Managing currency risks
Exposure to overseas earnings can hit a portfolio but hedging comes at a cost
There’s a never-ending stream of financial gurus encouraging you to reduce risk. Foreign exchange movements certainly add an extra layer of volatility to your portfolio if you own international stocks, or any ASX-listed companies that generate substantial revenues offshore (see breakout for local stocks with US revenue exposure).
Take Computershare as an example. Its 2017 result showed underlying earnings per share rising 4% to US57¢ ignoring currency effects – right in the middle of the upgraded guidance range of US56¢ -58¢. But the ignored currency effects were substantial. Putting them back in and translating those figures into Australian dollars at the year-end rates delivers a fall of 4%. ResMed and a host of other local stocks are subject to the same effect.
Before explaining a few strategies to reduce the impact of currency effects, it’s worth asking yourself whether you need to reduce this particular risk at all. There are three reasons for this.
First, Australia is a small country with a sharemarket dominated by banks and resources companies. That makes portfolio diversification challenging. If you own overseas-listed stocks or a few of the ASX stocks in the list because you want a properly diversified portfolio, any currency movement impact inherently forms part of that diversification rationale.
The second point is that some companies with substantial foreign earnings, such as Cochlear, hedge themselves – although only for periods of three years at a time (the rationale, although they won’t say it outright, is to smooth earnings). If the local companies in which you invest do likewise, there’s no point doubling up.
Other stocks with local costs but revenues in foreign currencies, such as miners, will also tend to have hedging strategies in place.
Finally, the research indicates that the predictability
of exchange rate movements is impossible. Here’s some evidence that currencies move towards purchasing power parity over the long term but as far as the next few years go currency movements are essentially random. Who, for example, predicted a strengthening of the US dollar under Donald Trump?
Hedging strategies to reduce currency risk also come at a cost. If you can afford the downside, why bet against yourself and incur extra fees when the outcome is random? If you’re well off and know that your portfolio will cover your cost of living, with plenty to spare, you may decide that incurring a little currency risk isn’t a bad thing.
It may therefore be better to simply manage your exposure to different currencies and stay diversified, rather than try to reduce volatility using one of the hedging options below.
Let’s say, though, that you have a modest portfolio, you’re close to retirement and most of your future expenses are likely to be in Australian dollars.
That being the case, it may be a good idea to eliminate some or all currency risk. The last thing you want is for your nest egg to be denominated in a foreign currency and then in the months before your retirement some calamity wipes
10% off your net worth because of a currency swing.
You have a couple of options. The first is to only buy Australian companies listed on the ASX. Woolworths (WOW) or Westpac (WBC), for example, add practically no currency risk to your portfolio because their earnings are in Australian dollars, as is their stock.
If you want exposure to overseas companies, however, but don’t want currency movements to impact your return, the cheapest and easiest way to eliminate currency risk is to buy international exchange traded funds (ETFs) that are hedged back to Australian dollars, such as the Vanguard International Shares Index Fund – Hedged (VGAD). These funds track international indexes but use derivatives to remove the impact of currency fluctuations. You incur a slightly higher management fee (0.21% versus 0.18% for the Vanguard fund relative to its unhedged version) but this is a much cheaper option than trying to do it yourself because the investment manager can get wholesale prices.
If you want to buy stocks individually rather than own a fund, things get more tricky. You’ll need to get familiar with currency derivatives – options and futures – which can be bought directly through most of the big brokers. Unfortunately, options are usually expensive and can easily cost 5% or more of your portfolio’s value each year, which takes a big bite out of your return.
Alternatively, you could buy a leveraged currency-focused ETF that profits from a strengthening Australian dollar, such as the BetaShares Strong Australian Dollar Fund (AUDS). These funds magnify the returns of currency movements using derivatives but management costs still come to 1%-2%, which is pricey in a world where your investment returns are likely to be in the mid to high single digits. These funds also tie up capital that you could be putting to use in other investments.
If you have a multimillion-dollar portfolio there are some cheaper options, such as a currency overlay, available through private bankers and specialist firms but these are out of reach for most investors.
One final option – and the one we loathe the most – is to use contracts for difference (CFDs). This adds all sorts of other risks, including liquidity issues, margin calls and counterparty risk. Holding costs are higher than for any other option, too, so CFDs are best avoided.