Portfolio benefits from a falling dollar

Nicki Bourlioufas | 21 Jul 2015

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Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.

 

Australian investors have long favoured local assets over international assets in their portfolios. This is particularly true of self-managed superannuation funds (SMSFs).

But in the event of a bear market, these investors could be missing out on the benefits of holding unhedged international equities, which could help to lessen portfolio losses.

Data from the Australian Taxation Office (ATO) shows SMSFs' Australian share holdings jumped to $193.1 billion to one third of their total assets of $580.2 billion in the March quarter of 2015.

In contrast, SMSFs had invested just $2.7 billion in international shares in the March 2015 quarter and just another $537 million in offshore managed investments, representing less than a combined 1 per cent of SMSF assets.

Retail investors, like SMSFs, also hold vastly more Australian shares than unhedged international equities. Is that a problem? If you want to cushion your portfolio from a global share-market downturn, then it could be a significant problem.

According to Morningstar senior analyst Kathryn Young, a falling Australian dollar boosts returns from unhedged international investments when those assets are converted into local currency. So if, for example, the Australian dollar falls by 10 per cent against the US dollar, the value of US equity investments would rise by 10 per cent when converted back into local currency. So, for investors in US assets, such currency movements represent gains on their portfolios.

"Typically, the Australian dollar is pro-cyclical. So it tends to rise when global equity markets are rising and fall when equity markets fall," Young says.

"So, to the extent you have offshore share investments denominated in other currencies such as the US dollar, and the Australian dollar depreciates, you gain a little bit back on your unhedged international equity exposures, which helps to offset any losses in your equity allocation if markets fall."

The chart below illustrates how powerful that protection can be at the total portfolio level. It shows that a portfolio of unhedged global equities, using Vanguard International Shares Index [4489] as a proxy, is far less correlated to domestic shares than a portfolio of hedged global equities, with Vanguard International Shares Index Hedged [6430] as the proxy.

 

Exhibit 1: 3-year rolling correlation to S&P/ASX 200 Index

chart

Source: Morningstar Direct™

"It also demonstrates that, if anything, the potential for unhedged global equities to diversify equity risk at the overall portfolio level seems to have only increased throughout the past year," Young says.

"The correlation to domestic shares has declined to almost zero, even going negative for a brief period, as the Australian dollar depreciated relative to other major currencies, especially the US dollar."

With current markets very volatile and Australia's terms of trade at lower levels, Young thinks there is potential for the Australian dollar to fall further, thereby offering further potential diversification benefits to portfolios with offshore unhedged investments.

"In periods of significant market stress, historically the Australian dollar has fallen to levels much lower than where it is today. During the technology wreck, the Australian dollar fell to around 50 US cents, and during the global financial crisis, it fell to around 60 US cents," she says.

"Given Australia's terms of trade are worse now than during the GFC, this suggests the currency could fall further. It's not surprising to see the Australian dollar has fallen in recent days, reflecting a flight to safety, triggered by volatility in the Chinese and European stock markets. And if that situation continues or worsens, then we could expect the Australian dollar to continue falling.

"While it's not a perfect relationship, the figure below clearly shows that during the worst times for equity markets, the Aussie dollar has declined."

 

Exhibit 2: AUD/USD exchange rate -- Jan 1999 to Apr 2015

chart

Source: Morningstar Direct™

SMSFs are especially being denied the benefits from holding unhedged offshore investments. The Investment Trends 2015 Member Sentiment & Communications report found MySuper funds are set to outperform SMSFs this year, as their average exposure to overseas listed equities is just 7 per cent of assets on average, far less than MySuper funds which have 31 per cent on average. And SMSF cash holdings are much higher (21 per cent versus 4 per cent).

The report found super funds with a significant allocation to unhedged overseas assets have benefited due to the strong growth in overseas share markets and the decline in the Australian dollar.

But of course, the downside to unhedged investments is that when the Australian dollar strengthens, then this reduces the values of unhedged international exposures. For that reason, some investors may choose to hold both unhedged and hedged shares and managed funds, to balance out the bets they are taking on the Australian currency, which over time, rises and falls dramatically.

But there is a cost to hedging and you can expect to add an additional fee of about 5 to 10 basis points to the cost of an unhedged managed fund versus the cost of a hedged managed fund.

 

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© 2022 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written content of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.