Clients frequently enquire about our views on where the Australian dollar is trading. They are seeking to determine how to position their client portfolios from a currency hedging perspective. While currency positioning affects returns from all offshore asset classes, most clients are predominantly concerned about their global equity exposures. Typically, global fixed interest and global real-estate investment trusts are fully hedged in most client portfolios.

At the outset, it’s important to recognise that trading (expressing short-term views on) currencies successfully is exceptionally difficult to do well consistently, even for professional investors. Although everyone can have a view, it’s the timing of implementation that matters to outcomes, and this is where investors become unstuck. In other words, you may be right in the long term but you could wear a lot of pain in the short term.

Irrespective of the difficulty, clients want guidance and expect to see you being active. Is there a way for clients to enact views without relying on timing markets perfectly? Before we explore this question, a few points should be noted:

  • Commonly accepted theory states that currency returns should wash out in the long-term, meaning no arbitrage opportunity from taking either position. However, over 20 years, this hasn’t quite played out. Hedged returns have outperformed unhedged returns convincingly (see Table 1 below).

 

Table 1: Returns (June 1997 to May 2017).

 RETURNS (% per annum) 1 Year 3 Year 5 Year 10 Year 20 years
MSCI World ex-Aust $A 13.33% 14.15% 18.72% 4.99% 5.80%
MSCI World ex-Aust Hedged $A 19.01% 10.20% 16.38% 6.16% 7.32%

 

  • It’s important to ask clients what they are trying to achieve through currency positioning. While hedged international equity returns have outperformed, they have done so with increased standalone volatility – hedged returns add risk (if volatility is defined as risk) to portfolios.

 

Table 2: Volatility from June 1997 to May 2017.

STANDARD DEVIATION (% per annum) 1 Year 3 Year 5 Year 10 Year 20 years
MSCI World ex Aust $A 9.03% 10.47% 10.37% 12.00% 12.46%
MSCI World ex Aust Hedged $A 5.18% 9.90% 9.26% 14.90% 14.62%

 

Furthermore, the Australian dollar is pro-cyclical and therefore has historically weakened in an equity sell-off. Consequently, having unhedged exposure provides a level of downside protection to the portfolio that shouldn’t be ignored. As an example, during the depths of the global financial crisis, the difference between hedged and unhedged international equity index returns was substantial, with the latter returning -22.15 per cent and former returning -43.26 per cent (from March 2008 to February 2009).

  • Even if you have a view, how do you execute it? If we restrict the universe to managed funds, your choices are limited. Unlike in an institutional environment, you can’t express views on individual currencies, or a basket, but rather can only invest in hedged, unhedged or actively managed funds. The latter option defers the active currency positioning to the manager but typically these don’t allow the manager to assume fully active positions, but tilts instead.
  • Any model should be repeatable and transparent, such that luck can be largely removed as a contributing factor and results can be objectively measured. As mentioned above, you may be able to call currency correctly over the short term due to luck but longer-term success is less likely to be from luck.

So back to the question. Mindful of the above, are there any models/indicators that can be used to guide currency positioning? What influences the Australian dollar? It’s possible you could use interest-rate differentials or look at commodity prices (see Chart 1: Australian/US Dollar cross versus CRB index and Chart 2: Australian/US Dollar cross versus Australian/US cash rate differential).

While there’s correlation (0.73 and 0.54, respectively, over the shown period) in movements to inform our directional views, there’s not enough to give a clear signal. Certainly, as can be observed in the bottom chart, the shrinking interest rate differential between the US and Australia points to a weakening Australian dollar.

If we accept that the above can help inform our views but not dictate them, what else can be used? It’s broadly accepted that purchasing power parity (PPP) works over the long term but can it be employed to create a successful currency hedging strategy? Recall that relative PPP is a theory that states the price of tradeable goods in two countries should be the same after adjusting for exchange rates. Consequently, countries with high inflation should generally experience falling exchange rates relative to countries with lower inflation.

Searching available relevant financial literature reveals that Russell Investments published a research paper in 2013 titled “A forward-looking approach to strategic currency hedging”. The paper was written from a Canadian investors’ perspective, focusing on PPP to determine an optimal hedging ratio for this investor. The paper concluded that superior outcomes were achieved, from a risk/return perspective, through a dynamic hedging approach based on PPP. However, as noted in the paper, since the Canadian dollar and Australian Dollar are both commodity currencies, there is a question of whether this research is equally applicable to Australian investors.

