The case for active currency management
Financial advisers and investors may have a tendency to shy away from taking an active approach to currency management due to the perception that currency movements are highly unpredictable. Whilst this may be true in the short term, the longer-term direction of currencies can often be reasonably predictable.
This article will explore how actively managing foreign currency exposure can potentially improve portfolio returns. In addition, the merits of treating foreign currency as a strategic asset class with its own risk management and diversification attributes will also be discussed.
The rationale for taking an active approach to determining currency exposure levels within a portfolio is summarised as follows:
- To the extent that currency movements have an element of predictability, then risk-adjusted returns can be improved via active currency management.
- The concept of a longer-term “neutral” or fundamental value of a currency is backed by the well-documented theory of Purchasing Power Parity. This provides a relatively solid theoretical basis that can underpin currency-related decisions. Arguably, this theoretical basis is stronger in the area of currency valuation than that which exist to justify active management in other areas such as stock selection and asset allocation.
- Currency related positions and risks within a portfolio are easier for the end investor to engage with and consent to than other areas of active portfolio management. The concept of exchange rates and their historical trading ranges are generally well understood by investors. This understanding is important as investors have a tendency to exit strategies after short-term losses if they lack the context of the longer-term rationale and opportunity.
- Whereas active stock selection and active asset allocation are available in overabundance via professionally managed funds, there are relatively few investment vehicles that provide active management of currency exposure. Generally, fund managers are benchmarked against either a “currency hedged” or “currency unhedged” index and have a low appetite for currency decisions to risk under-performing these benchmarks. Given this lack of active currency management in professionally managed funds, then it is left to the adviser or end investor to determine strategies in relation to currency exposure.
Adding value through currency management
Ultimately, the rationale for taking an active approach to currency is dependent upon the first of the propositions listed above holding true. That is, currency movements must be expected to exhibit a degree of predictability in order to justify an active approach.
To test this proposition, BMIS has worked with the data modelling firm “Foresight Analytics” to develop a currency forecasting tool. The tool quantifies the sensitivity of $A exchange rates to factors such as relative purchasing power and interest rate differentials; as well as shorter-term dynamic factors such as equity market movements and volatility levels.
Backtesting of the tool’s application for making decisions between holding fully hedged or fully unhedged exposures to global equities suggested significant value could be added to returns by dynamically managing hedging decisions, when compared to passive options of being fully hedged or unhedged (or holding a 50/50 passive hedged / unhedged allocation).
Clearly, an active approach to currency management requires access to some form of analysis framework or forecasting tool. However, even in the absence of an ability to predict movements in exchange rates, portfolio design should embrace an explicit currency strategy – even if this is only to determine longer-term passive currency exposure levels.
Unhedged currency exposure as a shock absorber
The benefits of holding some unhedged currency exposure in reducing global equity volatility are well documented. As a “growth” orientated currency, the tendency for the $A to rise in times of strong equity markets and fall when equity markets weaken can be a significant source of shorter-term volatility dampening for unhedged global equity exposures.
This was most evident in the GFC period, when the peak-to-trough decline in unhedged global equity indexed investments was some 19% less than the fall in hedged global equity exposures.
Due to the widespread practice of holding some global equity exposure on an unhedged basis, the level of currency exposure in a portfolio tends to increase as the risk profile of the portfolio increases. There is clearly some logic in this tendency, given the role that currency exposure can play in assisting in the management of equity volatility.
However, the potential benefits of currency exposure can be far wider than purely being an equity volatility dampener. This is particularly relevant for more conservative portfolios that, due to low levels of global equity holding, tend to have low levels of foreign currency exposure.
Fundamentally, the holding of investments domiciled in currencies other than the $A is a form of insurance against Australian specific events.
A recessionary environment in Australia, for example, would be expected to be associated with:
- an underperforming local equity market,
- a higher incidence of credit losses,
- a period of lower interest rates and
- a weaker Australian dollar.
In such an environment, unhedged currency exposure (boosted in value by currency depreciation) could assist in offsetting some of the lower earnings expected from local assets.
Alternatively, should Australia experience higher inflation than expected relative to inflation rates overseas, then again an unhedged currency exposure may provide some protection.
In theory, higher relative inflation in Australia should lead to a depreciation in the $A (thereby maintaining parity of purchasing power). For conservative investors looking to maintain the purchasing power of their savings, then foreign currency exposure could be an effective hedge against the eroding impact of an Australian specific inflation spike. The fact that many retirees may have significant future expenditure directly linked to overseas purchases and holidays should also not be ignored.
A more extreme economic downturn or crisis, perhaps associated with a collapse in currency value and associated hike in inflation, would magnify the benefits of conservative investors holding some foreign currency exposure. In the Argentinean crisis of the late 1990s, for example, it would have only been those investors who held some foreign currency denominated assets that had hope of maintaining an element of purchasing power from their investments.
Admittedly, it is a long bow to use an Argentinean type crisis to rationalize a strategy for an Australian investor. However, we shouldn’t lose sight of the fact that Australia’s external financial stability is somewhat dependent on the price of a limited number of commodities and increasingly concentrated to one major purchaser.
Holding a strategic allocation to foreign currency outside of that provided by unhedged global equity funds is also now more viable than previously via the advent of foreign currency ETFs.
In addition, that fact that interest rates are now higher in the United States than they are in Australia removes the opportunity cost that used be incurred by switching some $A domiciled assets to $US domiciled assets.
In a sense, the “insurance” qualities of currency diversification are now available free of charge. Hence, irrespective of whether an active or passive approach is taken in relation to currency exposure, decisions around currency should now go beyond a static targeting of currency hedge ratios within the global equity sleeve of a portfolio.
General Advice Disclaimer
This document has been prepared by Plain English Economics Pty Ltd, trading as “Brad Matthews Investment Strategies” (BMIS). Plain English Economics Pty Ltd is a Corporate Authorised Representative of First Point Wealth Management P/L AFSL 483004). The document is intended for the use of financial adviser clients of BMIS and their staff only. Any advice provided is of a general nature and does not take into account personal circumstances. Any decision to invest in products mentioned in this document should only be made after reviewing the relevant Product Disclosure Statements. Past performance is not a reliable indicator of future performance. No revenue has been received by BMIS as a result of the production of this document.
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I founded the investment consulting business, Brad Matthews Investment Strategies. BMIS provides assistance to financial planning practices in developing their investment philosophy and creating portfolio solutions consistent with this philosophy.
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