We get a lot of questions from our clients about foreign currency. Some clients are worried about losses resulting from a fall in the value of the Australian Dollar (AUD). Other clients wonder why anyone would give up the franked dividend yields paid by Australian shares to invest overseas.
Don’t worry if you’ve asked similar questions. The effects of foreign currency can be confusing to understand, even for experienced investors.
The short answer to these questions is diversification. Unhedged foreign currency exposure has historically been one of the most effective sources of diversification for Australian investors. This is because the Australian Dollar has historically displayed a positive correlation to growth assets (such as shares).
When growth assets such as stocks go up (down), the AUD goes up (down) and the AUD value of overseas assets goes down (up). In other words, the change AUD-value of unhedged assets has provided a buffer during periods when growth assets have performed poorly.
Importantly, this positive correlation has been stronger and more reliable when growth assets are at their worst.
AUD and US Shares
The chart below shows the monthly change in the value of the AUD (Blue) with the monthly return of the Dow Jones Industrial Index, in USD unhedged (Teal) between January 1980 and June 2019, sorted from largest to smallest.
The correlation for the entire period was 0.31. How did the AUD perform when US shares were down? The chart below shows the worst 25% (bottom quartile) returns for the Dow Jones Industrial Index during this period.
The positive correlation was stronger at 0.40. Conversely, there was almost no correlation (0.07) between the monthly return of Australian shares and the AUD in the best 25% (top quartile) of monthly returns.
The diversification effect was much stronger when US shares were at their worst. You can see this in the table below. We’ve tool the worst 25% of months (i.e. the bottom quartile) and sorted them into groups where returns are worse than -3% (74 months), -5% (42 months) or -7.5% (13 months).
The diversification effect, measured by the average and median currency return, was larger the worse US shares performed. This is because AUD’s losses also became bigger, thereby partially offsetting the negative performance of US shares.
The diversification effect also became more consistent. The batting average, percentage of months where the correlation is positive, increased when US shares did worse.
AUD and Australian Shares
The positive correlation between the AUD and growth assets is also present with AUD growth assets such as Australian shares.
Why is this important? Because most clients that we talk to invest predominantly in AUD assets such as shares and property. These investors are effectively taking a big bet on the Australian economy!
The chart below shows compares the monthly change in value of the AUD (Blue) with the monthly return of the All Ordinaries Index (Teal).
The correlation for the entire period was 0.33. How did the AUD perform when Australian shares were down? The chart below shows the worst 25% (bottom quartile) returns for the All Ordinaries during this period.
The correlation was 0.32. Conversely, there was almost no correlation (0.01) between the monthly return of Australian shares and the AUD in the best 25% (top quartile) of monthly returns.
While the correlations between all months and the worst 25% of months are similar, the diversification effect is much stronger when Australian shares are at their worst. You can see this in the table below. We’ve taken the worst 25% of months and sorted them into groups where returns are worse than -3% (79 months), -5% (43 months) or -7.5% (19 months).
Once again, the diversification effect, measured by the average and median currency return, was larger and more consistent. The batting average, or the percentage of months where the correlation was positive, increased when Australian shares assets did worse.
In summary, 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. It has acted as a buffer, partially offsetting a multi-asset portfolio against losses during bear markets. This makes it a powerful source of diversification for Australian investors.
Just how powerful a diversifier is foreign currency exposure? And how can investors decide how much allocate to international assets? We’ll answer these questions in future posts.