The increasing level of offshore assets in many Australian portfolios naturally exposes investors to currency volatility – where the performance of investments will depend not only on the local asset returns but also the fluctuations of international currencies versus the Australian dollar.
Three monthly implied volatility for the Australian dollar is currently over 12 per cent, which can leave many investors feeling very uncomfortable and pushes many to eliminate currency risk or look to at manage it.
Portfolio consensus is that lower volatility assets, such as global fixed interest, infrastructure, and real estate trusts should be currency hedged. It simply makes sense to remove currency exposure from investments where a significant percentage of the overall return comes from the domestic cashflows that those assets produce. Historically, this has provided more stable total returns – but can create some interesting short run challenges where physical assets need to be sold to cover out-of-the-market currency hedges.
The question regarding hedging international equities is a little more complicated. While there can be material deviations in the short term, the long-term evidence suggests that Australian investors should hold their international assets unhedged. The $A tends to move in the opposite direction to equity returns and can reduce the overall volatility of international equity returns by as much as 2 per cent. Generally, when global growth is strong and equity markets are rising, the $A appreciates on the back of rising commodities and risk sentiment. The reverse is also true, cushioning the blow to returns from risk off events. Really long run investors, like superannuation funds, tend to invest along these lines.
However, as Keynes said – in the long run we are all dead – and short-term changes in the $A can really impact how an investor feels about their international equity returns. In 2009, a strong $A wiped out a 30.79% return in the MSCI world index, with unhedged investors earning a paltry 0.77% return in $A terms.
So many investors adopt a half-way house – assuming some strategic level of hedging. In that way - you can be at least half right (and wrong) all the time.
As most investors would appreciate, the $A is driven heavily by commodity prices (mainly iron ore and coal). Other important factors that drive currency movements are short- and long-term interest rate differentials, relative inflation, economic surprise, and broader capital flows. In addition, traders will often focus on technical pattens in currency pairs for indications of future direction. Momentum, relative strength indicators and trend channels can all play a part in driving positioning and the movement of currency pairs.
There should be special legal disclaimer for commentators who confidently claim to be able to predict the path of currency movements. Currency changes are influenced by numerous factors that often change in significance, which makes predicting the currency direction notoriously difficult to get right on a statistically consistent basis. In fact, many academic papers simply conclude that currency movements follow a random walk – that the currency arbitrarily wanders away from where it started and therefore cannot be predicted.
Recently, the main factors driving foreign currency positioning ‘appear’ to be relative growth expectations (where countries with higher growth expectations are more attractive), capital flows, where investors have been buying U.S. assets versus those of Europe or Asia, and long-term rates, where higher bond yields are more attractive. Recent weakness in iron ore prices has seen the $A lose some ground against a relatively strong $US. Technical analysis would tend to support an $A in the middle of a trading range with is currently moving lower.
Notwithstanding the difficulty in getting currency moves consistently right, foreign currency alpha is a much sort after return as it is often truly non correlated to traditional equity risk. And while difficult to find, there are some very rare firms with pretty good histories of predicting currency movements and adding returns.
While the long run empirical evidence is clear to run international equities unhedged, in the short run there will inevitably be swings and roundabouts in returns. Sometimes it will work for you – other times against you. But the one thing we know for certain – everyone seems to have a view on currency there will be no shortage of people having a punt.