Observer: Currency issue can’t just be ignored

The rising Australian dollar (or perhaps more correctly the falling US dollar) caused all sorts of havoc for many investment portfolios in 2003.

In a year where most international equity markets (in local currencies) had their best year since 1999, many Australian domiciled international funds actually lost money. And in what was quite a positive year for investment markets generally, the median diversified pooled super fund returned just 7.7 per cent, with one asset consultant suggesting the rising currency had cost such funds as much as 6 per cent.

Should investors simply accept this situation as the result of the whims of financial markets? Or is there something fundamentally wrong with the way many fund managers, planners and investors approach currency exposure in their investment portfolios?

Of course, using hindsight it is easy to see that the best position last year was to substantially hedge the US dollar exposure in portfolios. But that is not the point. Short-term movements in currencies are notoriously unpredictable — and one year is still short-term — although there is evidence that valuations (as defined by purchasing power parity) do eventually matter and that once currency trends develop they can persist over many years.

In any case, the issue is really about managing risk and the probability of meeting investment objectives. Without even taking a view on the direction of currencies there is a strong case that the conventional unhedged approach adopted by most is flawed.

After all, most investors see their returns in Australian dollars, most of their liabilities are in Australian dollars and with a greater focus on ‘absolute returns’, it is clearly absolute returns in Australian dollars that matter. Some overseas currency may make sense for diversification (and because we do import part of our consumption), but I believe many in the industry have ignored how much currency risk (especially US dollar risk) a conventional index weighted diversified portfolio carries. With the size of the US market in world equity benchmarks and the fact that a number of countries (particularly Asian) run currencies linked to the US dollar, most conventional unhedged investors would have as much as two-thirds of their offshore equity exposure effectively exposed to the US dollar. This may be the commonly accepted ‘benchmark’ position, but is it low risk or proper diversification?

Some argue that currency movements ‘wash out in the long-term’. Perhaps, although it may sometimes take many years or even decades for this to occur, a timeframe well beyond the few years that most investors consider ‘long-term’.

Secondly when the primary currency risk most investors hold today is excessive exposure to the world’s reserve currency, at a time when it may be losing that status, it is not something that can be easily ignored.

Thirdly, we have the unusual situation where the current wide 4 per cent short-term interest rate differential between Australia and the US (which looks like persisting for some time) creates a positive carry for currency hedging. That is, hedged investors earn approximately this amount simply by hedging. This latter situation is not a prediction, nor does it require skill — it is something that can be determined by simply looking at today’s market interest rates. Surely it is not asking much for active fund managers to take advantage of such situations.

How did we get to this ridiculous situation where having up to two-thirds of a portfolio’s overseas equities component exposed to a falling and vulnerable currency with close to the world’s lowest interest rates is seen as the ‘low risk’ position?

The answer is clear. It all comes from almost universal acceptance of the religion of ‘strategic asset allocation’ and index benchmarks (where the unhedged MSCI world index has become the primary global equity benchmark). It wasn’t always like this. Originally, benchmarks were just one measure (and not the only one) for investors to judge their performance against, after the event.

Instead, fund managers, asset consultants and researchers have elevated such benchmarks to ‘starting points’ and ‘zero risk’ positions in their portfolios, from which active deviations (‘tracking error’) are decided. For overseas equities the tendency to emphasize the unhedged MSCI index was encouraged by the perception that the Australian dollar could only go down through the ’80s and ’90s based on our higher inflation rates and current account deficits and reliance on (deflating) commodity prices.

These arguments have little relevance today, but the die has already been cast.

How many more distortions and/or disasters does the investment industry have to go through before it abandons this dangerous mindset and puts benchmarks back in the lowly role they deserve in the active investment industry? That is, as signposts on how you are doing — not blueprints to determine what you should be doing.

Of course, not everyone simply accepts the unhedged benchmark approach. Some diversified managers and multi-managers simply hedge half the currency exposure — a simple solution but at least more diversified. Others use fund managers active in currency or employ overlay managers. Too often, however, such managers have been judged too simplistically and harshly — did they add to returns over short time frames rather than assessing them over longer periods and considering their ability to reduce the risk in a portfolio?

In addition, fund managers are increasingly offering hedged and non-hedged overseas funds that at least give planners and investors the tools to build more sensible portfolios (albeit somewhat late).

Finally, there are other ways for portfolios to diversify away this currency risk without explicitly touching the overseas component’s currency exposure. Gold and gold stocks (and even commodities generally) can offer a good hedge, particularly against the US dollar. Managed futures and other trading strategies (for example, global macro) are usually in good positions to take advantage of currency trends.

No normal long-term investor should expect to ever be totally immune from adverse trends in investment markets, including currency. However, when the conventional wisdom for managing this component can be described as unsophisticated, undiversified and failing to take any advantage of a simple arbitrage available in markets, investors should at least be asking some questions.

Why is an unhedged approach the ‘low risk’ benchmark position? Isn’t two-thirds of your offshore exposure effectively in one currency lacking diversification? If one actually gets paid for hedging against currency weakness because of the interest rate differential, why shouldn’t one be doing more of it? Given the totally unhedged approach would have cost investors around 30 per cent on their overseas holdings last year and that this could be part of a longer term trend, surely some answers are required.