In a previous post, we highlighted some of the diversification benefits of unhedged foreign investments for Australian investors. To briefly recap; the AUD is positively correlated with growth assets such as Australian and US shares. Historically, the AUD has fallen in value when these assets have experienced their worst returns. In other words, it has acted like a buffer, partially offsetting a multi-asset portfolio against losses during bear markets. This makes foreign currency exposure a powerful source of diversification for Australian Investors
Just how powerful a diversifier is foreign currency?
How can investors decide how much to allocate to international assets?
We’ll answer these questions in this article and in part three of our Currency Series.
In FY14/15 we saw a dramatic fall in the AUD, this is shown in the graph above. What does this mean for investors holding US shares? Say the AUD were to fall by 10%, irrespective of the move in the USD, the AUD denominated value of those stocks would increase by +10%. That is why FY14/15 is great year to analyse when trying to get a better idea of the power of foreign currency as a diversifier.
Average Superannuation Balanced Fund Asset Allocation – FY 2014/2015
To analyse what drives multi-asset portfolio returns, SuperRatings completed attribution analysis on a typical balanced portfolio for the 2014/2015 Financial Year. This mock portfolio held the following allocations:
Australian Shares: 27.05%
International Shares: 26.15%
Fixed Interest: 16.50%
The US stock market is approximately 50% of most international share indices. This means that the AUDUSD currency pair is the dominant currency exposure held by Australian investors owning international shares.
Contribution to the Average Balanced Portfolio Returns – FY 2014/2015
For the year ended 30 June 2015, the average balanced portfolio returned +9.6%, International Share returns accounted for 5% of that. In this analysis, International shares were by far the largest driver of returns, contributing more than 50% towards the overall portfolio return. These returns also came in a year where every other asset class did poorly.
The returns in the chart above further highlight the strength of international shares, thanks to the depreciation of the Australian Dollar. During the year June 2015, the impact of the currency movement accounted for +12.6% over the year (or 65.6% of the international shares return). Moreover, currency hedged and unhedged share options returned 10.3% and 22.9% respectively.
In summary, foreign currency exposure is one of the key drivers of balanced fund returns. It has the potential to dwarf the contribution of other asset classes over the short-to-medium term. This, combined with its positive correlation to growth assets, makes it one of the most powerful sources of diversification available to Australian investors.