countries.

Particular attention needs to be paid to how to fund the ongoing rolling of the currency forwards (because these cashflows do not match the cashflows of the underlying hedged physical asset), and also to the tax implications of the hedge.

In other words, the currency hedge is of the pre-tax financial performance of the investment, not post-tax, nor does it hedge (offset) the actual cashflows required or generated under the hedging arrangement.

Currency as a source of return

Currency management is changing from ‘risk mitigation’ to currency as a potential return source. This promising new chapter in currency thinking marks an evolution which began in the early days of compulsory superannuation in Australia (the 1990s), when a typical balanced equities/fixed income global investment portfolio would have the growth assets (equities) unhedged and the defensive assets (fixed income) fully hedged. Effectively, currency exposure was treated like a growth asset, appropriate for fund members with a reasonable time horizon and risk appetite.

In the 2000s, the idea of a setting a static ‘hedging ratio’ for offshore equities came to the fore, like a targeted 50% hedged, 50% unhedged exposure. This ‘least regret’ approach meant that, given the volatility inherent in currency, a hedged/unhedged combination would not overwhelm the underlying equity performance (if the AUD rallied) nor overly damage the results (if the AUD deteriorated) over successive performance periods.

Today, this classic balanced portfolio is more likely to have about 28% of the equities and 61% of the fixed income currency-hedged (APRA quarterly superannuation statistics – June 2020).

The thesis that currency can be a return source is being pursued in programmes to dynamically adjust currency hedging ratios and ‘tilt’ to or from currency positions based on shorter-term views around whether the AUD (or any other currency) is over- or under-valued and how global macro-economic themes will impact the currency’s supply and demand.

Few of these sophisticated, dynamic currency management programmes have been around for long enough to build up a long-term track record. As they do, it will be fascinating to see whether currency, long seen as an unwelcome risk in global portfolios, can make a successful, remarkable transition to becoming a valued source of returns.

Raewyn Williams is Managing Director of Research at Parametric Australia, a US-based investment adviser. This material is for general information only and does not consider the circumstances of any investor. Additional information is available at parametricportfolio.com.au.