Currency Part III: Foreign Currency Exposure - How Much is Right for Me?

In the first post of this series, we highlighted the historically positive correlation between the Australian Dollar (AUD) and growth assets (i.e. US Shares). This attribute of the AUD allows it to act as a buffer, partially offsetting the losses on growth assets in a multi-asset portfolio during bear markets.


Part two of the series answered the question: just how powerful is foreign currency as a diversification tool? We used the performance of a typical balanced fund in FY 2014/15 to demonstrate the diversification power of foreign currency exposure. We showed that foreign currency exposure is one of the key drivers of portfolio returns over the short-to-medium-term. In the case study, the fall in the value of the AUD accounted for more than 65% of the balanced portfolio return.


In the final instalment of this series, we outline a framework for determining the appropriate level of foreign currency exposure for your investment strategy.


How much FX exposure is right for you? A guide

The chart above shows the spread between Australian and US 10 – year government bond yields over the past 26 years. Historically, Australia’s relatively high interest rate, compared to other developed nations, has allowed investors to earn a positive carry by investing in AUD assets.


In other words, investors looking to increase diversification (by investing offshore) had to sacrifice the returns from carry (due to higher interest rates in Australia).


This is no longer the case. The cost (i.e. forgone interest) of improving portfolio diversification by increasing foreign currency exposure has now become a gain. This is because US interest rates are currently higher than Australian interest rates.


Currency strategy involves considering a broad range of factors. Investors can’t apply a “one size fits all approach” when answering the question of how much currency exposure is right for them.


A prudent investor considers all relevant factors before deciding on an appropriate allocation to unhedged overseas assets. These factors include:


  • Carry (see above)

  • Investment Horizon

  • Risk and Return Objectives

  • Tax

  • Liquidity

  • Strategic Asset Allocation to Growth Assets

  • Valuation

  • Correlations

  • Attractiveness of other diversifiers


We consider some of these factors below.


Investment Horizon

All investment strategies require a clearly specified time horizon that harmonises with the investor's objectives. Managing portfolio volatility may take precedence over shorter time frames. Consequently, it may be appropriate to increase unhedged foreign currency exposure currency to improve portfolio diversification. Over longer periods, managing short to medium term volatility by increasing diversification may be less important than maximising long-term returns. In other words, investors with long-term investment horizons may not require as much foreign currency exposure.


Strategic Allocation to Growth Assets

Investors looking to allocate a sizeable portion of their portfolio towards growth assets (i.e. shares) should note that this will also result in higher portfolio volatility. Higher portfolio volatility arguably increases diversification's importance. Therefore, the more you are willing to allocate towards growth assets, the more you should consider investing in overseas assets by taking an unhedged position in overseas assets.


Valuation

This factor is intuitive, foreign growth assets are more (less) attractive than AUD denominated assets when the AUD is overvalued (undervalued) relative to other currencies.


Correlations

As discussed in part one of our currency series, the AUD has had a historically positive correlation with foreign growth assets. Moreover, using data from the RBA and the Dow Jones Industrial Average Index (DJIA), we found that the strength of this relationship increases as global markets perform progressively worse.


This can be observed in the table above. We’ve aggregated the worst performing 25% of DJIA months (i.e. the bottom quartile) over the past 25 years and sorted them into groups where returns are worse than -3% (74 months), -5% (42 months) or -7.5% (13 months).


During this time frame, we observed that the losses on the AUD also become progressively more negative, and thus progressively more effective at offsetting losses on US shares. This diversification effect also became more consistent. The percentage of months in which a positive correlation between the AUD and Growth Asset returns increased as US shares performed worse (see the batting average provided in the above table).


Conversely, when foreign markets are rallying, we may observe a lower positive or even negative correlation between the AUD and growth assets.

Attractiveness of Alternative Diversifiers

Currency is not the only diversification tool in the investors arsenal, in some scenarios alternatives such as fixed income (bonds) and gold may be more appropriate. An abundance of attractive diversifiers would warrant less currency exposure and a greater allocation to other, more defensive asset classes. We would argue that bonds are less effective diversifiers when interest rates are low. Arguably, this makes the potential diversification offered by foreign currency exposure more attractive.


Investors would do well to consider how much foreign currency exposure is right for them. Historical returns, volatility and correlations suggest that somewhere between 10% and 40% of a multi-asset portfolio is suitable for most investors. Of course, the amount depends on the factors listed above. These factors can and do change, so we recommend that investors periodically check if the current allocation to hedged overseas assets remains appropriate.

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