There is nothing like an overseas holiday to remind you of the power of currency movements to either help or hinder your financial position.
Australian investors probably have more at risk in the currency stakes than most other investors in developed markets.
That flows from the small size of our local sharemarket – less than 3 per cent of the market capitalisation of global sharemarkets – which means to get international diversification Australian investors have to invest offshore. Contrast that to US investors where so many of their major companies are global players which means a lot international diversification comes built into the domestic US sharemarket.
Then comes the fact that the Australian dollar is one of the most volatile currencies by trading volume.
The reality is that the impact of short-term swings in the currency can dwarf underlying investment returns. For instance, the broad US equity market clocked an admirable return of 5.79 per cent, denominated in US dollars, in the first quarter of this year. But due to the Aussie dollar rallying from USD $0.72 to USD $0.76, the return figure denominated in Australian dollars would have been flat at 0.41 per cent.
Clearly, currency can have a material impact on investment outcomes particularly when we have seen the Australian dollar hit $1.10 in US dollar terms not that long ago (remember the so-called ‘parity parties’?) only to see it slide back to around USD $0.70, and now hovering around USD $0.80.
So how should investors think about currency within their portfolio?
It can be tempting given all the market forecasts and prognostications to think of currency as a source of extra return. That can be an incredibly challenging decision to make as some of the smartest, best resourced hedge fund managers in the world will attest.
Better to think of currency in the context of managing investment risk rather than return chasing.
Currency cycles can take years to play out notwithstanding some of the short-term market movements.
Your asset allocation and your risk tolerance will be key considerations when thinking about what level of currency hedging is appropriate. For example fixed income or bond portfolios as a general rule will always be hedged simply because the currency movement will swamp the underlying return.
When it comes to equities the hedging decision is more complex and really comes down to your risk appetite/tolerance. The more conservative investor you are – a retiree for example – the more likely that hedging away some if not all the currency risk will make sense.
You can choose between the two ends of the currency exposure spectrum – from fully hedged to unhedged – or somewhere in between.
But if the idea of currency movements causing your portfolio losses feels like a risk you simply do not want to take then you can opt to hedge away the currency impacts.
However, that does come with costs and tax considerations – for example gains on currency hedging are distributed as income rather than capital gains.
The complexity around how much or little to hedge the currency risk within your portfolio means it is an area where getting professional advice can be valuable both in deciding the right approach and how to implement it.
The key issue is understanding the currency risk within your portfolio and having the discipline to decide how it will be managed.