To find out if the Russell research is applicable, we can replicate the study using the Australian dollar as the base. Given the institutional framework, the paper focused on a basket of currencies; however, as noted above, it’s not possible to target individual currencies in a managed fund portfolio. If we instead dissect the currency weightings within the MSCI World ex-Australia Index, a common global equity benchmark, it becomes apparent the dominant currency is the US dollar (over 20 years, the average weighting has been about 54 per cent). The other main currencies are the euro, yen and the pound (average weighting of 14 per cent, 10 per cent and 10 per cent, respectively, over the period). Therefore, for simplicity, given the US dollar is the dominant currency, the focus of this study will be Australian PPP relative to the US.

The parameters of the study were:

  • A start date of June 1, 1997 (20 years)
  • A 50 unhedged/50 hedged neutral ratio
  • On a monthly frequency,
    • If the PPP indicated that the USD was more than 20 per cent overvalued, the portfolio was fully hedged
    • If the PPP indicated that the USD was more than 20 per cent undervalued, the portfolio was fully unhedged
    • The portfolio defaulted back to the neutral hedge ratio when PPP indicated the USD was within 5 per cent of fair value.

Adhering to the above stipulated parameters, and using Bloomberg sourced Organisation for Economic Co-operation and Development PPP data, the study demonstrated that, over the period to May 31, 2017, returns were improved, compared with the neutral portfolio and unhedged portfolio, and about in line with the hedged. However, volatility over the period decreased from 14.62 per cent a year to 13.16 per cent a year. Consequently, the risk/return (known as the Sharpe) ratio was improved from 0.18 to 0.20. (see below tables).

Table 3: Long-term historical annualised returns

RETURNS (% p.a.) 1 Year 3 Year 5 Year 10 Year 20 year
Dynamic hedging 16.20% 14.97% 19.23% 6.06% 7.28%
50/50 16.20% 12.25% 17.66% 5.78% 6.72%
MSCI World ex Aust $A 13.33% 14.15% 18.72% 4.99% 5.80%
MSCI World ex Aust Hedged $A 19.01% 10.20% 16.38% 6.16% 7.32%

 

Table 4: Long-term historical volatility

STANDARD DEVIATION (% p.a.) 1 Year 3 Year 5 Year 10 Year 20 year
Dynamic hedging 6.59% 10.04% 10.10% 11.85% 13.16%
50/50 6.59% 9.29% 8.78% 12.00% 12.45%
MSCI World ex Aust $A 9.03% 10.47% 10.37% 12.00% 12.46%
MSCI World ex Aust Hedged $A 5.18% 9.90% 9.26% 14.90% 14.62%

 

Table 5: Long-term historical Risk/Return (Sharpe Ratio)

SHARPE RATIO 1 Year 3 Year 5 Year 10 Year Since Inception
Dynamic Hedging 1.75 1.02 1.44 0.12 0.20
50/50 1.75 0.81 1.48 0.09 0.16
MSCI World ex Aust $A 0.96 0.90 1.35 0.03 0.09
MSCI World ex Aust Hedged $A 2.77 0.56 1.26 0.10 0.18

 

During this period, a change in the hedging ratio was enacted six times (see Chart 3), suggesting it wasn’t a highly active trading strategy. This is an important consideration, given there are costs associated with enacting any suggested changes and increased activity would make it more onerous to implement.

The study outlined above demonstrates that PPP can be used historically as a measure to implement a dynamic currency hedging policy that improves portfolio outcomes over the period of study. Given PPP is strongly grounded in economic theory, there’s reason to expect that it would continue to work in the future. It doesn’t require timing implementation perfectly and isn’t overly active. A caveat to the study results is that the policy doesn’t always improve returns and requires rigid adherence to the model for long-term success. The temptation for clients will always be to overlay qualitative judgement, particularly at times of underperformance.

Steven Tang is an invetment consultant with Zenith Investment Partners .He joined Zenith in June 2008 as an investment analyst in his first role in the financial services industry. Previously he worked in the retail pharmacy industry as a practicing pharmacist. Tang has extensive academic qualifications including a Bachelor of Pharmacy, Bachelor of Commerce, Graduate Diploma of Applied Finance and Investment and has successfully completed all three levels of the Chartered Financial Analyst (CFA) program. He has also completed both levels of the Chartered Alternative Investment Analyst (CAIA) program.
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