(August-2002) The currency hangover

The party of rising global equity prices and a declining Aussie dollar had to end. As with all hangovers, it now remains to be seen how seriously super funds will be affected by the rise in the Aussie dollar, lower global equity prices and an increased exposure to offshore assets, without the safety net of a currency hedge.

With hindsight, questions are being asked about the wisdom of leaving offshore investments at the mercy of fickle currency markets. Is this a gamble or a prudent investment strategy of portfolio diversification? And, all this has come at a time when local funds have rapidly increased their exposure to international assets to more than 20 per cent, from about half of that a few years ago.

The argument for not hedging is that it reduces overall risk by increasing portfolio diversification. By hedging back into Australian dollars, all eggs are effectively in one basket.

Van Eyk head of research Tom Cottam believes that significant currency losses are likely in individual years “even though, unlike other assets classes, in the long-run currencies are a zero sum game”.

Richard Smith, chief investment officer of Funds SA, questions how long the long-run is. “Is 20 years the long-term? The Aussie dollar has dropped by an average of one percentage point annually over the past 20 years. This is clearly an exposure that must be managed,” he says.

Stephen Roberts, head of institutional business at Frank Russell, believes that it is appropriate for investors to consider currency. “Nobody likes the short-term losses that can arise from rapid and powerful currency movements. But at the same time, investment decisions need to be made in the light of the investor’s objectives, a coherent strategy and be based upon a sound understanding of what is, and what is not, predictable.”

He adds that currency management is complex and requires a “deep understanding of the interaction between interest rates and currency movements, and in the pricing and operation of derivatives”.

“The issue of what hedging policy to undertake should be based on the assumption that currency markets are, by and large, efficient. And, there is no point in trying to time the implementation of an investment strategy, to take advantage of future currency movements — they are too unpredictable.”

However, Margaret Waller, the Australian head of Pareto Partners, a global specialist in currency risk management, believes that the problem is more serious for investors. “If they have an average of 25 or 30 per cent offshore and the dollar has rallied 10 per cent, they’ve just lost three per cent of their total investments.”

Fund managers who hold a five per cent overweight position in global shares, relative to the average manager, could have turned in a loss of around one per cent from the investment so far this financial year. This is because unhedged global equities have produced close to a 20 per cent loss since June 30, 2001.

BT Funds Management economic adviser Chris Caton says the situation is crying out for new products.

And, Richard Kerr, Macquarie Funds Management’s currency manager, notes that “the potential for currency fluctuations to have an impact on returns has never been higher”.

He adds that between June 1997 and September 2000, superannuation funds have more than doubled their exposure to international assets in Australian dollar terms, especially equities. “If more than 20 per cent of the equity portfolio is invested offshore, currency movements can have a strong impact on returns,” he says.

Roberts argues that most investors do agree that international diversification improves the performance of a portfolio. “But with this diversification comes a problem not found in all domestic portfolios — currency risk.”

He concludes: “Overseas investments provide both risk reduction and the potential for long-term incremental returns ... Adding international exposure to an investor’s portfolio provides an opportunity for Australian investors to share in the profits of some of the most successful companies worldwide. Remember, 98 per cent of the world’s equity capital/investment opportunities lie outside Australia.”

Also, investing overseas opens up opportunities to invest in industries that are not represented, or are under-represented, in Australia.

Finally, over the past 30 years, international shares have provided a higher annualised return, at considerably lower risk, than Australian shares.

CURRENCY HEDGING

With less than a third of super funds employing active currency managers, and with the average fund maintaining a benchmark currency exposure of 15 to 20 per cent, it is clear that super funds have a lot to lose.

At the end of the day, David St. John, UniSuper’s chief investment officer, notes that there are typically two aspects of a fund’s currency management policy — its strategic currency hedging position (most funds set this at around 15 to 20 per cent to take advantage of diversification benefits) and the question of whether to try to add value through active currency management.

He points to funds’ increasing exposures to overseas assets in recent years and the currency gains on unhedged assets achieved over this period. “It would be prudent for funds to ensure that their currency management policies are relevant and up-to-date.”

Mercer Investment Consulting’s Greg Burt reckons that only 200 to 300 major super funds worldwide currently employ a currency overlay manager and that fewer than a third of Australian super funds have opted for active management. “This is largely due to a lack of understanding on the part of trustees,” he says.

Stephen Roberts, head of institutional business at Frank Russell, says currency hedging is a process that removes the effect of a fluctuating currency on investments held offshore. “Essentially, it is an ‘insurance policy’, whereby hedging the currency preserves the exchange rate between the two currencies at a set value.”

So, a 100 per cent hedging policy means the effect of currency movements is removed, so that the returns from international investments are solely derived from the performance of that investment.

An unhedged policy means that the returns from international investments will depend on the movements of the value of the Australian dollar relative to the currency in which the overseas investment is being held, as well as the performance of the investment.

A partial hedging policy - such as 50/50 or 70/30 - means the investor won’t ever experience the major highs of an unhedged portfolio, but won’t be subject to the lowest returns either.

Van Eyk Research believes the ideal solution is to implement a basket protection approach. Van Eyk’s head of research Tom Cottam explains that the dynamic hedge differs from the plain vanilla or static hedge by using options instead of forward contracts. “This option-based or insurance approach effectively limits currency losses and allows significant positive returns when available. It adds value by not losing and maintains the currency diversification benefit,” he says.

Turning to bonds, Roberts notes that these are naturally a low risk, low return asset. “Their purpose, in a portfolio context, is to diversify and reduce risk. By adding in a foreign currency exposure to bonds, one can transform it into a high risk asset, without improving returns.”

As a result, in the case of global bonds, he believes a high hedge ratio (such as 100 per cent) is appropriate. This is because the volatility of global bond returns in the short-term is low, and the additional volatility introduced by currency risk is big. Furthermore, portfolio values in the short-term future are fairly predictable.

Richard Kerr, Macquarie Funds Management’s currency manager, agrees. “For fixed income portfolios, hedging is mandatory, as the currency outcome tends to swamp bond returns.”